For release on delivery
1:25 p.m. EDT
March 23, 2021
Financial Stability Implications of Climate Change
Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
"Transform Tomorrow Today"
Ceres 2021 Conference
Boston, Massachusetts
(via webcast)
March 23, 2021
I want to thank Ceres for inviting me to join this discussion. Let me start by
noting that these are my own views and do not necessarily reflect those of the Federal
Reserve Board or the Federal Open Market Committee.1
Climate change is already imposing substantial economic costs and is projected to
have a profound effect on the economy at home and abroad.2 Future financial and
economic effects will depend on the severity of the physical effects of climate change and
the nature and speed of the transition to a sustainable economy.3 Financial market
participants that do not put in place frameworks to assess and address climate-related
risks could face significant losses on climate-sensitive assets caused by environmental
shifts, by a disorderly transition, or both. Conversely, robust risk management; scenario
analysis; consistent, comparable disclosures; and forward plans can help ensure the
financial system is resilient to climate-related risks and well positioned to support the
transition to a sustainable economy.4
1
I am grateful to Elizabeth Kiser of the Federal Reserve for her assistance in preparing this text.
2
See David R. Reidmiller, Christopher W. Avery, David R. Easterling, Kenneth E. Kunkel, Kristin L. M.
Lewis, Thomas K. Maycock, and Brooke C. Stewart, eds. (2018), Fourth National Climate Assessment,
vol. II: Impacts, Risks, and Adaptation in the United States (Washington: U.S. Global Change Research
Program), https://dx.doi.org/10.7930/NCA4.2018.
3
On the effects of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas
emission pathways, in the context of strengthening the global response to the threat of climate change,
sustainable development, and efforts to eradicate poverty, see Valérie Masson-Delmotte, Panmao Zhai,
Hans-Otto Pörtner, Debra Roberts, Jim Skea, Priyardarshi R. Shukla, Anna Pirani, Wilfran
MoufoumaOkia, Clotilde Péan, Roz Pidcock, Sarah Connors, J. B. Robin Matthews, Yang Chen, Xiao Zhou, Melissa
I. Gomis, Elisabeth Lonnoy, Tom Maycock, Melinda Tignor, and Tim Waterfield, eds. (2018), Summary
for Policymakers of IPCC Special Report on Global Warming of 1.5°C Approved by Governments
(Geneva: Intergovernmental Panel on Climate Change),
https://www.ipcc.ch/2018/10/08/summary-forpolicymakers-of-ipcc-special-report-on-global-warming-of-1-5c-approved-by-governments.
4
See, for example, Financial Stability Board (2020), The Implications of Climate Change for Financial
Stability, (Basel: FSB, November 23), https://www.fsb.org/wp-content/uploads/P231120.pdf; and
ClimateRelated Market Risk Subcommittee, Market Risk Advisory Committee, U.S. Commodity Futures Trading
Commission (2020), Managing Climate Risk in the U.S. Financial System (Washington: CFTC, September
9),
https://www.cftc.gov/sites/default/files/2020-09/9-920%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf.
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Macroprudential and Microprudential Approaches
It is increasingly clear that climate change could have important implications for
the Federal Reserve in carrying out its responsibilities assigned by the Congress.5 Given
the implications of climate change for both individual financial institutions and the
financial sector as a whole, we need a framework that incorporates both microprudential
and macroprudential considerations.
The Federal Reserve created a new Supervision Climate Committee (SCC) to
strengthen our capacity to identify and assess financial risks from climate change and to
develop an appropriate program to ensure the resilience of our supervised firms to those
risks.6 The SCC's microprudential work to ensure the safety and soundness of financial
institutions constitutes one core pillar of the Federal Reserve's framework for addressing
the economic and financial consequences of climate change.7
5
A recent survey of central banks found a large majority view it as appropriate "to act within their existing
mandate to mitigate climate-related financial risks" that "could potentially impact the safety and soundness
of individual financial institutions and could pose potential financial stability concerns for the financial
system." See Basel Committee on Banking Supervision, Bank for International Settlements (2020),
Climate-Related Financial Risks: A Survey on Current Initiatives (Basel: BCBS, April),
https://www.bis.org/bcbs/publ/d502.pdf; see also Nick Robins, Simon Dikau, and Ulrich Volz (2021),
NetZero Central Banking: A New Phase in Greening the Financial System, (London: Grantham Research
Institute on Climate Change and the Environment at the London School of Economics and Political
Science, March),
https://www.lse.ac.uk/granthaminstitute/wp-content/uploads/2021/03/Net-zero-centralbanking-1.pdf. For overviews of climate change and economic damage, see, for example, Maximilian
Auffhammer (2018), "Quantifying Economic Damages from Climate Change," Journal of Economic
Perspectives, vol. 32 (Fall), pp. 33-52; Solomon Hsiang and Robert E. Kopp (2018), "An Economist's
Guide to Climate Change Science," Journal of Economic Perspectives, vol. 32 (Fall), pp. 3-32,
https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.32.4.3; and Solomon Hsiang, Robert Kopp, Amir Jina,
James Rising, Michael Delgado, Shashank Mohan, D. J. Rasmussen, Robert Muir-Wood, Paul Wilson,
Michael Oppenheimer, Kate Larsen, and Trevor Houser (2017), "Estimating Economic Damage from
Climate Change in the United States," Science, vol. 356 (June), pp. 1362-69.
6
See Federal Reserve Bank of New York (2021), "Kevin Stiroh to Step Down as Head of New York Fed
Supervision to Assume New System Leadership Role at Board of Governors on Climate," press release,
January 25, https://www.newyorkfed.org/newsevents/news/aboutthefed/2021/20210125.
7
See Lael Brainard (2021), "The Role of Financial Institutions in Tackling the Challenges of Climate
Change," speech delivered at the Institute of International Finance U.S. Climate Finance Summit:
Financing a Pro Growth Pro Markets Transition to a Sustainable, Low-Carbon Economy, Washington,
February 18, https://www.federalreserve.gov/newsevents/speech/brainard20210218a.htm.
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Climate change and the transition to a sustainable economy also pose risks to the
stability of the broader financial system. So a second core pillar of our framework seeks
to address the macrofinancial risks of climate change. To complement the work of the
SCC, the Federal Reserve Board is establishing a Financial Stability Climate Committee
(FSCC) to identify, assess, and address climate-related risks to financial stability. The
FSCC will approach this work from a macroprudential perspective-that is, one that
considers the potential for complex interactions across the financial system.
From a microprudential perspective, the Federal Reserve's Supervision and
Regulation Report discusses how the effects of climate change can manifest in the
financial system via traditional channels like credit, market, operational, legal, and
reputational risks that affect the safety and soundness of individual firms.8 From a
macroprudential perspective, our Financial Stability Report outlines how climate change
could increase financial shocks and financial system vulnerabilities that could further
amplify shocks.9
Microprudential and macroprudential objectives are often aligned. For example,
consistent disclosures are important not only to enable individual financial firms to
measure and manage their exposure to climate-related financial risks, but also to support
financial stability more broadly by helping the market to accurately price that risk. Given
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the importance of consistent, comparable, and reliable disclosures to financial stability
and prudential objectives, mandatory disclosures are ultimately likely to be important.10
There are situations, however, where microprudential and macroprudential goals
do not fully align so that it is important to take into account the implications both for
individual firms' safety and soundness and also for the broader financial system. For
example, the use of climate-related risk mitigants such as insurance or financial
derivatives may shift risk away from a particular financial institution but may not reduce
or eliminate risk from the system as a whole. In developing a framework to address
climate-related financial risks, we need to be mindful of this cascade of effects and the
implications across the Federal Reserve's range of responsibilities.
Financial System Shocks and Vulnerabilities Arising from Climate Change
Our macroprudential work program is focused on assessing not only potential
climate shocks, but also whether climate change might make the financial system more
vulnerable in ways that could amplify these shocks and cause broader knock-on effects
that could harm households, businesses, and communities. In some respects, climate
change can be seen as similar to other financial stability shocks emanating from outside
the financial system, such as COVID-19, which are difficult to predict with precision and
can lead to an abrupt reassessment of a broad array of economic and financial outcomes,
prices, and incentives. However, climate change shocks differ in a few important ways.
Unlike episodic or transitory shocks, climate change is an ongoing, cumulative
process, which is expected to produce a series of shocks. Over time, these shocks can
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change the statistical time-series properties of economic variables, making forecasting
based on historical experience more difficult and less reliable. The physical properties of
the earth's atmosphere shown by scientific climate records and climatological forecasts
include the risk of irreversible climate "tipping points," which can cause as yet unseen
disruptions in weather systems, regional water supplies, and the habitability of large land
masses-at large magnitudes. Quantifying the risks and implications of potentially
catastrophic climate-related tipping points for the economy and financial system is
extremely difficult.
Second, there is substantial uncertainty about the nature and timing of the policy,
behavioral, and technological changes that will occur during the transition to a
sustainable economy. This uncertainty could create significant challenges for financial
stability.
In addition, climate change might be expected to increase financial system
vulnerabilities.11 Financial system vulnerabilities could arise if intermediaries engage in
financial contracts or take on leverage to shift climate risk in ways that leave the overall
system vulnerable to the amplifying effects of shocks. In addition, even well-informed
investors could underestimate the likelihood of large shocks related to climate change,
resulting in systematic mispricing of risk. This mispricing could occur if the physical
effects of climate change arrive sooner or with greater intensity than expected or
investors systematically err in their expectations about the transition. Finally,
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vulnerabilities could result if climate risks in the aggregate are systematically correlated
across participants in the economy and financial system. These correlated aggregate
exposures could be missed by risk models and difficult or impossible to mitigate fully.
It might be useful to consider some examples of climate-related risks that could
manifest as shocks or increase financial system vulnerabilities or both.12 One example is
property and casualty insurance, which enables financial firms to engage in financial
contracts to hedge climate-related risks. While reinsurance contracts and agreements
among investors can shift risks across the global financial system, as I noted earlier, some
level of risk is likely to remain.13 A lack of transparency across participants in the
financial sector could cause climate-related risks to build up in hidden pockets,
embedding vulnerabilities that could result in cascading losses in the event of large-scale
adverse weather outcomes or other shocks to asset valuations.
We can already see examples of how such ripple effects might work. As physical
risks manifest, insurers update the availability and pricing of coverage to more accurately
reflect climate-related risks to real estate, physical facilities, and companies that are
subject to these risks through financing arrangements or supply chains. As we have seen
in California and in Florida, insurance companies can pull back from insuring properties
12
See Brunetti and others, "Climate Change and Financial Stability," in note 11; see also Sonia I.
Seneviratne, Neville Nicholls, David Easterling, Claire M. Goodess, Shinjiro Kanae, James Kossin, Yali
Luo, Jose Marengo, Kathleen McInnes, Mohammad Rahimi, Markus Reichstein, Asgeir Sorteberg,
Carolina Vera, and Xuebin Zhang (2012), "Changes in Climate Extremes and Their Impacts on the Natural
Physical Environment" in Matilde Rusticucci and Vladimir Semenov, eds., Managing the Risks of Extreme
Events and Disasters to Advance Climate Change Adaptation (Cambridge University Press, Cambridge and
New York), pp. 109-230.
13
See, for example, Antonio Grimaldi, Kia Javanmardian, Dickon Pinner, Hamid Samandari, and Kurt
Strovink (2020), "Climate Change and P&C Insurance: The Threat and Opportunity," McKinsey Insights,
November 19,
https://www.mckinsey.com/industries/financial-services/our-insights/climate-change-and-pand-c-insurance-the-threat-and-opportunity: ". . . insurers could play a role in matching risk transfer
solutions to alternative capital from investors with more risk appetite."
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and facilities in geographic areas subject to heightened flood or fire risk or seek to raise
insurance rates on these properties and facilities to more accurately reflect risks.14
Although such changes may ultimately result in a more accurate assessment of actual
risks, the abrupt changes to a wide range of contracts that embed systemic mispricing
could initially amplify the shock.
It is also increasingly apparent that the value and, in some cases, the usability of
real estate in many areas will be directly affected by the increased risks of floods,
wildfires, severe storms, and sea-level rise associated with climate change. The direct
effects on homeowners and businesses are geographically concentrated and can have
severe effects on safety and the usability of properties. As climate risks grow over time,
the mortgages on these properties may become riskier, along with financial instruments
involving these mortgages that may embed opaque, concentrated climate-related risks.
Sudden realizations of climate-related risks could cause rapid shifts in investor sentiment
and shocks to asset prices, including to real estate prices in specific geographic
locations.15
Federal, state, and local authorities are implementing policies to support
transparency in climate-related risk associated with real estate to allow property owners,
lenders, and investors to make better-informed investment decisions. Updated flood
maps, coastal resilience programs, and managed retreat from flood-prone areas can
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reduce the extent of hidden climate risks. While such transparency is vital, financial
system vulnerabilities could arise even in transparent markets-for example, through
aggregate common exposures to climate risk.
Finally, climate-related physical risks are increasing financial burdens on local,
state, and federal finances. Increasing physical damage to localities necessitates higher
expenditures to repair damage from extreme weather and fire events and to build
resilience to growing climate threats. Pullbacks in insurance coverage, the need to
relocate or bolster infrastructure, and increased provision of service in the wake of
disasters increase burdens on state, local, and federal finances. These rising burdens
could place strains on municipal financing markets over time, particularly in areas of
geographically concentrated climate risks, and create some risk of a cascade effect if a
shock causes investors to pull back from similar exposures.
New Approaches and New Tools
We are building the requisite institutional capacity and knowledge to deepen our
understanding of these risks and vulnerabilities. The new FSCC is a Systemwide
committee charged with developing and implementing a program to assess and address
climate-related risks to financial stability. The broad goals of the FSCC are to promote
the resilience of the financial system to climate-related financial risks, to ensure
coordination with the Financial Stability Oversight Council (FSOC) and its member
agencies, and to increase the Federal Reserve's international engagement and influence
on this issue. The FSCC will work in close coordination with the SCC-as well as with
our community development, payments, international coordination, and economic
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research and data areas-to build a coordinated approach to integrating climate-related
risks where they affect our responsibilities.
To support the work of these committees and the broader work throughout the
Federal Reserve System, we are investing in new research, data, and modeling tools. In
light of the high uncertainty inherent in estimating climate-related shocks, scenario
analysis may be a helpful tool to assess the effects on the financial system under a wide
range of assumptions.16 Climate scenario analysis identifies climate-related physical and
transition risk factors facing financial firms, formulates appropriate stresses of those risk
factors under different scenarios, and measures their effects on financial intermediaries
and the financial system. This analytic approach gives us a structured way of uncovering
the parts of the financial system where physical, transition, and other risks may have
outsized effects through potential spillovers. It also helps identify the limits of our
knowledge.
For scenario analysis, we would anticipate long time horizons, substantial
uncertainty, the use of qualitative elements, and reliance on external data and models. To
capture the potential for complex interactions across the financial system, such scenario
analysis would consider the effects on bank and nonbank financial intermediaries and
financial markets broadly. We are informing ourselves about the scenario analysis work
under way by policymakers in foreign jurisdictions, such as by the European Central
Bank and the Bank of England, as well as the scenarios developed by the Network of
Central Banks and Supervisors for Greening the Financial System (NGFS).17
Collaboration across Jurisdictions and Sectors
Climate change is inherently a cross-border and cross-sectoral challenge, and we
recognize the benefit of collaborating with other regulatory agencies, central banks, and
international standard-setting bodies while taking into account the important differences
across jurisdictions. In the United States, close coordination with the FSOC member
agencies will be important. We are also working with member agencies of the U.S.
Global Change Research Program to learn about scientific data, models, and other
information to expand our analysis of the economic and financial effects of weather-
related disasters and climate-related risks.18
We participate actively in the Financial Stability Board's (FSB) work on climate
change. The FSB's membership, mandate, and relationship with the Group of Twenty
(G-20) and the standard-setting bodies position it well to play a coordinating role in
addressing the interdependencies among different workstreams and supporting the G-
20-including the G-20 Sustainable Finance Study Group co-chaired by the U.S.
Treasury. The FSB has been tasked by the G-20 to play a leadership role on data gaps
and to identify recommendations to support the use of comprehensive, comparable, and
auditable climate-related disclosure standards. In addition, the Federal Reserve is co-
chairing one of the workstreams-the Basel Committee on Banking Supervision's Task
Force on Climate-Related Financial Risks (TFCR).
We are actively gathering essential knowledge from a wide range of groups,
including nongovernmental organizations such as Ceres, private-sector market
participants, academic researchers, and others. The Federal Reserve recently became a
member of the NGFS, which is sharing research and identifying best practices to improve
the financial system's resilience to climate-related risks.
Conclusion
These are not easy problems, and they will not have easy solutions. Despite the
challenges, it will be critical to make progress, even if initially imperfect, in order to
ensure that the financial system is resilient to climate-related risks and well positioned for
the transition to a sustainable economy. We are committed to building our capacity to
understand and address the risks, complexities, and challenges related to climate change
within the Federal Reserve's responsibilities. In working toward these goals, we will
undoubtedly reach better outcomes if we tackle this challenge through open dialogue,
information sharing, and transparency.