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Over the next couple of years, the big Canadian banks will face increasing climate-related regulation, including tougher disclosure demands, stress tests and possibly climate-driven capital requirements, says Fitch Ratings.

In a new report, the rating agency said that it expects policymakers in Canada to establish climate-related regulation for banks on several fronts over the next two to three years, following recent efforts by both the Office of the Superintendent of Financial Institutions (OSFI) and the Bank of Canada to understand the risks of climate change in the banking sector.

This year, OSFI carried out a consultation on assessing climate-related risks at federally regulated financial firms and pension plans. The regulator also joined Canada’s central bank in a pilot project to examine the use of climate-risk scenarios developed by a handful of banks and insurers.

Taken together, these efforts are expected to form the basis for regular climate-related stress tests, Fitch said. And, OSFI has signalled that it expects climate-risk disclosure requirements to ramp up beyond the voluntary disclosures they currently provide.

“Over the medium term, therefore, Fitch expects greater standardization of disclosures around climate risk, and comparability of performance under stress, supporting greater transparency and systemic stability,” the rating agency said.

Today, OSFI published a report on the feedback that it received on its consultation, and said that it plans to set out its next steps in climate-driven bank regulation in early 2022.

The regulator reported that there was support for its focus on climate-related risks, but that financial institutions and pension plans are still in the “early stages” when it comes to “assessing and quantifying these risks.”

“There was general agreement that any new OSFI climate-related guidance be principles-based and aligned with global standards where they exist, while considering the Canadian context,” OSFI said, adding that any guidance will also be informed by results of its pilot project with the Bank of Canada.

The findings of that project will be reported later this year, OSFI added.

Fitch said that this enhanced focus on climate-related risks in the Canadian financial sector “should improve the scope and transparency of data, corporate governance and enhance the stability of the banking system.”

The banks are likely to be exposed to a transition to a low-carbon economy through their financing of the energy sector, agriculture, manufacturing and utilities, Fitch noted.

“The scale or scope of emissions from these sectors is not disclosed, but taken together, positions vulnerable to a green economy transition are likely sizeable,” the rating agency said.

Additionally, Fitch’s report noted that the potential for unaccounted climate risk “is also present in residential real estate, the largest share of banks’ loan books at nearly 47% on average as of July 2021.”

“Although generally tightly underwritten, location specific vulnerabilities to natural disasters or un-insurability, as well as higher heating and retrofitting costs, could erode collateral values or household debt capacity,” the rating agency said. “Higher regulatory requirements around disclosure and standards around risk management will likely clarify the materiality of these and other vulnerabilities.”