Cascading effects of climate change increasingly a Fed concern

Lael Brainard
Federal Reserve Board Governor Lael Brainard seen giving a speech at the “Renewing the Promise of the Middle Class” 2019 Federal Reserve System Community Development Research Conference.

Editor’s Note: Federal Reserve Board Governor Lael Brainard addressed climate change at a conference in Boston in March. An edited version of her speech follows.

 

Climate change is already imposing substantial economic costs and is projected to have a profound effect on the economy … and could have important implications for the Federal Reserve in carrying out its responsibilities.

The Federal Reserve created a new Supervision Climate Committee 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. The SCC’s 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.

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. The Federal Reserve Board is establishing a Financial Stability Climate Committee to identify, assess, and address climate-related risks to financial stability. 

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…  [The report] outlines how climate change could increase financial shocks and financial system vulnerabilities that could further amplify shocks.

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 the importance of consistent, comparable, and reliable disclosures to financial stability and prudential objectives, mandatory disclosures are ultimately likely to be important.

There are situations, [when] 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.

Our macroprudential work is focused on assessing not only potential climate shocks, but also whether climate change might make the financial system more vulnerable in ways that 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 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; over time, these shocks can change the statistical time-series properties of economic variables, making forecasting based on historical experience more difficult and less reliable. 

It might be useful to consider some examples of climate-related risks that could manifest as shocks or increase financial system vulnerabilities or both. 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, some level of risk is likely to remain. 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.

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. 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 locations.