Several major announcements over the past two weeks indicate U.S. financial regulators are finally starting to take climate change seriously. The timing is no coincidence. The election of Joe Biden as our next president freed financial regulators from facing the wrath of President Trump and his acolytes for simply acknowledging that climate change is real.
The new tone started at the top, with President-elect Biden discussing the importance of tackling the climate crisis and building a “sustainable economic recovery” in a round of separate congratulatory calls with the leaders of France, Germany, Ireland, and the United Kingdom on November 10th. The President-elect has already signaled that climate change is one of his top priorities.
But the real climate news last week came from the Federal Reserve. On Monday, November 9th, the Federal Reserve, for the first time, formally identified climate change as a risk to financial stability in their latest biannual Financial Stability Report. The report acknowledges that climate change can cause economic disruptions, and that climate risks are likely to increase “financial shocks and financial system vulnerabilities that could further amplify these shocks.” The Fed noted that acute climate hazards, “such as storms, floods, droughts, or wildfires,” and chronic hazards, “like a slow rise in sea levels,” can “quickly alter, or reveal new information about, future economic conditions or the value of real or financial assets.” These abrupt repricing events, combined with the direct losses associated with climate hazards, “can result in an increased frequency and severity of financial shocks.”
The Fed assessed the risks posed to the real-estate market as an example of how the potential downstream consequences of climate change threaten to disrupt financial stability. The report notes that the continued productive use of residential and commercial properties that are subject to climate hazards (such as storm surges, rising sea levels, and hurricanes) would require investment and adaptation. But as extreme weather events increase in frequency and in intensity, “the expected value of exposed real estate may decrease, which may in turn pose risks to real estate loans, mortgage-backed securities, the holders of these loans and securities, and the profitability of nonfinancial firms using such properties.” Given the uncertainty of future climate-related events, investors in these assets “may react abruptly to new information about a region’s exposure to climate-related financial risks,” thereby incentivizing fire sales by leveraged financial and nonfinancial firms.
The report also highlights the dangers associated with the vacuum of climate-related information. According to the Fed, the “uncertainty about the timing and intensity of severe weather events and disasters,” the “poorly understood relationships between these events and economic outcomes,” and the overall “opacity of asset exposures” could lead to abrupt repricing of assets and “downward price shocks.” The central bank acknowledged the need for “continued research into the interconnections between the climate, the economy, and the financial sector” and for “increased transparency through improved measurement and disclosure” in order to “clarify linkages and exposures, and facilitate more efficient pricing of risk.”
The Fed stated that it expects banks to have “systems in place that appropriately identify, measure, control, and monitor all of their material risks,” including climate change. Though the agency did not call on banks to disclose their climate-related risks, Fed Governor Lael Brainard stated, in comments attached to the report, that “increased transparency through improved measurement and more standardized disclosures will be crucial.”
In their recent semiannual Supervision and Regulation Report, the Fed indicated that supervisors will “seek to better understand, measure, and mitigate climate-related financial risks, including through analysis of transmission channels of climate change risk to the banking sector, measurement methodologies, and data gaps and challenges.” The report indicates that the “effects of climate change can manifest as traditional microprudential risks, including through credit, market, operational, legal, and reputational risk,” and highlights the role of Federal Reserve supervisors in “ensuring that supervised institutions operate in a safe and sound manner and can continue to provide financial services to their customers in the face” of these risks. The Fed is also working with foreign bank supervisors to develop consistent supervisory practices to mitigate the risks from climate change. The head of the New York Fed’s Supervision Group, Kevin Stiroh, is co-chair of the Basel Committee’s Task Force on Climate-Related Financial Risks (TFCR). In a speech last week, Stiroh noted that the TFCR’s current focus is “on understanding climate risk transmission channels, as well as methodologies for measuring and assessing these risks.” Once this work is done by mid-2021, the TCFR will “then consider the extent to which climate-related financial risks are incorporated in the existing Basel Framework.”
Last Tuesday, in another meaningful step towards incorporating climate change into its supervisory mandate, Fed Vice Chair for Supervision Randal Quarles informed the Senate Banking Committee that the Fed has requested membership in the Network for Greening the Financial System (NGFS). The NGFS is an international coalition of 75 central banks and supervisors established to enhance the role of the financial system in managing climate risks. The U.S. central bank has been notably absent, and has faced increasing pressure from sustainable finance advocates and other stakeholders to join its global counterparts by becoming a participating member of the NGFS. The group of central banks and regulators requires that its members be signatories to the Paris Climate Accord. Though the United States withdrew from the treaty on November 4th, President-elect Biden has pledged to rejoin on his first day in Office. Governor Quarles stated that the Fed could likely join before the next NGFS annual meeting in April 2021.
The U.S. Securities and Exchange Commission (SEC) is also poised to incorporate climate change into its regulatory mandate under a Biden Administration. The SEC requires public companies to disclose information related to their financial position and performance, future prospects, and material risks. But its guidance on climate change disclosures has been largely insufficient to incentivize the disclosure of decision-useful climate related information. Allison Herren Lee and Caroline Crenshaw, the SEC’s two Democratic commissioners, have been urging the agency to address climate change for months, noting that investors are demanding consistent and decision-useful information regarding “how their assets and business models are exposed to climate risks,” and advocating for the incorporation of a standardized disclosure framework for climate information.
In a speech on November 5th, Commissioner Lee said that the SEC must begin to recognize “climate risk as systemic risk.” She urged the agency to respond to the “extraordinary [market] demand” for climate-related disclosure by adopting “uniform, consistent, and reliable disclosure” requirements for climate-related risks. Commissioner Lee wants the SEC to “work with market participants toward a disclosure regime specifically tailored to ensure that financial institutions produce standardized, comparable, and reliable disclosure of their exposure to climate risks.” Importantly, the President-elect has pledged to issue an executive order on his first day in office requiring “public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains.” Further, the Biden Administration will have the immediate opportunity to appoint a more climate friendly SEC chairman given current chairman Jay Clayton is stepping down at the end of the year.
These recent regulatory announcements have been supported by some within the private sector as well as policymakers abroad. Larry Fink, the CEO of the world’s largest investment manager, BlackRock, stated on November 10th that the United States should “move faster” in implementing a climate-risk disclosure framework. His comments came a day after the U.K. became the first country to require economy-wide disclosures of the financial impacts of climate change. The U.K. rule comes into effect in 2025 for most “companies, banks, large private businesses, insurers, asset managers and regulated pension funds,” but requires premium listed companies to begin making the disclosures in January.
Speaking during an online panel last Thursday, Federal Reserve Chair Jerome Powell acknowledged that the central bank is in the “very early stages of trying to work through” the potential implications of climate change risks “for monetary policy, for bank regulation, [and] for financial stability.” The past two week’s announcements are a step in the right direction and build off a landmark report released in September by the Commodity Futures Trading Commission’s (CFTC) Climate-Related Market Risk Subcommittee. The report marked the first time that a U.S. financial regulatory agency acknowledged that “climate change could pose systemic risks to the U.S. financial system,” and urged financial regulators to “move urgently and decisively to measure, understand, and address” the physical and transition risks associated with climate change. It seems like the message was received, and we can only hope, and expect, that further progress will be made under the Biden administration.
Lee Reiners is the Executive Director of the Global Financial Markets Center at Duke Law
Charlie Wowk is a J.D. candidate at Duke Law and a research assistant at the Global Financial Markets Center