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Memo: What to Watch for in Upcoming Biden Administration Report on Climate-Related Financial Risk

Evergreen Explains: Why action from regulators is essential and six key types of action that experts and activists will be looking for when the report is issued next week.

The US Department of Treasury. © APK/Wikimedia CC-BY-SA 3.0

Next week, the Biden Administration is expected to release a highly anticipated report from the Financial Stability Oversight Council (FSOC) detailing recommendations for how regulatory agencies can reduce the threat that climate-related financial risk poses to the stability of our entire economy.

FSOC was created under the Dodd-Frank Wall Street Reform and Consumer Protection Act in the wake of the 2008 financial crash to address emerging risks to our economy—and there’s no greater emerging economic threat than the climate crisis. Put simply, FSOC was created precisely to help multiple agencies coordinate to address complex, systemic threats to our financial system—precisely like climate change. Now, it is incumbent upon FSOC member agencies to fulfill their core purpose and use every tool at their disposal to mitigate climate-related financial risks, including by addressing the financing of the fossil fuels that drives the risk. 

This memo details why action from regulators is essential, and outlines six key types of action that experts and activists will be looking for when the report is issued next week. Each of these tools has the power to help protect our economy from a climate crash, but any one or just a few of them will not be enough to address this threat. The forthcoming report must outline a full range of tools that agencies will use to take on climate risk—a narrow focus on disclosure or stress tests alone is not sufficient.

Why It Matters

We know what can happen when regulators fail to rein in unchecked risk in our financial system. In the years leading up to the Great Recession of 2008, regulators were asleep at the wheel and their negligence allowed Wall Street’s reckless behavior to plunge our economy into a crisis that many Americans are still recovering from to this day.

Now experts are warning that, just like in 2008, unpriced risks in our financial system—this time driven by climate change—could drag us into a recession “like we’ve never seen before.” But even as economists are sounding the alarm, Wall Street continues to pour trillions of dollars into risky fossil fuel assets, increasing the greenhouse gas pollution that is fueling the climate crisis itself and increasing our economy’s exposure to climate risk. Indeed, climate-related financial risk threatens the economic security of every American, as Evergreen explained in “How Climate Change Puts Our Financial System At Risk."

Luckily, after financial disaster struck in 2008, Congress took action and handed regulators the tools they needed to avoid another catastrophic crash. As Evergreen has explained, Dodd-Frank empowers regulators, including all member agencies of FSOC, with the tools they need to help our financial system prepare to weather the shocks to our economy from climate change, and to rein in the drivers of climate-related financial risk—namely, fossil fuel use. Now, regulators must use the ample tools at their disposal to protect our economy, and the report coming next week will be our best view yet into their willingness to take on this systemic threat at the scale necessary to prevent a climate-fueled crash.

What To Watch For

The forthcoming FSOC report was called for in President Biden’s Executive Order On Climate-Related Financial Risk in May to “reduce risks to financial stability” and “incorporate climate-related financial risk into regulatory and supervisory practices.” To do that, the report should include a roadmap for each FSOC member agency, outlining concrete actions they should take to decrease regulated entities' contributions to the climate crisis and associated financial risk, and to bolster the financial system against those associated risks. 

Below, we lay out the types of tools these agencies can and should name in the report, and deploy to protect our collective future. While each of these tools has an important role to play, one, or a few, of them is not enough. In order to meet this moment, the agencies on FSOC must actively confront Wall Street’s financing of the climate crisis, and take steps to address it. Otherwise, climate risk will continue to multiply.

Disclosure: Necessary But Not Sufficient 

Right now, Wall Street firms are able to conceal their exposure to climate-related financial risks from their investors and the public, making it impossible for most investors to make informed decisions about the threat that climate risk poses to their own savings and investments. Climate risk disclosure rules would require banks and companies to share quantitative information about their exposure to climate risk and the carbon pollution they are financing—providing the transparency investors need to understand their own vulnerability to climate-related financial risk. The Securities and Exchange Commission (SEC) has already taken promising steps toward developing a new mandatory disclosure rule, and other agencies should follow suit.

While disclosure is an essential piece of the puzzle to help understand systemic climate-related financial risk in our economy, on its own it will not be enough to mitigate the threat of a climate-fueled crash. Disclosure can provide greater information and transparency on banks’ climate risks, but federal financial regulators must require entities to act on that information and address the sources of that risk, head-on. Put simply, the FSOC report must recommend further concrete actions for regulatory agencies to use all of the tools at their disposal to rein in climate risk.

Stress Tests: A Vital Tool To Measure Resilience To Climate-Fueled Shocks

To ensure our financial system can withstand climate-related economic shocks, bank regulators on FSOC must conduct regular climate stress tests. Regulators already use routine stress tests to assure banks’ resilience to traditional macroeconomic risks, helping ensure banks have a sufficient cushion baked into their financial plans to withstand a hypothetical severe shock. Climate stress tests would operate the same way, specifically modeling how climate-related shocks, including both physical and transition risks, could impact banks.

The Fed has already signaled that they are developing climate-related scenarios to incorporate into routine stress testing—but it’s important that they design those scenarios to account for the long term nature of climate risks. While existing stress tests use a horizon line of nine fiscal quarters, climate stress tests should look 15-30 years down the line. Like disclosure, stress tests are an important step to take but will be insufficient on their own to address the full threat climate change poses to our financial system.

Supervisory Guidance: Giving Banks the Information They Need to Mitigate Risk

Federal bank regulators have the authority to issue supervisory guidance, a means of advising banks on specific subject areas and providing examples of risk-mitigating practices. Although supervisory guidance does not create legally enforceable obligations, it has the potential to meaningfully influence the practices of banks and the flow of money. 

Now, federal bank regulators, including the Federal Reserve Board, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA), must issue new supervisory guidance for banks to "measure, monitor, and manage" risks faced by banks due to the climate crisis. 

This supervisory guidance should cover credit, market, liquidity, and operational risks to financial institutions that emerge in the context of the climate crisis. Specific attention should be paid to both physical and transitional risks when drafting supervisory guidance on climate-related risks. Finally, we have been pleased to see indications that this supervisory guidance is moving forward, and hope to see specific timelines for that guidance included in Monday’s report. 

Capital Requirements: Reflecting The True Risks Of Climate-Vulnerable Assets

Capital requirements set regulatory standards for how much liquid capital banks and other firms must have on hand. They are based, in part, on the risk associated with each type of asset that the institution holds. When required to maintain more capital, these institutions are more able to absorb losses, and are thus more resilient to economic shocks.

Regulators should impose higher capital requirements on climate-risky assets to account for the higher risk that those assets pose to the institution’s stability. In addition to helping financial institutions be more resilient, these capital requirements would help better reflect the higher costs of climate-risky assets, thus incentivizing shifts away from high risk fossil fuel assets and towards more climate-friendly projects.

Portfolio Limits: Aligning Financial Institution’s Holdings With Science-Based Emissions Targets

Ultimately, regulators can and should require financial institutions to ramp down their investments that are directly driving climate-related financial risk—namely, the financing of fossil fuels. To do this, regulators may impose limits on how much greenhouse gas pollution a firm can finance overall. We know that Wall Street’s investments in the fossil fuel industry are underwriting unsustainable levels of climate pollution, creating a vicious cycle that drives worsening climate impacts and therefore even more risk to the financial sector. To break that cycle, regulators should set portfolio limits on financed emissions that are in line with America’s Paris Climate Agreement commitments.

Promoting Green Finance: Incentivizing Investment In Our Clean Energy Future

Mitigating climate risk in our financial system is about more than just disincentivizing reckless investment in risky fossil fuel assets. Regulators should also take steps to drive investment in equitable green finance to ensure our transition to a clean energy economy is smooth and equitable. One way to do that is by improving the implementation of the Community Reinvestment Act (CRA), which was passed in 1977 with the goal of promoting investment in low- and moderate-income communities, to clarify that the climate needs of those communities meet the standards for CRA lending. 

The Takeaway

To fulfill President Biden’s directives to “protect workers’ life savings, spur the creation of good-paying jobs, and help position the United States to lead the global economy,” the forthcoming FSOC report must affirm financial regulators’ authority to directly limit financial institutions’ investment in the drivers of climate change and lay the groundwork for them to do so. 

We can’t afford to repeat the regulatory negligence that allowed Wall Street to drive our economy into the ground back in 2008. Regulators have a mandate to intervene to stop a climate-fueled economic crash, and the authority to do so. It’s time for them to take action.