Co-authored with Richard Berner, NYU Stern Clinical Professor of Finance and Co-Director, Volatility and Risk Institute.
“[F]or the first time, FSOC is recognizing that climate change is an emerging and increasing threat to U.S. financial stability.” Remarks by Treasury Secretary Janet L. Yellen, FSOC meeting, October 21, 2021.
Many sources of risk threaten the U.S. financial system. Pandemic risk and cyber risk are at or near the top of our list of nightmares. Yet, with the UN Climate Change conference (COP26) under way in Glasgow, attention is shifting to efforts aimed at limiting the economic and financial damage from climate change, including a timely new “Report on Climate-related Financial Risk” from the U.S. Financial Stability Oversight Council (FSOC).
As the Report makes clear, U.S. policymakers need a far better understanding of climate-related financial risk. Indeed, when President Biden issued an executive order in May instructing financial regulators to conduct a thorough risk assessment, the United States already was behind other advanced economies. As an initial response to the President’s directive, the Report catalogs the range of climate risk threats, describes actions individual U.S. regulators have begun taking to address them, and lists many things that still need to be done. By setting priorities, the FSOC is now putting climate change “squarely at the forefront of the agenda of its member agencies.”
In this post, we highlight three themes in the Report: (1) the ongoing rise of physical climate risk; (2) the conceptual challenges associated with measurement, as well as the data gaps; and (3) the benefits of scenario analysis as a tool for assessing the financial stability risks arising from climate change.
The key lesson that we draw from scenario analysis is that a financial system resilient to a range of other shocks is more likely to be resilient against climate risk. Put differently, a less-resilient financial system is vulnerable to all types of shocks, including those arising from climate change.
FSOC Report. The Report focuses properly on what FSOC is supposed to do: preserve financial stability. In outlining the framework for building resilience to climate-related shocks, it wisely avoids proposals that would usurp Congressional authority to reduce the carbon intensity of the economy or shift the composition of energy production—policies that U.S. fiscal authorities can implement using taxes or subsidies. In this sense, it is consistent with the view expressed in the new Climate Change Adaptation Report of the U.K. Prudential Regulatory Authority (PRA) that regulatory tools are a means to address the “consequences (financial risks),” not the underlying sources of climate risk itself. As a result, the FSOC Report will almost surely disappoint some environmental advocates who have called for regulators to both set “portfolio limits on financed [fossil fuel] emissions” and actively promote “investment in equitable green finance.”
We note that the FSOC Report is not the first U.S. government analysis to highlight climate-related threats to financial stability. For example, the Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee’s 2020 report entitled Managing Climate Risk in the U.S. Financial System recommends that FSOC “incorporate climate-related financial risks into its existing oversight function, including its annual reports and other reporting to Congress.” But the FSOC Report is the first to represent the views of most federal financial regulators (see the opening citation from Secretary Yellen). While we welcome the clarity and detail in the Report, we note that it comes more than six years after the U.K. PRA’s initial examination of the financial stability risks arising from climate change (see here).
Moreover, because the FSOC itself lacks the authority to mandate action, the Report is primarily an appeal for its members to build regulatory expertise, fill data gaps, and develop risk assessment and monitoring tools. All of these are essential, but late in coming. Not only that, but the FSOC’s call to action is merely advisory: the Report’s most aggressive proposals—to form two committees to help coordinate actions among the many agencies constituting the balkanized U.S. regulatory framework—are mere stage setters for regulation and supervision to come.
From our perspective, the lagging response leaves the U.S. financial system unprepared for a range of near-term risks. The current most likely source of fragility that we see is a sudden widespread repricing like the one that triggered the Great Financial Crisis (GFC). In the GFC, when the prices of subprime mortgage debt plummeted, the impact on the balance sheets of leveraged intermediaries—namely, the erosion of capital—prompted a widespread loss of confidence in the U.S. financial system as a whole (see our earlier post).
It is easy to imagine a comparable “climate risk perception shock” that lowers prices on a wide range of “vintage capital” ranging from fossil-fuel plants to flood-prone real estate. A large plunge of asset values could deplete capital in the financial system, impairing intermediaries’ ability to provide key financial services, such as the provision of funds to healthy (“green”) users. Potential triggers for such a repricing include changing perceptions of physical risk—which could trigger spikes in the price of insuring threatened real estate—or of transition risk, such as concerns about abrupt changes in policy or preferences that strand a wide range of assets. Unfortunately, the failure thus far of U.S. regulators and financial institutions to develop the data and tools to assess such risks leaves everyone simply hoping that the probability of such disruptions is and will remain low in coming years.
Rising physical climate risk. Physical risk arises from the increased frequency and severity of droughts, floods, wildfires, heat waves, hurricanes, and other damaging storms brought on by the ongoing accumulation of greenhouse gases (GHG). The following chart shows the rising trend in both the count (black line, left axis) and the total cost of such disasters (bar, right axis) over the past decade. Importantly, in the sample of U.S. disasters since 1980, nearly 36% of total costs occurred since 2016. Furthermore, in this five-year period, the damage from tropical cyclones accounts for a whopping 66% of the cost.
United States: Billion-dollar climate and weather-disaster events—count and CPI-adjusted cost, 1980-October 2021
Source: NOAA NCEI; update of Figure 1.1 in FSOC Report on Climate-Related Financial Risk.
Looking forward, the Network for Greening the Financial System (NGFS)—a group of nearly 100 central banks and supervisors that the Federal Reserve joined only after the presidential election of 2020—publishes projections of climate-related physical costs under various policy paths. The following chart displays how, assuming current policy, there is a substantial projected rise over time in the tails of the cost distributions (the 97.5th percentiles) both for damage from tropical cyclones and for the fraction of the population exposed to heatwaves. Presumably, it is the concern for (as well as the realization of) these severely adverse tail risks that could destabilize the financial system by triggering plunges in the prices of climate-sensitive assets sitting on the balance sheets of leveraged intermediaries.
United States: NGFS projected changes in physical climate-related risks under current policies, 2020-70F
Notes: Similar to FSOC Report Figure 1.3. Shows percent changes of the 97.5th percentile distributions from the 2015 distribution norms for the expected damage from tropical cyclones and for the expected fraction of population exposed to heatwaves.
Source: NGFS Climate Impact Explorer—cyclones and heatwaves (accessed October 2021).
Measurement and data gaps. Because we lack both generally agreed-upon models and comprehensive, high-quality data, it is difficult to measure systemic financial risk. As the FSOC Report makes clear, this challenge is even greater when it comes to measuring climate-related financial risk. First, the modeling of these financial risks is still in its infancy. Second, the data requirements are enormous and include indicators of non-financial firms’ climate exposure that are not yet standardized. Perhaps most important, the need is immediate: Climate science tells us that the emissions already trapped in our atmosphere, as well as what we expect to release in the near future, will continue to raise atmospheric temperatures with adverse physical consequences. Therefore, to quote Secretary Yellen again, “The longer we wait to address the underlying causes of climate change, the greater [the] risk. [So] we cannot wait for perfect assessments or data to take action.”
Against this background, the FSOC Report is just the beginning of what is sure to be a long process of developing modeling techniques and building the necessary databases. Accordingly, its recommendations focus on identifying necessary data, developing consistent reporting standards, and procuring what is missing. In that connection, the Report identifies the well-known shortcomings of current corporate disclosures in allowing observers to assess a firm’s climate risk exposure. Even so, its recommendations are highly tentative, calling on FSOC member agencies “to consider updating disclosure requirements to promote consistency, comparability and decision usefulness” [authors’ emphasis]. And, while the Report highlights the thoughtful proposals of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD), again it merely calls for FSOC members to “consider” the use of the TCFD disclosure framework. Not surprisingly, the TCFD’s 2021 Status Report highlights North America as a laggard in the quality of corporate climate reporting (see next chart).
Task Force on Ciimate-Related Financial Disclosures: Extent of TCFD-aligned corporate climate disclosure by type and region (percent of firms), 2020
Scenario analysis. Given the general inability to assess climate-related financial risk, the Report highlights the value of scenario analysis as a pragmatic tool that can help both firms and authorities learn to assess climate-related financial vulnerabilities. Scenario analysis is critically different from stress testing. While stress tests are commonly based on recent history, scenario analysis sets out possible future paths that may have little to do with our experience. Clearly, a climate risk assessment based solely on the past would overlook the key reasons for concerns—namely, that (under current policies) climate problems are expected to intensify for decades to come, leading to potentially sudden changes in a broad array of asset prices. No less important, potentially abrupt policy shifts aimed at containing climate-change risk can trigger financial disruptions by stranding assets that currently are of great value.
In highlighting the benefits of the early application of scenario analysis, the Report notes that Fed stress tests for the largest banks have evolved greatly since the initial 2009 SCAP test. These tests have come to define the capital regime for the most systemic U.S. intermediaries. Yet, their success still depends on key features of the 2009 test: namely, severity, flexibility and an appropriate degree of transparency (particularly regarding the publication of individual firm results).
Importantly, regulators in France and the United Kingdom already are using climate-related scenario analysis both to help identify the data and knowledge gaps that need to be filled and to nudge financial institutions to improve their understanding of and ability to manage climate-related financial risk. To facilitate the process, the NGFS publishes a set of climate-related financial scenarios that regulators can adapt as needed to initiate exploratory programs in their jurisdictions.
Scenario analysis also can help assess whether we are correct in our view that a financial system which is sufficiently robust to withstand a wide variety of other shocks is more likely to endure climate shocks, too. As evidence for this view, we highlight the recent work of Jung, Engle and Berner in developing CRISK—a market-based estimate of the capital shortfall of a financial institution in a climate risk scenario. Analogous to SRISK, an estimate of a publicly traded financial firm’s capital shortfall following a 40% decline in the global equity markets, CRISK measures the impact of a 50% drop in the value of climate sensitive assets on intermediaries’ net worth relative to a benchmark.
How does CRISK illustrate the importance of generalized financial resilience? For the sample of the 10 leading US. banks and the 5 leading U.K. banks, the correlation of end-2020 SRISK and CRISK is 0.81. Put differently, a financial institution that has capital to withstand a large financial shock can likely withstand a large climate shock as well. Importantly, however, firms that are poorly capitalized are fragile regardless of the source of the shock.
To be clear, our view about the general properties of intermediaries’ resilience does not reduce the importance of assessing climate risk both at the level of individual firms and the system as a whole. It does, however, support the conclusion that a regulatory framework that ensures sufficient capitalization of the financial system in good times will yield a resilient financial system when adverse shocks—climate or otherwise--inevitably hit.
Bottom Line. The FSOC Report marks the start of what is sure to be a marathon. By avoiding the use of regulatory tools to mitigate climate change itself, FSOC appropriately safeguards the prerogatives of elected officials and focuses on its own financial stability mandate. Yet, FSOC could certainly go further, pushing its member agencies to be more aggressive. To promote a safe and sound financial system in the face of rising climate risk, U.S. regulators need to act quickly to improve disclosure that supports market discipline, identify and monitor risks both at the firm and system levels, motivate effective risk management at U.S. intermediaries, and limit spillovers to the financial system as a whole.