This is how the Federal Reserve will confront climate change

Is this a green central bank?
Is this a green central bank?
Image: Reuters/Kevin Lamarque
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The US Federal Reserve isn’t ready for climate change—yet.

But the world’s most powerful central bank, like every major global institution, will have to react to the disruptions caused by a changing climate, and by our efforts to mitigate them.

The good news for the Fed is that it won’t have to work out how to decarbonize the economy. (That’s mostly up to the world leaders meeting at the United Nations conference on climate change, where governments are confronting the reality that the Earth’s temperature will increase dangerously unless they take drastic action to reduce emissions.)

But how that process plays out will test the Fed’s primary duties. Maintaining stable prices and full employment will get trickier as old-line, carbon-emitting industries shrink or get phased out altogether. Meanwhile, in its role as the regulator supreme of the US financial sector, enshrined in law after the Great Recession, the Fed will have to think carefully about the exposure lenders have both to fossil-fuel industries and to the cost of ongoing climate change through things like extreme weather events

Think of it this way: By deciding how swiftly to eliminate reduce emissions, world leaders will have to balance the impact of a changing climate and the impact of decarbonization. And the Fed will have to make sure neither wrecks the economy.

A hotter planet means riskier markets

Lael Brainard, the member of the Fed’s board of governors who has taken the lead on environmental issues, likes to note the record cost of $630 billion incurred by natural disasters in the US over the past five years, as extreme weather, driven by climate change, has burned the west and flooded the midwest. Insurance companies forced to pay up for these losses have been among the first movers in the business world pushing for attention to climate change.

While climate shocks will shape the path of monetary policy, what worries the Fed most, according to observers and bank officials, is the possibility of hidden climate risk in the financial system.

Before the 2008 market crash, banks were convinced that mortgage-backed securities were largely safe investments. As it became clear that some significant share of home loans backing those securities would not be paid back, panic set in and banks endured runs that left them requiring government bailouts. Afterward, US lawmakers handed the Fed responsibility for the stability of the financial system—poking behind the scenes to make sure future shocks didn’t bring a surprise financial panic.

Brainard worries about similar scenarios, but in climate terms. A simple example is if bankers don’t realize their capital cushion is built on real estate threatened by flooding. But the Fed also worries about more complex efforts to shift risk among financial institutions in unexpected ways. To wit, few thought Lehman Brothers was dependent on mortgage securities until days before its collapse. The revelation that a major fund or bank’s assets are climate-compromised could launch a fire sale and a panic. Or, if the world moves more quickly toward decarbonization, that transition could dramatically change the model for energy-intensive businesses and their financiers.

To avoid all that, the Fed has launched a new organization, the Financial Stability Climate Committee (FSCC), which will stress-test US financial institutions against realistic scenarios for climate disruption.

How central banks prepare for climate change

“When the Fed needs to do something new like this, they economist up,” says Claudia Sahm, a former economist at the central bank. “When the stakes are very high, the Fed brings in the very best people to think through those questions.”

In this case, that person is Adele Morris, an economist whose career has focused on the economic cost of climate change. Most recently, she was an economist at the Brookings Institution, where her attention was on developing proposals for a carbon tax.

Previously, she worked at the Treasury Department and at the White House, where she was a key member of the US delegation that negotiated the Kyoto Protocol, a precursor of sorts to the Paris agreement on climate change. Now, she will chair the new FSCC. “I can’t think of too many other people you could appoint,” said Warwick McKibben, an Australian economist who was Morris’ collaborator at Brookings.

While the Federal Reserve declined to comment on Morris’ role or the FSCC, Brainard delivered a speech in October that laid out the bank’s near-term climate agenda. Her focus is on “scenario analysis”—exploring how climate change and the policies that might mitigate it will affect the economy. Brainard cited the work already being done by the European Central Bank to understand how banks and businesses will respond to a hotter world.

“We at the Fed are developing a program of scenario analysis to evaluate the potential economic and financial risks posed by different climate outcomes,” Fed chair Jay Powell said in an Oct. 21 statement.

Stress testing for climate change

Stress tests emerged in the US after the financial crisis as a tool for the Fed to ensure banks could handle another crisis. Fed officials forced bankers to face questions about what would happen in a severe recession or market crash—and if they didn’t like the banks’ answers, regulators could make them hold more capital in reserve.

In the future, banks also will face questions about the share of their lending that goes toward carbon-intensive industries, or that is secured by real estate in areas facing environmental disruption.

“As we have seen in California and in Florida, insurance companies can pull back from insuring properties and facilities in geographic areas subject to heightened flood or fire risk or seek to raise insurance rates on these properties and facilities to more accurately reflect risks,” Brainard said in March. “Although such changes may ultimately result in a more accurate assessment of actual risks, the abrupt changes to a wide range of contracts that embed systemic mispricing could initially amplify the shock.”

Tough questions mean tricky politics for the Fed

The Fed is running behind the European Central Bank and other central banks when it comes to addressing climate issues. That, insiders say, reflects the US central bank’s desire to be divorced from politics.

While it has had internal working groups focused on the issue and participated in global discussions, the Fed’s leadership was reluctant to engage publicly at a time when US president Donald Trump repeatedly said he did not believe in climate change, and rolled back policies intended to fight global warming.

Under a Democratic president, the Fed has been more willing to publicly face the scientific consensus on the changing planet. Still, many conservative American politicians connected to the fossil-fuel industry are fighting even voluntary efforts at greening finance, like Texas governor Greg Abbott attempting to ban state investment in businesses that decarbonize.

The conflicts will become even more clear once the Fed starts asking some of the most politically powerful businesses in the US to add the previously uncounted cost of carbon into their decision-making. Economists in the US widely reject the idea that the Fed should explicitly preference lending to decarbonized businesses, but just accounting for the reality of carbon emissions will likely be demagogued as an effort to pick winners.

Can anything change behavior like a carbon tax would?

Morris has devoted much of her recent career to assessing the potential of a carbon tax, the preferred solution of economists and wonks but one largely seen by US politicians as infeasible: The upfront cost of such a tax on consumers and businesses is just too much, they say, even if the plan includes redistribution of the gathered funds

Holding a measuring stick up to the banks may yet convince them to do more about climate. In a 2019 interview with Jason Jacobs, an entrepreneur turned climate activist, Morris lamented the lack of interest in carbon taxes from the financial sector.

“Those people in your world, Jason, that are managing gigantic financial portfolios and that kind of thing, large banks and investor groups and so on, I do not see them in DC engaging on promoting carbon pricing,” Morris said then.

It’s safe to say that if she puts the Fed on a path to stress-test banks against climate change scenarios, that dynamic could easily reverse.