The US Federal Reserve Is Running Its First Climate Change Experiment. Will It Be Able To Follow Through With Next Steps?

Read Time:4 Minute, 41 Second

Ishani Srivastava

Edited by Alexandra Huggins

Last month, the Board of Governors of the U.S. Federal Reserve announced that six of the nation’s largest banks will be required to participate in a “climate scenario analysis” pilot exercise to assess their resilience to climate risk.

Climate risk manifests in two forms: physical risk (such as the loss of physical assets due to a storm or other extreme weather event) and transitional risk (such as changes in regulations, technology, consumer preferences, or market sentiments in the course of the transition from a high-carbon to a low-carbon economy).

The physical risk module of this exercise has banks map out how their real estate loan portfolios would be impacted by a severe hurricane in the Northeast as well as a second climate shock of their choosing in another part of the country. The transition risk module requires banks to analyze the ten-year impacts of two different “transition” scenarios on their real estate lending—one where fossil fuel use continues and the other where energy use is transitioned to zero-carbon by 2050.

Scenario analysis is one step behind standard regulatory stress tests, as it does not involve capital consequences for banks. Rather, it is exploratory in nature, meant simply to build an understanding of how climate-related financial risks could manifest.

Globally, a consensus is building: while governments are the primary actors, central banks cannot stand on the sidelines in the fight against climate change. The Network for Greening the Financial System, a group of central banks and regulators committed to environmental and climate risk management in the financial sector, was established six years ago with eight members and has now grown to 110 members and observers, including the International Monetary Fund. In fact, climate stress tests are already playing a growing role in bank supervision. The European Central Bank already conducted its climate risk assessment last year and intends to follow up with quantitative capital requirements, as experts expect that European banks will start to face climate-related capital requirements in the next two to three years. Regulators in Canada, China, Japan, Hong Kong, Taiwan, Australia, New Zealand, Brazil, Mexico, Peru, and Chile are all accelerating their climate risk assessments through stress tests, according to S&P Global Ratings research released in October.

On the other hand, the outlook in the United States is uncertain.

Some members of Congress, particularly Republicans, have urged the Federal Reserve to avoid climate policy. Federal Reserve Chair Jerome Powell has responded with assurances that the central bank has no plans to shape credit decisions or try to steer investment away from the fossil fuel industry, even while Federal Reserve officials are acknowledging that their responsibility for the stability of the financial sector requires preparation for climate risks. When the central bank published a broad set of guidelines for large banks on climate-risk mitigation, Federal Reserve Bank Governor Chris Waller dissented on the grounds that climate change doesn’t pose financial stability risks and that the regular stress tests already show banks are resilient.

In the face of opposition from conservative camps and a lack of consensus among its own senior leaders, it is highly unlikely that the Federal Reserve will be able to mandate full-fledged stress tests and capital reserve requirements for climate risk anytime soon.

As things stand, even the ongoing risk assessment exercise is severely watered down compared to global standards. It suffers from a few glaring omissions—banks are required to evaluate only their real estate loan portfolios while completely overlooking the performance of their trading books, investment banking portfolios, and commercial loan portfolios. “They should be covering 100% of every area where the biggest risks come from,” said Dennis Kelleher, President and CEO of Better Markets, a D.C.-based nonprofit that focuses on building a more secure financial system.

Climate change has crucial implications for price stability, which is the Federal Reserve’s primary mandate. It also affects its secondary mandates, in several ways, such as the overall stability of the financial system and supervision of banking.

First, the consequences of climate change might impair the transmission of monetary policy measures to households and firms. For instance, losses from physical risks or stranded assets could reduce the flow of credit to the real economy. The longer monetary policy continues to insufficiently address climate change, the greater the risks to policy transmission.

Second, climate change could diminish the space for conventional monetary policy by lowering the equilibrium real rate of interest, which balances savings and investment. For example, higher temperatures might impair labor productivity and productive resources might be reallocated to support adaptation, while climate-related uncertainty may increase caution and reduce incentives to invest. Collectively, these factors can reduce the real equilibrium interest rate and therefore increase the likelihood that a central bank’s policy rate will be constrained.

Third, climate change and policies to mitigate its effects can directly impact inflation dynamics. Recent history confirms that a greater incidence of physical risk can cause short-term fluctuations in output and inflation that amplify longer-term macroeconomic volatility.

Thus, the impacts of climate change affect all the core roles of the Federal Reserve – conducting monetary policy, regulating and supervising the banking system, and ensuring a safe and sound money economy. While central banks around the world are moving ahead with incorporating climate risk into their monetary policies, the U.S. Federal Reserve finds itself threading a desultory path, shackled by domestic objections. How well it will be able to do its job in the face of this domestic indecision remains to be seen.