By Richard Chevalier, FCIA; Maxime L. Delisle, FCIA; and Vincent Carrier-Côté, ACIA
There is no doubt that actuaries are aware of the risks posed by climate change. After all, it has topped the list of emerging risks for many years now. Therefore, it should be no surprise that climate change has also caught the attention of the public and regulators. Actuaries and other professionals will be increasingly expected to incorporate climate change considerations into their work.
Of course, this is easier said than done. The effects of climate change are far reaching and clouded with uncertainty. Considering its effects in day-to-day actuarial practice remains a challenge. But like the saying goes: “There is only one way to eat an elephant: a bite at a time.” In this spirit, the Climate Change and Sustainability Practice Committee is pleased to issue this series of articles devoted to climate change in actuarial work and climate change research. The objective of this series is to:
- share climate research that might be directly or indirectly relevant to actuarial practice; and
- share insights and ask interesting questions in order to spark thinking and discussion among the actuarial community.
Introduction
With the release of the Office of the Superintendent of Financial Institutions’ (OSFI) “Standardized Climate Scenario Exercise – Draft for consultation” (SCSE) in October 2023 and its Guideline B-15 “Climate Risk Management” earlier that year, climate-related scenarios are increasingly becoming an area of focus for federally regulated financial institutions.
While the response to these new regulatory requirements will demand multi-disciplinary collaboration, actuaries are likely to play an important role in many institutions, most notably with the assessment of the financial impact of physical risks on insurance liabilities. Since the amount of literature covering this complex and rapidly evolving topic is overwhelming, we have decided for this inaugural article to spotlight materials from the CIA’s climate resource page that would be most useful to Canadian actuaries who are beginning this journey. We encourage a review of the three papers described below as they provide fundamental climate-related scenario concepts.
1. “Introduction to Climate-Related Scenarios” by the International Actuarial Association (IAA)
In September 2020, the IAA started publishing a series of papers to encourage understanding and debate of climate-related risks and opportunities. While these papers do not set forth actuarial standards of practice, they provide useful information for actuaries wishing to quickly get a basic understanding of climate-related scenarios.
“Introduction to Climate-Related Scenarios” breaks down the topic in one of the clearest and most comprehensive ways that we have encountered in literature. It defines climate-related scenarios as being comprised of four integrated components: socioeconomic context, climate policy landscape, technological evolution and emissions pathways. The paper stresses that the interaction between these components should obey strong logic and could create complex ripple effects and tipping points. It explains that once a scenario’s socioeconomic, regulatory, technological and energy factors have been defined, they are then translated into impacts on the macroeconomic, financial and insurance variables that can be used in actuarial modelling.
In practice, Canadian actuaries commonly use “climate-related scenarios” to describe a wide range of activities of varying sophistication, such as stress-testing insurance variables most likely to be affected by climate change, without a clear link to socioeconomic, regulatory, technological and energy factors. Few, if any, have performed the types of fully integrated scenarios envisaged in this IAA paper, let alone assessed the impact of complex climate tipping points on their clients’ future financial condition.
2. “Using Scenario Analysis to Assess Climate Transition Risk” by the Bank of Canada and OSFI
This report was jointly published in 2022 as a result of the Bank of Canada-OSFI Climate Scenario Analysis Pilot. The pilot served as the foundation for the scenarios that underpin OSFI’s recent draft SCSE and was conducted in collaboration with six Canadian financial institutions, including two banks, two life insurers and two property and casualty insurers.
The report focuses on the use of climate-related scenario analysis to assess transition risks (those that arise from transitioning to a lower-carbon economy), which are particularly important for life and health (re)insurers and pension funds due to the significant assets held by these entities to back their long-dated liabilities.
The report lays out three plausible and intentionally adverse global climate transition scenarios that are consistent with commitments to limit global warming to below 2°C, as well as a baseline scenario consistent with global climate policies in place at the end of 2019:
- baseline (2019 policies)
- below 2°C immediate
- below 2°C delayed
- net-zero 2050 (1.5°C)
The scenarios describe pathways with various degrees of ambition and timing of climate policy and pace of technological change and consider sectoral-level financial impacts to the economy. They are well-aligned with the scenarios developed by the Network for Greening the Financial System – a common source for climate-related scenarios around the world. They were developed using general equilibrium models,[1] which are common in climate risk modelling today, despite certain limitations.
The transition scenarios capture the additional climate policy that may be required beyond the baseline (current) policies to meet the emissions targets in each scenario through a “shadow price of carbon.” The mechanism by which this carbon price helps meet those targets is by making emissions-intensive energy commodities more expensive to consume, and this higher cost acts like a negative demand shock for these commodities, pushing down the prices producers receive. Outputs from the scenarios are then mapped into risk factor pathways at the sectoral level, such as direct emissions costs, indirect costs, capital expenditures and revenues. These are further assumed to vary across geographies (i.e., Canada vs. the United States). The linkage between the energy-economy model and the Bank of Canada’s macroeconomic models produces the macroeconomic impacts to variables like GDP and inflation under each scenario.
The scenarios are described in detail in an accompanying Bank of Canada staff discussion paper, and the climate transition scenario data developed for this exercise is also available.
In the pilot, the financial institutions used a mix of top-down and bottom-up approaches to assess the magnitude of credit risks, and a top-down approach to assess market risks, on their asset portfolios using this set of climate transition scenarios. The insurers analyzed the credit risk to their bonds and corporate loans portfolios and market risk to their equity portfolio. The analysis used the simplifying assumption of a static balance sheet due to the added complexity of a more sophisticated dynamic balance sheet approach.
A few takeaways from the report include the following:
- Scenario analysis lends itself well to the assessment of climate transition risks due to these risks’ long-time horizon and high uncertainty about policy, technology and socio-economic developments.
- Scenario analysis is not meant to be a forecast but rather is a form of “what if” analysis.
- Transition risks are material to the Canadian economy due to the country’s carbon-intensive commodities and its unique needs for heating and transportation. In particular, the macroeconomic impacts from the transition are expected to be more costly for commodity-exporting countries like Canada.
- Delaying climate policy action, as in the “below 2°C delayed” scenario, increases the overall economic impacts and risks to financial stability.
We note that the report dives into other topics in considerable detail, such as the methodology used to assess credit and market risks along each scenario in the pilot exercise, as well as an overview of governance and risk management practices at participating institutions. We leave these details for the reader to explore.
3. “Climate scenario analysis for pension schemes” by the Institute and Faculty of Actuaries (IFoA)
Although the financial entity in focus in this paper is pension plans, actuaries starting their SCSE journey will find it useful to develop their understanding of the various underlying risk drivers of asset returns. The analysis focuses on the evolution of the financial state of a fictitious pension plan under three different climate pathways. The climate-related scenario analysis framework used in this paper is the following:
- Define “climate pathway narratives.”
- Articulate the impact of the narratives on a set of financial and economic variables.
- Evaluate how the financial state of the entity changes as a function of these variables.
The climate pathways in the study (Paris Orderly Transition, Paris Disorderly Transition and Failed Transition) are defined relative to a climate-uninformed baseline. This is slightly different from the framework envisioned by OSFI for its SCSE, where the baseline would reflect global climate policies currently in place.
Like most other climate-related scenario exercises in use presently, a large emphasis is placed on assets. The paper walks through the economic scenarios developed by Ortec Finance, which translate climate narratives into economic and financial variables. Asset class returns and interest rates are projected, which allows the determination of the financial state of the plan through the projected period. The stochastic nature of the exercise allows for the effect of market volatility (e.g., in the Paris Disorderly Transition scenario) to be captured in the results.
One of the key messages of this IFoA study is that the pension scheme featured is likely to be in a more precarious financial state in the three climate-aware scenarios presented compared to the climate-uninformed baseline. This conclusion should motivate engagement between stakeholders on investment strategies, plan sponsor resiliency to climate change and funding strategies. A very valuable aspect of the paper is its transparency on the evolving state of climate-related scenario analysis. Although the paper was published in 2020, we believe that many modelling challenges identified (difficulty in modelling tipping points, market volatility in response to climate change, long horizon…) are still relevant today.
Closing thoughts
Up to now, climate-related exercises, like OSFI’s SCSE or Task Force on Climate-related Financial Disclosures reporting, have been focused on risk exposure and disclosure as opposed to risk sizing. Reflecting on the three papers presented, current actuarial practice and emerging regulations, it seems clear that climate-related scenario modelling is poised to evolve in the coming years. To facilitate this evolution as a profession, we need to take the following steps:
- Find a common framework to effectively discuss climate-related scenarios between ourselves and with our clients, including data and modelling limitations, materiality assessments and projection timeframes.
- Support the development, improvement and availability of climate-related data.
- Work with other professionals to develop scenarios that are appropriate to their clients’ circumstances.
- Act now – Canadian financial institutions are in the early stages of building climate-related risk assessment capabilities for transition risks. Initiatives such as the Bank of Canada-OSFI Climate Scenario Analysis Pilot were conducted with large institutions; smaller organizations are likely to be even less further along on this journey and may face a steep learning curve when completing the SCSE for the first time.
As natural critical thinkers who understand model limitations, actuaries not only have a role to play in shaping the evolution of climate-related exercises, but also in turning the results from such exercises into concrete action. Share your thoughts on how we can navigate the climate frontier in the comments below.
This article reflects the opinion of the authors and does not represent an official statement of the CIA.
[1] Specifically, the scenarios were developed by linking a computable general equilibrium energy-economy model with two Bank of Canada dynamic stochastic general equilibrium macroeconomic models, and the sectoral-level scenarios were developed by working closely with the Massachusetts Institute of Technology and its Emissions, Prediction and Policy Analysis model.
