Governments around the world are gearing up to use an old regulatory tool for a new purpose: protecting the economy from climate change.
Financial regulators for years have used “stress tests” to gauge whether major banks are prepared to stay afloat amid extreme, unanticipated—yet entirely plausible—economic shocks. They were widely implemented in the United States and abroad following the 2007-08 global financial crisis to help prevent systemwide catastrophes down the line.
Economists, environmentalists and advisers to President-elect Joe Biden warn that global warming could spur that next catastrophe. The climate finance proponents among them argue that major lenders should be required to undergo climate-related stress testing before it’s too late.
Standing in the way are a slew of challenges—including insufficient corporate climate disclosures, still-developing climate projections and the banking sector itself, which has already signaled opposition to the idea.
There’s a chance that banks could use their lobbying might to delay or water down future climate finance regulations, advocates say. But global momentum around the issue—and the incoming Biden administration—could mean that mandated climate stress testing in the United States isn’t far off.
“It’s pretty tough to imagine that regulators wouldn’t do this, because I don’t see how they can act in an informed way if they don’t know what the problem is. And the only way you know the problem is by looking under the hood of [banks’] balance sheets,” said Justin Guay, director of global climate strategy at the Sunrise Project.
“There is a very clear consensus agreement among regulators globally that climate change is a systemic risk,” Guay added. “So that ship has sailed.”
According to Monsur Hussain, who heads financial institution research at Fitch Ratings Inc., the main point of stress testing is to help regulators assess how a financial system or firm would cope under immense pressure—climate-related or otherwise.
They do so by modeling the impacts that an economic shock would have on a bank’s profitability and balance sheet over a two- or three-year period.
The United States currently requires financial firms to conduct stress tests with a “pass-or-fail threshold,” Hussain said. If a bank does not have enough capital on hand to stay in business during the simulated crisis, it fails. The Federal Reserve then requires firms that fail the tests to set aside extra capital to prevent the hypothetical situation from taking place in real life.
Climate finance proponents say regulators in the United States need to take a similar approach to climate change. They would do so by way of climate scenarios that consider how physical risks—like extreme weather events—and the transition to a low-carbon economy could affect banks’ loans to vulnerable businesses and sectors.
Between 2016 and 2019, for instance, companies in the fossil fuel industry received more than $2.7 trillion in financing from 35 major banks, according to a report compiled by a group of environmental organizations.
“If we have two hurricanes, a wildfire and droughts in the farming country, will our banking system be able to withstand that? We don’t really know,” said Sarah Dougherty, a former researcher at the Federal Reserve Bank of Atlanta who is now with the Natural Resources Defense Council.
‘A fundamental shift’
In June, a coalition of central banks—dubbed the Network for Greening the Financial System—published stress testing guidance for regulators around the world.
The document included several high-level climate stress testing scenarios. Among them was an “orderly transition” scenario, which would help regulators gauge how much money banks would lose if governments set a price on carbon this year—and achieved net-zero emissions by 2050.
But the NGFS also included a “hot house world” scenario, in which no additional emissions policies are adopted and the world blows past the warming goals enshrined in the Paris Agreement—leading to severe climate impacts.
Central banks in countries including the United Kingdom, France and Japan have already unveiled their plans to roll out stress tests to gauge financial firms’ exposure to global warming.
The U.S. central bank is much further behind its global peers on the issue and hasn’t yet indicated that it intends to do the same.
But there are signs of progress. The Federal Reserve in November acknowledged for the first time in its Financial Stability Report that global warming “is likely to increase financial shocks and financial system vulnerabilities” (Greenwire, Nov. 10).
Also notable is the incoming Biden administration’s commitment to taking an all-of-government approach to climate change, including by tapping a number of climate hawks to fill high-level economic positions (Climatewire, Nov. 25).
“For the first time, potentially ever, finance policy is being used as climate policy, which is a fundamental shift—it never has been in the past,” Guay said.
The incoming administration and the Fed’s change in tone do not eliminate the challenges inherent to measuring how much climate change could cost banks in the long term.
Dougherty, Hussain and the Bank Policy Institute, a lobbying group, are among those who have emphasized that climate stress tests remain in their infancy—in part due to the reality that measuring banks’ exposure to global warming is far more complicated than assessing other hypothetical shocks.
That’s for a few reasons.
Climate stress tests would need to measure banks’ risk over a longer period. That’s because some climate impacts—such as sea-level rise and the transition to a low-carbon economy—will take place over several decades rather than several years.
Beyond that, developing climate-related scenarios would require banks to make a variety of difficult assumptions—including predicting how climate change would affect each portfolio company, how different sectors will adapt to rising temperatures, and what climate policies will be passed in the United States and elsewhere.
‘Bridge too far’
There’s widespread agreement that those factors make climate stress testing complex. But there’s less consensus regarding what should be done with stress tests’ results—and whether they should be required at all.
Greg Baer, the chief executive of BPI—whose members include Bank of America Corp., Citibank and Goldman Sachs Group Inc.—said in a recent op-ed that “banks have an important role to play in managing a transition away from carbon.”
But in an interview with E&E News, Baer said BPI’s stance is that climate stress tests are a “bridge too far.”
“Trying to capture climate change effects decades in advance—without considering the extraordinary adaptability of the financial system and economy—and incorporating those results into the regulatory capital framework is no easier than predicting how pandemics or machine learning will affect banks by 2050,” BPI argued in a recent research note.
For those reasons and more, the trade association concluded that it’s premature to incorporate climate change scenarios into existing macroeconomic stress tests—“and even more so to link climate stress test[s] to capital requirements.”
JPMorgan Chase & Co., Bank of America and the Financial Services Forum—another banking trade group—did not respond to questions about their organizations’ stance on climate stress testing. A Wells Fargo & Co. spokesperson declined to comment.
A spokesperson for the American Bankers Association, another trade group, said in an email that quantifying climate impacts on financial firms “is in its early stages” and that “any potential changes to the regulatory framework, no matter how well-intended, must be thoroughly understood to avoid any unintended consequences.”
Climate finance experts and advocates disagree with BPI’s position—or at least parts of it.
A global meltdown?
Financial regulatory expert Gregg Gelzinis, of the left-leaning Center for American Progress, acknowledged that measuring climate risk is riddled with challenges and that climate stress tests shouldn’t necessarily be used to adjust banks’ capital requirements right off the bat.
“Yes, we are projecting out significantly into the future, and yes, a bank’s balance sheet as it stands in 2020 is going to be different than a bank’s balance sheet as it stands in 2030, or 2040, or 2050,” Gelzinis said.
But he disagreed that those challenges are insurmountable—or that they would render the tests’ results useless.
“If climate stress tests show that 15 years from now, you’re expected to have ... severe losses on your carbon-sensitive assets—things like fossil fuel bonds and fossil fuel loans—and it encourages you to today shift away from those assets, that’s a positive outcome,” Gelzinis added.
He also warned against regulators implementing stress tests that lack any consequences at all, amounting to what he called “completely toothless exercises.”
In his view, banks think about climate stress tests as “maybe an interesting informational exercise. But they don’t want it in any way to impact how much capital they have to fund themselves with, which is one of the most powerful financial regulatory tools in regulators’ arsenal to bolster the resiliency of these banks.”
Even if not immediately, he said, climate stress tests should lay the groundwork for more aggressive regulatory measures that would actively safeguard the financial system to avoid an economic meltdown in the future.
Dougherty, the former Fed researcher, agreed.
“Of course they don’t want to do something that might make them do more work and hold more capital in reserve,” she said. “But we also don’t want them to fail and take the entire financial system down with them.”
Reprinted from Climatewire with permission from E&E News. E&E provides daily coverage of essential energy and environmental news at www.eenews.net.