Canada’s new pricing model means financial lenders must now consider carbon emissions as part of their credit risk assessment

By putting a price on the cost of carbon, the Government of Canada aims to curtail greenhouse gas (GHG) emissions, but it comes with an increased risk for financial lenders and borrowers with high carbon emissions. 

In a first-of-its-kind study, University of Waterloo researchers analysed the effects of Canada’s carbon price regime on the economy.

The results indicate that as carbon costs rise, high-emitting carbon industries such as mining and energy are at the greatest risk of default, with total assets of CAN $256bn (~£153bn) at risk of being lost and almost a quarter of the Canadian GDP exposed to climate risk.

The study exposes the grave uncertainty facing the Canadian economy and the value for financial lenders and regulators to assess carbon emissions and carbon price scenarios as part of the credit risk assessment procedure. 

Adeboye Oyegunle, PhD candidate in the School of Environment, Enterprise and Development, said: “Canadian banks are deeply involved in lending to carbon-intensive clients and have increased lending to those companies by billions of dollars despite their public commitments to support global climate goals.

“If we are not proactive, these investments could create increased costs, default rates and bad debt when you put these investments into context of the changing market and new government regulations.”



Carbon price regime


Using Toronto Stock Exchange data between 2010 and 2020 as a sample, the researchers applied the Canadian Government’s carbon price regime of $0 to $170 to analyse variables for predicting bankruptcy until 2030.

While the results show that high-emitting carbon borrowers and banks are at the greatest risk, their loss could gravely affect the rest of the economy and affordability within Canada, as companies tend to pass on increased costs to consumers, leading to increased prices that will further stretch the finances of the average Canadian.

The researchers propose that lenders should start or continue to consider a real and a shadow carbon price in their credit risk assessments.

This practice will enable them to analyse carbon-related credit risks accurately and set an appropriate interest rate for loans.

In addition, central banks and other financial sector supervisors should start introducing indicators that measure the financial sector’s exposure to climate-related credit risks to be able to assess climate-related risks to the financial industry appropriately. 

Olaf Weber, professor in the School of Environment, Enterprise and Development, said: “Implementing a carbon price is a first step, but not the last one if we are to achieve an orderly transition to a low-carbon economy with minimal disruption to credit.

“For Canada, we must analyse the financial consequences, develop risk assessment tools and indicators, and accelerate the transition to a low carbon economy.” 

The study, Carbon Costs and Credit Risk in a Resource-Based Economy: Carbon Cost Impact on the Z-Score of Canadian TSX 260 Companies, appears in the Journal of Management and Sustainability. 

Image: Dennis Jarvis from Halifax, Canada, (CC BY-SA 2.0), via Wikimedia Commons.

Research Aether / Earth Uncovered