How to deal with climate change’s increasing threat to US financial stability, in 4 charts
- Climate change could destabilize the US’ financial system if regulators and institutions don’t take a uniform approach, according to a new report.
- Implementing scenario analysis, enhancing disclosures and improving data are among the top recommendations.
Climate change is “an emerging and increasing threat” to the US’ financial system and affects the economy in a variety of direct and indirect ways, according to regulators.
“Increasing adverse effects from climate change to households, communities, and businesses will exacerbate climate-related risks to the US and global financial systems if not addressed,” said the US Financial Stability Oversight Council.
In a new report on the effects of climate change upon the US’ financial system, the FSOC detailed the climate-related risks faced by the industry and offered recommendations for regulators and financial institutions to improve resiliency.
The tools currently at hand are insufficient for proper climate-related risk assessment, it found. Investors, regulators and market participants need better data, including enhanced and transparent disclosures to create an accurate picture of financial risks posed by the changing climate.
An important recommendation was that banks and financial institutions use scenario analysis, which is similar to a stress test, to assess their risk exposure. This move is supported by the Federal Reserve, which is already undergoing such an exercise, hoping to guide other financial institutions in the future.
The effects of climate change on the financial system have been getting more attention over the past year, especially from the Biden administration. The FSOC was tasked with identifying vulnerabilities in the US financial system, and its report follows President Biden’s executive order on Climate-Related Financial Risks signed in May, aimed at mitigating economic risks to climate change.
Moreover, the adverse effects of climate change are likely to be disproportionately suffered by financially vulnerable communities, including low-income communities, communities of color, and Native-American communities. Future actions to address climate-related financial risks could negatively impact these communities through higher insurance and credit costs, the report noted.
Here are the main takeaways from the report, in four charts.
1. How climate risks translate into financial risks
There are many different ways in which a financial institution is exposed to climate-related risks.
The phenomenon impacts households, communities, businesses, and governments through property damage, business activity impediments; it impacts income and alters the value of assets and liabilities.
The FSOC grouped climate-related financial risks into two broad categories: physical risks and transition risks.
Physical risks consist of damages to people and property from climate-related disaster events such as hurricanes, wildfires, floods, and heatwaves.
For example, weather-related physical losses may impair the value of real-estate collateral, leading to higher credit risk for mortgage lenders, according to the report.
Transition risks refer to negative impacts of changes necessary to limit climate change. This can mean policy changes, consumer and business sentiment, or changing technologies.
In the financial sector, transition risks can take the form of credit and market risks associated with loss of income, defaults and changes in the values of assets. Banks can also be impacted by changing demand for liquidity, operational disruptions from infrastructure changes, or legal risks.
The graphic below shows how these risks can add to form a feedback loop that can adversely affect financial institutions and economic stability.
2. The need for better data
Having access to proper data is key to understanding the risks faced by banks and the financial market as a whole. There is a huge gap in this area, as current data and research is limited.
The Council highlighted a key finding by the Basel Committee on Banking Supervision:
“Existing analysis does not generally translate changes in climate-related variables into changes in banks’ credit, market, liquidity or operational risk exposures or bank balance sheet losses. In addition, the current state of data reflects the historical approach of financial institutions to climate change. Financial institutions, like most businesses, have historically viewed climate change through a corporate social responsibility lens instead of a financial risk lens.”
There is an “acute need” for standardized data that facilitates cooperation between entities or industry sectors, the report said. This is particularly important when assessing physical risks, as it would make it easier for data to be processed to generate actionable insights.
To assess transition risk, entities should consider their emissions footprint, which is more complex to calculate. The global standard used to quantify this is called the Greenhouse Gas Protocol.
The GHG protocol splits emissions into three segments. Scope 1 includes direct emissions, such as in manufacturing, and Scope 2 concerns emissions resulting from the production of the business’ acquired electricity, heat, and cooling. Scope 3 is defined by indirect emissions from the value chain of an organization’s activities.
Importantly, investments are included as a Scope 3 category also known as “financed emissions.” Financed emissions are particularly important for assessing the climate-related risks of financial institutions, the FSOC noted.
3. Enhancing public climate-related disclosures
Of course, an increased need for data also means better disclosures from market players.
The Council called for increased transparency and “high quality climate-related disclosures,” as current requirements “have not resulted in consistent, comparable, or decision — useful information for investors and other market participants.”
“Some U.S. regulators are taking steps to consider enhanced climate-specific disclosure requirements,” the report said.
“One important consideration for climate-related disclosures by financial institutions is the treatment of an institution’s financed emissions. Disclosure of financed emissions can provide insight to investors and market participants regarding the transition risks a financial institution faces from their investing and lending activities.”
The FSOC noted that a good starting point would be the four core elements of disclosure identified by the industry-led Task Force on Climate-Related Financial Disclosure, as outlined in the figure below.
4. Scenario analysis
Assessing climate-related financial risks and their implications is a complex endeavor, and tools for tackling this remain under development.
However, one way institutions can go about this is by implementing scenario analysis. An emerging tool in the study of climate-related financial risks, it has been used internationally to measure current and potential future exposures.
“Scenario analysis considers a range of possible future climate pathways and associated economic and financial developments. For example, scenarios may include pathways associated with current or planned policies and expectations for technological developments as well as alternatives.”
In order to be applied effectively, scenario analysis requires a close link between the objectives and outputs of the analysis, as highlighted in the figure below.