Paper outlines financial risks presented by climate change; outlines efforts by regulators to address

The Federal Reserve, other U.S. financial regulators, and central banks and financial supervisors around the world have made progress on a path to identify, assess, and manage climate-related financial risks, according to a paper published Monday.

“The effects of climate change are inescapable and include far-reaching economic and financial consequences for many households and businesses,” the Economic Letter published by the Federal Reserve Bank of San Francisco said. “However, the precise magnitude, timing, and form of these effects are uncertain.”

The paper by Glenn D. Rudebusch, a senior policy advisor and executive vice president in the economic research department of the San Francisco Fed, said that the ongoing trend of climate change—including higher temperatures and more extreme weather—will result in economic and financial losses for many businesses, households, and governments. Moreover, he wrote, the uncertainty about the severity and timing of these losses is a source of financial risk.

The paper asserts that the Fed has undertaken two broad efforts on its own. First, it noted the Fed’s supervisory expectation that financial institutions it supervises should “monitor all of their material risks, which for many banks are likely to extend to climate risks.”

Second, the paper stated, late last year the central bank said that it “will monitor and assess the financial system for vulnerabilities related to climate change through its financial stability framework.”

The paper cites efforts by at least eight other international and U.S. financial regulators to address the risks posed to the financial sector by climate change. Those efforts include:

  • New York State Department of Financial Services: Asked financial institutions under its supervision to incorporate climate-related risks (DFS 2020).
  • Commodity Futures Trading Commission (CFTC): Released a report (CFTC 2020) that argued: “U.S. financial regulators must recognize that climate change poses serious emerging risks to the U.S. financial system, and they should move urgently and decisively to measure, understand, and address these risks.”
  • Securities and Exchange Commission: Current acting chair called for financial institutions to disclose their climate risks, including those associated with the financing they provide (Lee 2020).
  • Bank of England: Provided details of an upcoming climate risk stress exercise for major U.K. banks and insurers including a 30-year time horizon (Bailey 2020). The central banks of France and the Netherlands have similar examinations completed or underway (CFTC 2020).
  • European Central Bank: Described its supervisory expectations related to the management and disclosure of climate-related risks by financial institutions (ECB 2020).
  • Network of Central Banks and Supervisors for Greening the Financial System: Issued a guide to assist in quantifying how bank lending portfolios and balance sheets react to climate risk (NGFS 2020).
  • United Nations: Published detailed handbooks (UNEP FI 2020a, 2020b) on the physical and transition risks of climate change that financial institutions must identify and manage.
  • The Basel Committee on Banking Supervision (BIS 2020): Surveyed supervisory actions that can lessen climate risks to banks.

The financial risk resulting from climate change, according to the paper, can adversely affect financial markets, asset classes, and institutions as well as the income and balance sheets of businesses, households, and governments.

The paper outlines oft-cited risks resulting from “business as usual,” high-carbon emissions scenarios, both physical and transition.

“’Physical risk’ reflects the uncertain economic costs and financial losses from tangible climate-related adverse trends and more severe extreme events,” the paper states. “For example, low-lying coastal real estate and public infrastructure face physical risk from higher sea levels and more destructive storms, and hotter temperatures pose chronic risks to human health, worker productivity, and food production.”

“Transition risk,” according to the paper, stems from an uncertain pace and scope of the economic transformation required to produce fewer carbon emissions. “Such decarbonization risks include possible declines in asset prices, income, and profitability in the sectors that rely on high carbon emissions,” the paper states.

Climate Change Is a Source of Financial Risk