The US Federal Reserve is running its very first climate change experiment.
The central bank this month announced details about how it will conduct a “pilot climate scenario analysis exercise” involving the six largest US banks: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.
The Fed basically wants major banks to game out how they’ll handle climate change-related shocks. For example, what would happen to their real estate holdings in the northeastern United States under a future hurricane when sea levels are higher? These scenarios are grouped together in the exercise as “physical risks.”
Then there are “transition risks”: How will financial institutions cope with a wholesale shift away from fossil fuels toward cleaner energy? What will happen to their investments in coal mines or gas plants? How will loans fare when customers turn away from businesses with a large impact on the climate?
These are immensely consequential questions, not just for the banks, but for everyone. How banks manage, or fail to manage, climate risks will affect things like home loans, business lending, retirement accounts, and insurance — things that will touch every sector of the economy. The Fed has set a deadline to receive these reports from banks by the beginning of August.
Given the extraordinarily expensive spate of climate-worsened disasters around the world in recent years and the far-reaching economic disruption of future warming, it makes sense that the US central bank would want financial institutions to figure out how this will affect them. In 2022, the US suffered 18 disasters where losses exceeded $1 billion.
“The Fed has narrow, but important, responsibilities regarding climate-related financial risks — to ensure that banks understand and manage their material risks, including the financial risks from climate change,” the Fed’s vice chair for supervision, Michael Barr, said in a statement last week.
Other arms of the government are also studying climate-related financial risks. In 2021, President Joe Biden issued an executive order directing federal agencies to tally up these threats and disclose them.
But the Fed’s core mission is to keep employment up and inflation down, and its main lever is setting interest rates, which doesn’t give it much space to do anything about the climate.
Earlier this month, Federal Reserve Chair Jerome Powell explicitly distanced the Fed’s activities from climate change. “We are not, and will not be, a ‘climate policymaker,’” he said at a conference in Sweden. The US dollar is also the world’s dominant reserve currency, so tiny changes in monetary policy in the US can ripple throughout the globe. Banks, governments, and journalists wait on tenterhooks for announcements from the Fed and carefully parse every word from Powell like he’s a cryptic oracle of the economy. As a result, the Fed is extremely cautious about what it says and does. The Fed declined to comment on the record.
So how will the Fed use the results of this climate scenario analysis? It probably won’t serve as a tool to inform monetary policy, but it could serve as a signal to banks that their climate change risks may be greater than they realized and that they should start preparing now.
How to run a climate experiment on a bank
The Fed is careful to note that its climate scenario analysis is different from a stress test. In Fed-speak, a stress test measures whether a bank has enough money to meet its obligations during difficult economic times. The Fed can then use the results to set new rules or adjust its policies.
The climate scenario analysis, by contrast, is more of a storytelling exercise. One pathway imagines a world in which there are basically no new climate policies between now and 2050, allowing current economic trends to continue. The other chalks out a pathway to net-zero greenhouse gas emissions by the middle of the century. The Fed is building on climate models developed by the Intergovernmental Panel on Climate Change (IPCC) and financial models from the Network of Central Banks and Supervisors for Greening the Financial System (NGFS).
In both of these worlds, banks will then have to figure out how their loan portfolios would respond to the aforementioned physical and transitional risks.
This is a new type of analysis for the Fed, and it’s one of the most complicated: Take all the complexity of sea level rise, melting ice, feedback scenarios, and extreme weather and marry that to the intricacies of the business cycles, consumer confidence, real estate trends, and innovation. From there, figure out whether your bank will have enough money to cover its losses and lend to customers whether the world does or doesn’t get its act together on climate change.
It’s a lot to process, and not every variable will be captured, so one of the key goals with this exercise is simply to figure out what it would take to run a better version of this analysis in the future.
“This is a pilot program so learning is really the purpose of the program,” said Jiro Yoshida, a professor of business at Pennsylvania State University, who studies macroeconomics, risk, and climate change.
The Fed says climate change is outside its wheelhouse. Activists and economists say it could do a lot more.
Though the Fed is the most important central bank in the global economy, it’s a latecomer to this type of exercise. Other central banks, including the Bank of England and the Bank of Japan, have already done their own climate studies. The European Central Bank did run actual stress tests.
Part of the difficulty for US monetary policy is that the Fed is more limited in its remit than other central banks. “I see an analogy between Western medicine and Japanese medicine,” said Yoshida. “Western medicine targets specific symptoms, like aspirin for fever and pain. Japanese medicine is more of a combination of many ingredients that handle many symptoms at the same time.”
The Bank of Japan, for instance, is coming up with tools to reward banks that are better equipped to deal with climate chaos and spur those that aren’t. It’s explicitly working with policymakers and local governments to help mitigate these risks. The Fed, on the other hand, prides itself on its independence from politics and siloes monetary policy from fiscal policy, leaving the latter to lawmakers. Environmental activists have called on the Fed to explicitly factor climate change into its decision-making, but the central bank has been resistant.
“We should ‘stick to our knitting’ and not wander off to pursue perceived social benefits that are not tightly linked to our statutory goals and authorities,” Powell said earlier this month. “Taking on new goals, however worthy, without a clear statutory mandate would undermine the case for our independence.”
Yoshida said it’s not clear which approach is better to deal with the financial impacts of climate change, but either could theoretically work to reduce risks if they’re well-informed.
A climate scenario analysis could help inform these policies, but the Fed’s current version has some key limitations. It examines banks individually rather than assessing interrelated risks. A major flood could inundate thousands of homes, for example, leading to massive losses and cash shortages at multiple banks at the same time. Unable to borrow money from each other, the banks would have to turn to the Fed. Some economists have warned that the concurrent effects of climate change could trigger the next major financial crisis.
“How much will you learn about risk management practices and challenges if you aren’t capturing risks very well?” said Anne Perrault, climate finance policy counsel at Public Citizen.
The worry is that a positive result from an incomplete test could give a bank or regulators a false sense of security. The Fed should emphasize that there is a great deal of uncertainty around these risks and that banks should err on the side of caution, according to Perrault.
For its part, the Fed did acknowledge that the experiment isn’t comprehensive. “These issues challenge existing risk-management and supervisory approaches and result in a high degree of uncertainty around the potential implications of climate risk drivers for large banking organizations,” according to the climate scenario analysis.
But the fact that the Fed is looking at this tells all financial institutions, not just the six studied in this analysis, that they can’t ignore the effects of climate change on their operations.
“It’s a start. It’s putting banks on notice the Fed cares about financial risk,” Perrault said. “The problem is how people will perceive it.”