Lael Brainard: Building climate scenario analysis on the
foundations of economic research
Speech (via webcast) by Ms Lael Brainard, Member of the Board of Governors of the Federal
Reserve System, at the 2021 Federal Reserve Stress Testing Research Conference, Federal
Reserve Bank of Boston, Boston, Massachusetts, 7 October 2021.
* * *
I want to thank all of you for joining our research conference and the organizing committee for
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inviting me to share some thoughts on climate scenario analysis.
Economic analysis suggests that climate change could have profound consequences for the
level, trend growth, and variability of economic activity over time and across regions and sectors.
Some of these effects could occur gradually, while others could occur relatively quickly in the
presence of "tipping points." Policy, technology, and behavioral responses could similarly have
material financial consequences. Against this backdrop, the Federal Reserve is carefully
considering the potential implications of climate-related risks for financial institutions and the
financial system, with scenario analysis emerging as a potential key analytical tool for that
purpose.
Climate change is projected to have profound effects on the economy and the financial system,
and it is already inflicting damage. The Sixth Assessment Report by the Intergovernmental Panel
on Climate Change (IPCC) notes that "if global warming increases, some compound extreme
events with low likelihood in [the] past and current climate will become more frequent, and there
will be a higher likelihood that events with increased intensities, durations and/or spatial extents
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unprecedented in the observational record will occur."
We can already see the growing costs associated with the increasing frequency and severity of
climate-related events. The total cost of U.S. weather and climate disasters over the last 5 full
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years exceeds $630 billion, which is a record. During this period, massive flooding in the
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Midwest has caused billions of dollars in damages to farms, homes, and businesses. The
California Department of Insurance has documented growing problems with the availability of fire
insurance for homeowners, and the state legislature provided new protections for wildfire
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survivors. Last year was the sixth consecutive year that the United States experienced ten or
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more billion-dollar weather and climate disasters. And this summer, Hurricane Ida alone is
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estimated to have caused more than $30 billion in insurance losses.
The pandemic is a stark reminder that extreme events can materialize with little warning and
trigger severe financial losses and market disruptions, and the IPCC Sixth Assessment Report is
a reminder of the high uncertainty and potential costs associated with climate-related risks. It will
be important to systematically assess the resilience of large financial institutions and the broader
financial system to climate-related risk scenarios.
Climate Scenario Analysis
As we are learning from the pandemic, risks emanating from outside the economy can have
devastating financial consequences. As part of our prudential and financial stability
responsibilities, we are developing scenario analysis to model the possible financial risks
associated with climate change and assess the resilience of individual financial institutions and
the financial system to these risks. The future financial and economic consequences of climate
change will depend on the severity of the physical effects and the nature and speed of the
transition to a sustainable economy. So it is important to model the transition risks arising from
changes in policies, technology, and consumer and investor behavior and the physical risks of
damages caused by an increase in the frequency and severity of climate-related events as well
as chronic changes, such as rising temperatures and sea levels.
From the IPCC's work, we know that the physical risks related to climate change will grow over
time, while the transition risks will depend in part on how abruptly policy, technology, and
behavioral changes take place. Since financial markets are forward looking, a change in
expectations regarding climate-related risks could lead to a sharp repricing of assets at any time.
Acute hazards, such as damaging hurricanes, or climate-related policy changes could quickly
alter perceptions of future risk or reveal new information about the value of assets. Sudden asset
price changes can lead to financial instability when they interact with other vulnerabilities, such
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as high leverage or correlated exposures.
Scenario analysis is a useful tool in assessing the links between climate-related risks and
economic outcomes because it requires assessing the implications for financial stability and
individual financial institutions in a systematic way. The interactions across institutions and
market segments must be traced out, and missing data must be identified, acquired, and
analyzed, leading to a clearer picture of the transmission of risks. Scenario analysis should
ultimately facilitate estimating the possible effects on individual financial institutions as well as on
financial markets more broadly. By systematically modeling the effects of climate-related risks
across the financial system, scenario analysis can help inform risk management at the level of
individual financial institutions and more broadly.
Given that this conference is about stress testing, it is worth revisiting some lessons from the
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first generation of bank stress tests. Bank stress tests were developed at the height of the
2007-09 financial crisis to provide a more systematic way to assess the effects of complex and
interrelated exposures within the financial system. The first test, known as the Supervisory
Capital Assessment Program (SCAP), used simplified models with limited data inputs. Despite
substantial uncertainty about the economy's path, the SCAP was broadly viewed as successful.
It provided a solid foundation for building out the stress-testing program over the subsequent
decade. The stress test infrastructure and granular models and data that are currently available
bear little resemblance to that first stress test. In parallel, banks have improved their
riskmanagement operations, and large banks now routinely use their own stress tests to assess and
manage their risks.
So what are the lessons for scenario analysis? Starting down the path of climate scenario
analysis, even with a rudimentary first attempt, will help with risk identification and suggest useful
lessons to inform subsequent improvements in modeling, data, and financial disclosures.
Although we should be humble about what the first generation of climate scenario analysis is
likely to deliver, the challenges we face should not deter us from building the foundations now.
Learning from Climate Scenario Analysis in Other Countries
There is a growing international consensus that climate scenario analysis is a vital tool for
assessing the effects of climate-related risks on financial institutions and the financial system.
Since 2017, a group of regulators from across the world has been sharing best practices
regarding climate-related risk management within the Network of Central Banks and Supervisors
for Greening the Financial System (NGFS). The Federal Reserve joined this international
collaboration late last year.
Several countries have already made substantial progress on climate scenario analysis. The
scenarios produced by the NGFS, with appropriate tailoring to local conditions, have been
incorporated in climate change analysis by the European Central Bank (ECB) as well as by
financial regulators in Canada, France, and the United Kingdom. For instance, the ECB
published results from its analysis of climate-related risks in September 2021, and the Bank of
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England published scenarios in June 2021 with results expected in the middle of 2022. The
Federal Reserve is actively learning from these early adopters.
Overcoming Challenges in Implementing Climate Scenario Analysis
There are challenges to quantifying the effects of climate-related risks on the economy and the
financial system. Climate scenario analysis faces the challenge of having to consider plausible
but novel combinations of risks that are associated with substantial uncertainty. For traditional
financial risk scenarios, modelers can draw on the historical record to help gauge the plausible
repercussions for different asset classes as well as the economic consequences at the national
level. Even in the case of the COVID-19 pandemic, modelers could draw useful lessons from
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previous pandemics, such as the 1918 influenza. By contrast, there may not be analogous
historical precedents to draw on in the formulation of appropriate climate scenarios and the
quantification of their effects on different asset classes, regions, and sectors.
In addition, climate scenario analysis may need to consider interdependencies across the
financial system. Banks and other financial institutions often rely on insurance and other hedging
strategies to reduce potential losses. With climate risk raising insurance premiums charged to
property owners or reducing the availability of insurance in certain geographies and on certain
asset classes, it may be important to assess the resilience of insurance and other hedging
strategies and the associated implications for supervised institutions. Stress could be
transmitted through a sudden repricing of insurance contracts or by a withdrawal of coverage, as
we are already seeing in the case of wildfires and flooding in certain areas. While reinsurance
contracts and agreements among investors can transfer risk across the financial system, some
level of risk is likely to remain. Climate-related risks could build up in hidden ways that could
result in cascading losses.
Using Established Economic Foundations for Transition Risks
The costs and timing of the transition to a low-carbon economy will depend on hard-to-predict
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policy, technology, and behavioral changes. While an orderly and steady transition to a
sustainable economy may have manageable economic consequences, more costly changes
would likely accompany an abrupt transition. A disorderly scenario could generate sizable
economic consequences that vary substantially across geographies, sectors, and assets. Some
of these effects could manifest in the near term if investment sentiment were to change
suddenly. That said, the long tradition within economics of estimating the effects of policy
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changes can be applied to the modeling of transition risks, even disorderly scenarios.
Mapping the Economic Consequences of Physical Risks
Whereas existing economic tools can be applied to transition risks, the building blocks for
assessing the economic consequences of physical risks in the presence of substantial
uncertainty are still in development. The literature on the economic consequences of physical
risk is growing, but there are still some challenges in linking this literature to the formulation of
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scenarios. For instance, extrapolating from the historical experience of sporadic extreme
weather events may turn out to be misleading. Economic activity has tended to rebound quickly
after sporadic extreme weather events in recent experience, often supported by significant
reconstruction. In contrast, climate change is an ongoing, cumulative process that could
significantly increase the prevalence and severity of extreme events as well as contribute to
chronic changes. These cumulative and chronic changes could have economic effects that differ
substantively from the historic experience, for example, if they contribute to shifts in the location
of economic activity or the sectoral composition within a region.
The physical manifestations of climate change could increase the volatility of economic activity
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and slow economic growth. The cumulative effects associated with climate change could lead
to irreversible "tipping points" that introduce new climate shocks and change the relationships
between climate-related shocks and economic variables. Tipping points, such as melting ice
sheets and loss of permafrost or forests, have the potential to create large disruptions in weather
systems, regional water supplies, and the habitability of large land masses. The potential
cumulative effects of climate-related shocks as well as potential climate-related tipping points for
the economy and financial system could reduce the accuracy of forecasts based on historical
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experience.
Regional and Sectoral Differentiation in Projections of Revenues and Losses
The consequences of climate change are likely to be highly differentiated by region and
economic sector, which can bring both risks and opportunities for financial institutions. Regional
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and sectoral differentiation has important implications for scenario analysis. Climate-related
risks can be expected to have direct effects not only on the valuation of assets on the balance
sheets of financial institutions, but also on revenues and costs. While standard models for
projecting the net revenues of financial institutions are typically driven by national-level proxies of
aggregate demand, such as growth and unemployment levels, additional sectoral and regional
granularity will be necessary for climate scenario analysis. And while standard models for
projecting losses on assets account for regional and sectoral characteristics, climate scenario
analysis will require capturing the potential intensification of climate-related risks.
Closing Data Gaps
These efforts to systematically assess climate-related risks will require substantial work to
address current data gaps. Financial institutions are collecting data and developing scenario
analysis to understand the potential effect of climate-related risks. Similarly, the Federal Reserve
is gathering key data resources, such as acquiring external data and making existing publicly
available climate data more useful for modeling and research capabilities.
Current voluntary climate-related disclosures are an important first step in closing data gaps, but
they are prone to inconsistent quality and incompleteness. Without harmonization of the
definitions and methods underlying these disclosures, it will be challenging to make comparisons
across firms and exposures. Consistent, comparable, and, ultimately, mandatory disclosures
are likely to be vital to enable market participants to measure, monitor, and manage climate risks
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on a consistent basis across firms. The Securities and Exchange Commission has
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responsibility for this critical workstream in the United States.
Making Progress
Going forward, it will be important to improve our understanding of climate-related financial risks
and vulnerabilities. The Federal Reserve's Supervision Climate Committee is engaging with
domestic stakeholders and other supervisors from a prudential perspective. Ultimately, I
anticipate it will be helpful to provide supervisory guidance for large banking institutions in their
efforts to appropriately measure, monitor, and manage material climate-related risks, following
the lead of a number of other countries.
In addition, the Federal Reserve's Financial Stability Climate Committee is assessing
climaterelated risks to financial stability from a macroprudential perspective-that is, one that considers
the potential for complex interactions across the financial system. Both the prudential and
macroprudential work programs will benefit from the development of climate scenario analysis.
Conclusion
Together these efforts can help ensure that the financial system is resilient to climate-related
risks and well positioned for the transition to a sustainable economy. Our conversations with
climate experts, large banking institutions, other financial intermediaries, stakeholders, and
regulators underscore the complexity of the connections between the climate and economic and
financial systems. To better understand these connections, several foreign regulators have
already undertaken climate scenario analysis, affording us the opportunity to learn from their
experiences. It will be helpful to move ahead with the first generation of climate scenario analysis
to identify risks and potential issues and to inform subsequent refinements to our models and
data. We will reach better outcomes if we tackle these challenges through open dialogue and
continued engagement of the kind exemplified by today's conference.
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I am grateful to Luca Guerrieri and Cindy Vojtech as well as Kevin Stiroh of the Federal Reserve Board for their
assistance in preparing this text. These views are my own and do not necessarily reflect those of the Federal
Reserve Board or the Federal Open Market Committee. Return to text
2
See Intergovernmental Panel on Climate Change (2021; in press), "Summary for Policymakers," in V.
MassonDelmotte, P. Zhai, A. Pirani, S.L. Connors, C. Péan, S. Berger, N. Caud, Y. Chen, L. Goldfarb, M.I. Gomis, M.
Huang, K. Leitzell, E. Lonnoy, J.B.R. Matthews, T.K. Maycock, T. Waterfield, O. Yelekçi, R. Yu, and B. Zhou,
eds., Climate Change 2021: The Physical Science Basis. Contribution of Working Group I to the Sixth
Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge, United Kingdom:
Cambridge University Press), p. SPM-35, paragraph C.3.3. The report also notes that "global surface
temperature will continue to increase until at least the mid-century under all emissions scenarios considered"
(p. SPM-17, headline statement B.1). Return to text
3
Damage estimate uses events listed in years 2016 through 2020 in the National Oceanic and Atmospheric
Administration's Billion-Dollar Weather and Climate Disasters database, available on the agency's website
at www.ncdc.noaa.gov/billions/events. Return to text
4
See Donnelle Eller (2021), "Climate Change-Driven 'Midwest Water Hose' Caused Massive 2019 Flooding in
Iowa, Elsewhere, UI Researchers Find," Des Moines Register, March
2, www.desmoinesregister.com/story/money/agriculture/2021/03/02/ui-study-climate-change-midwest-water-
hose-dumping-rain-university-iowa/6884486002. Return to text
5
See California Department of Insurance (2018), "Insurance Commissioner Dave Jones Releases Report
Addressing Fire Insurance Availability Issues," press release, January 4; and California Department of
Insurance (2021), "Wildfire Survivors Now Covered by New Insurance Protections," press release, July
27. Return to text.
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See the National Oceanic and Atmospheric Administration's Billion-Dollar Weather and Climate Disasters
database, in note 3. Return to text
7
See Leslie Scism (2021), "Ida Storm Damage Expected to Cost Insurers at Least $31 Billion," Wall Street
Journal, September 22. Return to text
8
See the box "The Implications of Climate Change for Financial Stability" in Board of Governors of the Federal
Reserve System (2020), Financial Stability Report (PDF) (Washington: Board of Governors, November), pp. 58-
59. Return to text
9
Several of the conference papers apply lessons from stress testing to the analysis of climate-related risks. See
Paulo Issler, Richard Stanton, Carles Vergara-Alert, and Nancy Wallace (2021), "Mortgage Markets with
ClimateChange Risk: Evidence from Wildfires in California"; Hyeyoon Jung, Robert Engle, and Richard Berner (2021),
"Climate Stress Testing"; and Henk Jan Reinders, Dirk Schoenmaker, and Mathijs van Dijk (2021), "A Finance
Approach to Climate Stress Testing." These three papers can be downloaded from the conference website,
hosted by the Federal Reserve Bank of Boston
(www.bostonfed.org/news-and-events/events/federal-reservestress-testing-research-conference/2021.aspx). Return to text
10
For the European Central Bank, see ECB (2021), "Firms and Banks to Benefit from Early Adoption of Green
Policies, ECB's Economy-wide Climate Stress Test Shows," press release, September 22; and Luis de
Guindos (2021), "Shining a Light on Climate Risks: The ECB's Economy-wide Climate Stress Test, " ECB
Blog, March 18. For the Bank of England, see Bank of England (2021), Key Elements of the 2021 Biennial
Exploratory Scenario: Financial Risks from Climate Change (London: BOE, June). Return to text
11
See Sergio Correia, Stephan Luck, and Emil Verner (2020), "Pandemics Depress the Economy, Public Health
Interventions Do Not: Evidence from the 1918 Flu," working paper, June. Return to text
See International Energy Agency (2021), Net Zero by 2050: A Roadmap for the Global Energy Sector (Paris: IEA,
May). Return to text
13
See Robert Vermeulen, Edo Schets, Melanie Lohuis, Barbara Kölbl, David-Jan Jansen, and Willem Heeringa
(2018), "An Energy Transition Risk Stress Test for the Financial System of the Netherlands," Occasional
Studies, vol. 16-7 (Amsterdam: De Nederlandsche Bank, October), available
a t www.dnb.nl/en/publications/research-publications/occasional-studies/nr-7-2018-an-energy-transition-risk-
stress-test-for-the-financial-system-of-the-netherlands. Return to text
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For instance, see Melissa Dell, Benjamin F. Jones, and Benjamin A. Olken (2012), "Temperature Shocks and
Economic Growth: Evidence from the Last Half Century," American Economic Journal: Macroeconomics, vol. 4
(July), pp. 66-95; 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; and Maximilian Auffhammer (2018), "Quantifying Economic Damages from Climate Change," Journal
of Economic Perspectives, vol. 32 (Fall), pp. 33-52. Return to text
15
See Network of Central Banks and Supervisors for Greening the Financial System (2020), NGFS Climate
Scenarios for Central Banks and Supervisors (PDF) (Paris: NGFS, June). Return to text
16
See, for instance, Simon Dietz, James Rising, Thomas Stoerk, and Gernot Wagner (2021), "Economic Impacts
of Tipping Points in the Climate System," PNAS, vol. 118 (August). Return to text
17
See, for instance, ECB (2021), "Firms and Banks to Benefit from Early Adoption of Green Policies, ECB's
Economy-wide Climate Stress Test Shows," press release, September 22. Return to text
18
See, for instance, Network of Central Banks and Supervisors for Greening the Financial System
(2021), Progress Report on Bridging Data Gaps (PDF) (Paris: NGFS, May); and the communiqué (PDF) on the
Third G-20 Finance Ministers and Central Bank Governors Meeting, held July 9-10, 2021. Return to text
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See Gary Gensler (2021), "Prepared Remarks before the Principles for Responsible Investment 'Climate and
Global Financial Markets' Webinar," Washington, July 28. Return to text