The Federal Reserve, a latecomer to the climate debate relative to other central banks, is starting to think more carefully about how to incorporate the various threats from climate change into their analysis of the financial system.
Fed Governor Lael Brainard, a pioneer in this area, offered some basic guidance on how the central bank is considering taking on efforts, strongly opposed by the financial industry, to take climate risks into account when assessing possible sources of volatility.
Brainard said the total cost of U.S. weather and climate disasters over the last five years is $630 billion, a record for such a period. This includes billions in damages to farms, homes and businesses, she said, with 2020 marking a sixth straight year seeing ten or more billion-dollar weather and climate events.
“We can already see the growing costs associated with the increasing frequency and severity of climate-related events,” she told a Boston Fed conference.
“Several foreign regulators have already undertaken climate scenario analysis, affording us the opportunity to learn from their experiences. It will be helpful to move ahead with the first generation of climate scenario analysis to identify risks and potential issues and to inform subsequent refinements to our models and data.”
Brainard cited the Sixth Assessment Report by the Intergovernmental Panel on Climate Change, which warned of a surge in climate events and their intensity, as well as the Covid-19 pandemic, as reminders that “extreme events can materialize with little warning and trigger severe financial losses and market disruptions.
“It will be important to systematically assess the resilience of large financial institutions and the broader financial system to climate-related risk scenarios.”
So how would the process actually work? Brainard proposes using the existing bank stress test framework as a template for thinking about how to get started. Greater transparency on the part of banks as to their risks of not only direct risk to climate shocks but also potential pitfalls from the costs of energy transition will be key.
She noted the earliest stress tests, developed after the financial meltdown of 2008, proved successful at restoring confidence and boosting bank capital despite what she described as simple models with limited data.
“The stress test infrastructure and granular models and data that are currently available bear little resemblance to that first stress test,” she said.
“So what are the lessons for scenario analysis? Starting down the path of climate scenario analysis, even with a rudimentary first attempt, will help with risk identification and suggest useful lessons to inform subsequent improvements in modeling, data, and financial disclosures,” Brainard said.
“Although we should be humble about what the first generation of climate scenario analysis is likely to deliver, the challenges we face should not deter us from building the foundations now.”