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US Federal Reserve Board (Fed) Governor Lael Brainard said the
central bank is developing "scenario analysis" to assess the
possible risks associated with climate change to the resiliency of
individual financial institutions and the financial system as a
whole.
Speaking at the 2021 Federal Reserve Stress Testing Research
Conference on 7 October, Brainard said scenario analysis is
emerging as the "best tool" to assess climate risk as economic
analysis suggests climate change could have "profound consequences"
for the level, trend growth, and variability of economic activity
over time and across regions and sectors.
"It is important to model the transition risks arising from
changes in policies, technology, and consumer and investor behavior
and the physical risks of damages caused by an increase in the
frequency and severity of climate-related events as well as chronic
changes, such as rising temperatures and sea levels," Brainard told
the Federal Reserve Bank of Boston-hosted event.
Brainard's remarks serve to underscore the steps the
Fed is taking to include climate change into its framework for
assessing the financial stability of the banks it oversees.
A week earlier, the staff at the Federal Reserve Bank of New
York—one of the 12 regional reserve banks that constitute the
Fed—released a report that for the
first time quantified the impact that indirect climate effects pose
to the banking sector. The report examined the impact on banks with
sizeable loans to the oil and natural gas sector by using a stress
test approach that was developed in response to the 2008 global
subprime mortgage crisis.
Taking a cue from other banks
The Fed's Supervision Climate Committee is engaging with
stakeholders to assess the resilience of financial institutions,
and Brainard said it might be helpful if the Fed were to provide
supervisory guidance for large banking institutions to
appropriately measure, monitor, and manage material climate-related
risks, following the lead of a number of other regulators, such as
the European Central Bank (ECB) and the Bank of England.
Likewise, the Fed's Financial Stability Climate Committee is
assessing the effects of climate-related risks across the financial
system, including banks, markets, investors, and insurers.
Although the view that fighting climate change falls within
central banks' remit is far from unanimous, IHS Markit Economics
Associate Director Diego Iscaro told Net-Zero Business Daily there
is an increasing consensus in favor of central bank
intervention.
"Indeed, the Fed would be following other major central banks in
Europe, including the ECB and the Bank of England, which have
already incorporated climate-related risks into their toolkit," he
added.
The ECB tested the impact of climate change on more than 4
million firms worldwide and 1,600 banks that are domiciled in the
Eurozone under three different climate policy scenarios. It concluded 22 September that
firms and banks clearly benefit from adopting green policies early
on to foster the transition to a zero-carbon economy. The exercise
also revealed that the impact of climate risk is concentrated in
certain regions and sectors of the euro area.
In 2022, the ECB will apply the results from this test to banks
that it directly supervises as well as its own balance sheet.
Challenges of modeling climate risk
Brainard acknowledged the challenges of modeling climate risk
scenarios, such as having to consider "plausible but novel
combinations of risks" that are associated with substantial
uncertainty.
These include the cumulative yet varying impacts of climate
change on regional and economic sector impacts as well as
interdependencies on other financial institutions, namely
insurers.
With climate risk raising insurance premiums charged to property
owners or reducing the availability of insurance in certain regions
as well as for certain asset classes, Brainard said it may be
important to assess the resilience of insurance and other hedging
strategies plus the associated implications for supervised
institutions.
While Brainard did not mention it, the US Department of the
Treasury already is
eyeing how insurers weigh risk, according to a notice it issued
on 31 August.
"Stress could be transmitted through a sudden repricing of
insurance contracts or by a withdrawal of coverage, as we are
already seeing in the case of wildfires and flooding in certain
areas," she said.
Regional, sector variation
Brainard also noted that the standard models for projecting net
revenues at financial institutions, though able to project losses
on asset accounts on a regional and sectoral basis, are unable to
capture what she considers "the potential intensification of
climate-related risks."
Noting the increase in the frequency and severity of climate
disasters, she cited US National Oceanic and Atmospheric
Administration (NOAA) estimates that the US has incurred
approximately $630.2 billion in climate-fueled events between 2016
and 2020 alone.
As of 9 July, NOAA reported there had been eight
weather and climate disaster events in the US with losses exceeding
$1 billion each so far in 2021. This does not include the impact of
recent wildfires or Hurricane Ida.
The consequences of climate change are likely to be highly
differentiated by region and economic sector, which has important
implications for scenario analysis, she said, as "[c]limate-related
risks can be expected to have direct effects not only on the
valuation of assets on the balance sheets of financial
institutions, but also on revenues and costs."
Brainard cautioned against extrapolating climate risk from past
sporadic extreme weather events because evidence is showing that
climate change is an ongoing, cumulative process that could
significantly increase the prevalence and severity of extreme
events as well as contributing to chronic changes.
"These cumulative and chronic changes could have economic
effects that differ substantively from the historic experience, for
example, if they contribute to shifts in the location of economic
activity or the sectoral composition within a region," she
added.
To get a complete picture of climate risks, banks and the Fed
need to fill up the data gaps that will come from climate-related
risk disclosures by companies, Brainard said. She acknowledged that
current voluntary climate-related disclosures are an important
first step in closing data gaps, but said they are prone to
inconsistent quality and incompleteness.
"Consistent, comparable, and, ultimately, mandatory disclosures
are likely to be vital to enable market participants to measure,
monitor, and manage climate risks on a consistent basis across
firms," Brainard said, nodding to the US Securities and Exchange
Commission, which is
writing a mandatory climate reporting proposal.
Reacting to Brainard's speech, Steven Rothstein, managing
director of the Ceres Accelerator for Sustainable Capital Markets,
said her words shows "sign of leadership and a thoughtful
approach."
"This is a big step that the Fed is developing scenario analysis
for climate stress tests, but it would be even bigger if the Board
of Governors were to adopt it," he added.
As reports by Ceres indicate, "we believe there is more risk
today on the balance sheets of banks than the entire risk posed by
the global climate crisis in 2008 and 2009," he added.
A Ceres report released in September
analyzing $2.2 trillion of exposure for syndicated loans found the
physical risk to major US banks could amount to more than $250
billion annually.
Posted 07 October 2021 by Amena Saiyid, Senior Climate and Energy Research Analyst