Understanding the Systemic Implications of Climate Transition Risk

Applying a Framework Using Canadian Financial System Data

April 22, 2024Published by Bank of Canada

Investment funds may trigger and promote the spread of a stressful climate transition shock and increase market volatility in a fire-sale environment, according to this Bank of Canada staff paper. However, pension funds have long-term investment horizons and diverse investment strategies that may allow them to play a role as shock absorbers, say the authors.

The paper examines the interconnections within the Canadian financial system, such as common exposures and business similarities, and concludes that these connections can amplify climate transition risks.

The research makes a significant contribution to standardising systemic climate risk assessment, say authors Gabriel Bruneau, Javier Ojea Ferreiro, Andrew Plummer, Marie-Christine Tremblay and Aidan Witts.

However, they note the study is subject to various limitations. The assumption of static balance sheets, the exclusion of macroeconomic feedback loops, and a lack of analysis on concurrent shocks mean the extent of risk may be an underestimate.

The paper examines the credit, market and liquidity risks of climate transition shock scenarios on the assets and derivative portfolios of four distinct financial entities: deposit-taking institutions, insurance companies, pension funds and investment funds.

The paper puts forward a methodological framework to capture both the direct and indirect systemic effects of climate transition shocks in Canada. It leverages climate transition scenarios developed by the Bank of Canada and Office of the Superintendent of Financial Institutions to assess direct effects, and extends an agent-based model to explore systemic transmission channels.

The results show liquidity ratios decline for all entities, with investment funds experiencing the largest drops, highlighting their vulnerability to the climate transition shock.

Whereas credit quality of climate-vulnerable assets generally deteriorates, climate-positive assets in sectors that benefit from the transition see an improvement in credit quality.

Overall, the direct effects of the transition are relatively “mild”, but the results show these effects are likely to be amplified by systemic risks. The authors find fire sales can have a particularly significant amplifying effect.

Investment funds are the most vulnerable of the entities examined to the direct and systemic impacts of a climate transition shock. This is largely attributed to their short-term investment horizons and susceptibility to redemption shocks.

Their limited exposure to sectors that will benefit from the transition, as well as the likelihood of equity market losses and liquidity pressures, make investment funds a key transmission channel for climate risks across the financial system, according to the authors.

In contrast, the long-term horizons and diverse strategies of pension funds may allow them to act as stabilising buyers for undervalued assets during the transition, despite being relatively more exposed to direct credit and market risks.

Deposit-taking institutions face greater direct credit and market risks, but their diversification and liquidity help mitigate overall impacts, even as systemic effects from other entities, especially investment funds, amplify their direct exposures.

Life insurance company assets are less impacted, owing to their diversified portfolios, lower risk-taking, and limited climate-relevant equity exposure. However, since the study does not consider the liabilities side of balance sheets, concurrent shocks or macroeconomic feedback loops, these findings should be interpreted with caution.

This page was last updated April 22, 2024

Share this article