In mid-July, investors representing nearly $1 trillion in assets joined with a bipartisan group of former legislators, regulatory agency heads, investors and other leaders to call on the Federal Reserve and other financial regulators to address and act on climate change as a systemic risk.
They wrote: "We call on you to immediately consider whether decisions being made right now could inadvertently exacerbate the climate crisis. Additionally, we ask you to implement a broader range of actions to explicitly integrate climate change across your mandates. Such actions are needed to protect the economy from any further disruptive shocks."
The ongoing response to the COVID-19 pandemic has underscored the critical importance of financial regulators — particularly the Fed — in keeping the economy stable and resilient in the face of systemic disruptions. Yet, as the Fed has pumped trillions of dollars into keeping our markets afloat through efforts like the Main Street Lending Program and by broadening the tent of corporate bond purchases, there are growing questions about the climate impacts of these decisions and the embedded financial risks that they expose our markets to.
For instance, the Fed appears to be on track to purchase $19 billion in corporate bonds from the fossil-fuel sector — assets that have underperformed the market for years and have plummeted in value more recently. A range of congressional leaders, former regulators and others have also called into question the expansion of the Main Street Lending Program to allow support for the oil sector, which was in decline even before the pandemic.
This focus on the role of financial regulators in addressing climate change comes on the heels of mounting evidence of the physical and transition risks climate change brings. Much of the country remains in the grips of a punishing heat wave that is breaking high temperature records and alarming scientists. This warmth has spread to the Arctic, precipitating increased sea ice loss. Historic rainfalls and floods pummeled states from Georgia to Michigan this spring, forcing both to declare states of emergency.
Companies like BP and Shell have written down their asset values by billions of dollars as they consider the pandemic's impacts, their exposure to climate risk, a potential peak in demand and stranded assets in their portfolio. Some analysts have even proclaimed that the carbon bubble has already burst.
So what action should the Fed take? A report by Ceres finds that, given climate change's potential to destabilize markets, it belongs on the Fed's agenda — laying out a series of action steps that the central bank can take to address climate change across its mandate.
As a first step, the report recommends the Fed affirm that climate poses a systemic threat to the stability of financial markets, and lay the groundwork to research its impacts on U.S. financial markets. Regional banks can jump-start this process by building awareness of regional climate vulnerabilities, and by conducting meetings and research on the economic impacts in their jurisdictions. Over the past year, regional Federal Reserve banks in San Francisco, Dallas and New York outlined potential financial losses, economic disruption and slowing productivity in their communities. The Federal Reserve Bank of St. Louis estimated a potential 5% to 10% loss in GDP in its region as a result of climate change.
The Fed can also integrate climate change into its systems for supervising large financial institutions, ensuring they mitigate against climate change and the inevitable market and regulatory adjustments that come with it. This includes conducting climate stress tests on these institutions and defining robust scenarios, time horizons and modeling approaches to help the Fed understand and define activities that make climate change worse.
A number of central banks globally, including England, France, Australia and others have announced such climate stress tests. The recently concluded stress tests, which folded in scenarios related to the COVID-19 pandemic, provide a template that the Fed can use to integrate the science (in this case on the pandemic's spread) with forecasts on the impacts on financial markets.
The Fed should also take the impacts of climate change into account in setting monetary policy, considering the climate-related impact of its ongoing efforts to infuse more liquidity into the economy. Specifically, it should link any support for the oil and gas sector with repayment criteria linked to climate risk management and disclosure. The Canadian government recently linked its support of large companies receiving stimulus relief with a requirement for climate change disclosure.
Finally, the Fed should explore how bank community investment efforts can integrate climate adaptation efforts to bolster the resilience of low-income communities, which are disproportionately affected by climate change impacts.
And the Fed shouldn't do this work in a vacuum. It can spearhead a collective action plan with other federal and state financial regulators to address the crisis with its global peers. A good place to start is for U.S. regulators to join the global Network for Greening the Financial System, currently composed of 66 global members. Nationally, the Fed can take the lead in helping coordinate with other financial regulators, for instance as a part of its role in the Financial Stability Oversight Council.
The role of the Fed in maintaining financial stability in the face of global systemic risks has never been clearer. It is time for the agency to take up the mantle on climate change.
Veena Ramani is senior program director, capital market systems, at Ceres, based in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.