Climate Change: A Primer
Not only are extreme weather events becoming more common, but signals from Federal administration, industry leaders, regulatory agencies and the United Nations clearly demonstrate that climate change is a top concern. In February 2021 Governor Lael Brainard spoke about the role of financial institutions in addressing climate change and the path forward. More recently, the United Nation’s Intergovernmental Panel on Climate Change (IPCC) released a report on August 9, 2021 noting that many of the changes to the climate, like the continued rise of sea levels, are irreversible over the next several hundred years. You may understandably wonder how climate change translates into climate risk at a financial institution and why an institution that’s not vulnerable to rising sea levels, wildfires, or other physical manifestations of climate change would be concerned about the increasing risks. The fact is, it’s nearly impossible to name an industry without some exposure to climate risk, and many are likely to have more risk than is initially evident.
The physical threats of climate change are just one subset of risks under the larger umbrella of "climate risk." These threats can be further divided into acute or chronic risks. Acute risks are extreme weather events like hurricanes or floods, while chronic risks refer to the slow onset of change, like rising sea levels and warming temperatures. These weather events can impact a bank's operations (operational risk) or their borrowers' ability to repay loans (credit risk). For example, the unprecedented winter storm in Texas earlier this year devastated many farmers' crops, killed livestock, and resulted in incalculable building and infrastructure damage, not to mention lost wages for workers. While many may have insurance to mitigate loss, it is uncertain whether extreme events will impact insurance market conditions, particularly related to the affordability and availability of insurance policies. Physical risks are what many may initially consider when determining how climate change may impact their institution.
However, the less considered but potentially more imminent risk to financial institutions may be "transition risk," or the risks related to the transition to a low-carbon economy. Transition risk is a broad term that includes many sub-risks, including technology risk, market risk, reputation risk, policy risk, and legal risk. As national and global initiatives to mitigate the effects of climate change continue, it’s likely that more governments and companies institute policies that change the way many do business. Consumer and investor preferences may shift to greener alternatives in energy, transportation, or even food choices. Regardless of a financial institution's geographic location, transition risks could present challenges to banks and/or their customers.
In a December 2020, Federal Reserve Chairman Jerome Powell gave a speech in which he discussed the link between climate change and the Federal Reserve’s mandate to safeguard the stability of the financial system and ensure the safety and soundness of financial institutions. In response to this emerging risk, the Board of Governors created a new Supervision Climate Committee (SCC). Lisa White (our EVP of Supervision, Regulation, and Credit) is a member of this committee. The SCC has a micro-prudential focus and aims to develop a program to promote the resilience of banks to climate risk. Currently, the SCC is in the early stages of conducting research by partnering with economists and supervisors. The SCC does not have a policy view on the appropriate supervision or regulatory approach to climate risk and there is no formal guidance on this topic; however, this emerging risk continues to be top of mind for local and global regulators. If you or your team has questions regarding this topic, please reach out to your Federal Reserve central point of contact.
