US Fed’s Brainard says “scenario analysis” emerging as best tool to assess climate risk at banks

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