The upheavals of climate change hit every sector of the financial ecosystem, from how major disasters wreak havoc on insurance companies to how these climate-related disasters can throw loan pricing into a frenzy.
On top of the physical risks of climate change, there are also transition risks posed by the policy and technological changes necessary to achieve a greener economy. For example, what happens when the widespread shift to renewable power affects stocks and bonds in fossil fuel companies?
That’s why the Federal Reserve is launching a new pilot program to measure how hurricanes, droughts, and other extreme weather events can affect banks’ portfolios.
The Federal Reserve announced the details of the plan last Tuesday. The plan asks six major Wall Street banks to conduct climate risk analyses. These banks include JPMorgan Chase, Wells Fargo, Citigroup, Bank of America, Morgan Stanley, and Goldman Sachs, Bloomberg reports.
The analyses will offer a peak into the worst-case climate-related scenarios financial regulators fear. According to a 2019 report by the Center for American Progress Action Fund (CAP), these fears consist of a long laundry list of ways climate change threatens the stability of the financial system.
For one, many banks may exacerbate the risks fossil fuels pose by continuing to provide substantial financing to climate change-intensifying activities.
The six Wall Street banks participating in the program committed more than $700 billion toward fossil fuel financing from 2016 to 2018. According to the survey, the largest insurers held $528 billion in fossil fuel investments. Plus, as the world attempts to transition away from fossil fuels, the biggest asset managers increased their holdings of assets tied to carbon-intensive industries by 20% between 2016 and 2019.
In 2019, the Sierra Club, Rainforest Action Network, Banktrack, Oil Change International, the Indigenous Environmental Network, and Honor The Earth released a report detailing banks’ role in climate change.
As the report puts it, these six U.S. banking giants are in the top “dirty dozen” of fossil banks. Together, they account for an astonishing 37% of global fossil fuel financing since the Paris Agreement was adopted. In terms of financing fossil fuels, JPMorgan takes the (oil) cake, leading by 29%.
These banks play a huge role in fossil fuel expansion, by financing drilling, mining, extracting, fracking, and so on. On top of that, the report details the human rights side of things. "Fossil fuel companies are increasingly held accountable for their contributions to climate change,” the report states, “finance for these companies also poses a growing liability risk for banks."
"The fossil fuel industry has been repeatedly linked to human rights abuses, including violations of the rights of Indigenous peoples and at-risk communities, and continues to face an ever-growing onslaught of lawsuits, resistance, delays, and political uncertainty.”
The transition risks are vast, but they don’t begin to touch on what’s known as “physical risks.”
These types of risks include the decreased value of damaged assets in disasters, housing costs associated with post-disaster migration, climate-driven changes in mortgages and loans for commercial real estate and businesses, the dissemination of valuable forest land, and what happens when increasing hurricanes, droughts, floods, fires, heatwaves, and sea-level rise destroy property and crops banks invest in.
In fact, as The Economist’s Intelligence Unit estimates, the current value of direct private investor losses globally due to the physical risks of climate change range between $4.2 trillion and $13.8 trillion, depending on a not-so-bad or very very bad warming scenario.
Between now and the net-zero target year of 2050, that type of loss could be catastrophic for the American and global economies. It could also impact the transition to a greener economy before and after that all-important year.
That’s why, according to CAP, U.S. regulators must protect the financial ecosystem from each climate change risk. That’s where the Federal Reserve’s pilot program comes in.
The Federal Reserve oversees the financial ecosystem, and its main job is to ensure stability. With the Fed’s new program, banks will assess both the physical and transition risks of climate change.
This type of analysis is known as a “stress test,” which according to the Federal Reserve tests whether or not banks are able to capitalize on and absorb losses during stressful conditions. They’re used because the Fed requires that large banks demonstrate they can withstand financial shocks. This is the first time the U.S. government has asked banks to account for the financial shock of climate change.
As Grist reports, the test will consist of two parts. Firstly, banks will assess physical risks by surveying how their portfolios would fare if one or more severe hurricanes struck the Northeast. This could be a “common shock,” the Fed says because here, all participating banks have “material commercial and residential real estate exposures,” and the region will likely see an “increase in the severity of shocks.”
In the second part, the Fed will look at how their investments and loans would perform during a rapid energy transition to net zero emissions by 2050. In the event that we decarbonize by that timeline, major oil and gas companies will have severe losses. The stress test will answer how banks will account for that.
According to CAP’s report, the benefits of such regulation exceed financial stability. This type of mitigation may also increase the likelihood that policymakers take the necessary transition steps in the first place. As Grist points out, the Federal Reserve is independent of the Biden administration.
While this climate impact exercise comes on the heels of historical regulatory action, understanding the risks climate change poses to banks may help them divest from the fossil fuels causing it. The results of the stress test will go public later this year after banks submit their analyses by July 31.