Addressing Climate as a Systemic Risk: A Call to Action for Financial Regulators

Executive Summary

Systemic risks have the potential to destabilize capital markets and lead to serious negative consequences for financial institutions and the broader economy. Under this definition, climate change, like the current COVID-19 crisis, is indisputably a systemic risk. Its wide-ranging physical impacts, combined with expected transitions to a net-zero carbon economy and other socio-economic ripples, are likely to manifest in both cumulative and unexpected ways and present clear systemic risks to U.S. financial markets—and the broader economy. Left unmanaged, these risks could have significant, disruptive consequences on asset valuations, global financial markets and global economic stability.

This post, “Addressing Climate as a Systemic Risk: A call to action for U.S. financial regulators,” outlines how and why U.S. financial regulators, who are responsible for protecting the stability and competitiveness of the U.S. economy, need to recognize and act on climate change as a systemic risk. It provides more than 50 recommendations for key financial regulators to adopt, including the Federal Reserve Bank (the Fed), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CTFC), state and federal insurance regulators, the Federal Housing Finance Agency (FHFA), and the Financial Stability Oversight Council (FSOC).

Given the ongoing response to the COVID-19 pandemic, the role of financial regulators is more prominent than ever. While financial regulators are taking critical actions to support the U.S. economy in response to this immediate crisis, it is imperative that their efforts do not inadvertently worsen the impacts of climate change.

The evidence on climate risk is compelling investors to reassess core assumptions about modern finance. Research from a wide range of organizations—including the U.N.’s Intergovernmental Panel on Climate Change, the BlackRock Investment Institute, and many others, including new studies from McKinsey on the socioeconomic implications of physical climate risk—is deepening our understanding of how climate risk will impact both our physical world and the global system that finances economic growth.”

“These questions are driving a profound reassessment of risk and asset values. And because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself. In the near future—and sooner than most anticipate—there will be a significant reallocation of capital.

Larry Fink
Chairman and CEO, BlackRock
“A fundamental reshaping of finance,” Fink’s 2020 CEO Letter to BlackRock portfolio companies

Addressing Climate as a Systemic Risk

Frequent extreme weather events are leading to mounting economic losses.

Physical risks from rising global temperatures—up 1.8° F since the mid-20th century—are the most immediate threat to the U.S. economy. Catastrophic flooding, droughts, wildfires and storms are becoming more frequent and extreme and have caused billions of dollars in financial losses. As global greenhouse gas (GHG) emissions and temperatures continue to rise, deeper economic losses are projected for the years ahead.

The Fourth National Climate Assessment (Vol.11), based on the work of thousands of researchers, suggests that unmitigated climate change could reduce the U.S. economy by as much as 10% annually by 2100. In a 2019 CDP survey, 215 of the world’s largest listed companies reported nearly $1 trillion at risk from climate impacts, much of it in the next five years. A London School of Economics study projects that, unless it is addressed, climate change could reduce the value of global financial assets by as much as $24 trillion—resulting in permanent damage that would far eclipse the scale of the 2007-2009 financial crisis.

Social and environmental factors are exacerbating the economic impacts.

Unmitigated climate change and extreme weather events will have significant health impacts, including respiratory issues, the spread of diseases and premature deaths. Climate change and extreme weather events will also create major productivity losses, particularly in industries that require workers to be outside. Migration forced by climate change has already displaced an average of 26.4 million people per year globally between 2008 and 2015. By 2050, climate change will force 50 to 700 million people to emigrate. Finally, the rapid loss of forests and other ecosystems is starting to impact ecosystem-dependent industries such as agriculture, tourism, drinking water and pharmaceuticals.

Climate impacts are already manifesting in the largest state economies.

In just the last few years, California has experienced recording-breaking wildfires, in both number and size, that have taken hundreds of lives, bankrupted the state’s largest utility, left millions regularly without power and brought home insurability into question. Florida is facing rapidly rising sea levels and now-routine flooding that are eroding coastal property values and wiping out freshwater supplies. Texas experienced two devastating once-in-a-thousand-years flood events between 2016 and 2019, each caused by torrential rains of 40 inches or more.

An unplanned transition to a low-or-zero-carbon economy could cripple key industries.

Changes in government policies, consumer sentiment, liability risks and technological innovation could cause significant losses for high-carbon industry sectors, and those that rely on them. Given the large size of these industries, these cumulative losses could send broad, intersecting and amplifying financial ripples on major financial institutions holding related assets.

Economists and financial leaders say the scale of the losses from climate change could eclipse the subprime mortgage securities meltdown that triggered bank failures and, ultimately, a deep global recession a dozen years ago. “Even if only a fraction of the [climate] science is right, this is a much more structural, long-term crisis [than the 2007-2009 recession],” said BlackRock CEO Larry Fink in 2020.

Despite these risks, national and global efforts to mitigate climate change’s impacts could create enormous clean energy investment opportunities that would translate into economic growth and job creation. Research suggests that transitioning to a low-carbon sustainable economy could deliver direct economic gains of $26 trillion through 2030, compared to business as usual.

Insurance companies and banks are on the frontlines of risk.

The insurance sector is particularly vulnerable to the physical impacts of climate change, and has already faced growing losses; insurers’ investments are also at risk. Banks and financial institutions that have lent to and invested in risky, carbon-intensive sectors have the potential to have their investments become “stranded” in the face of the transition to a low-or-zero-carbon future.

The cumulative and unpredictable nature of climate impacts poses a risk to financial market stability. While any of the impacts outlined above are significant, their cumulative, correlated and nonlinear nature poses the real risk to financial market stability. To put it simply, the whole is not only greater than the sum of its parts—it magnifies them, as well. If climate change affects markets suddenly and unexpectedly, it could burst a “carbon bubble,” which could pose grave dangers to financial markets and the real economy, already weakened from the ongoing coronavirus pandemic.

At the same time, the response to the pandemic has also underscored the power financial regulators have to buttress markets in the face of a disruptive risk. With that power, regulators also have the responsibility to assess market vulnerability to such risks, and take action to make the economy resilient to such shocks.

As stewards of the largest economy in the world, U.S. financial regulators, including the Federal Reserve, the SEC and others, have critical roles to play. They can send the appropriate market signals about the risks posed by climate change to the U.S. and global economy, and take the necessary steps to recalibrate our financial system.

Actions Needed

This post outlines why and how key U.S. financial regulators can and should take action to protect the financial system and economy from potentially devastating climate-related shocks. Financial regulators have a mandate to maintain financial market stability, foster capital growth and competitiveness, protect consumers and investors and ensure market efficiency and integrity. Climate risk is relevant to each of these considerations.

The complete publication focuses on the roles of those financial regulators that Ceres believes are particularly important to jumpstart the necessary action on climate risk now. However, we also believe that all regulators—financial and otherwise—have important roles to play in addressing the climate risk. “Addressing Climate as a Systemic Risk” makes a series of recommendations that build on the existing mandates of the relevant regulatory agencies. We also identify similar actions being taken by global regulators that could serve as important models for U.S. agencies to consider.

Our key recommendations:

The Federal Reserve System, including the Federal Reserve Bank, should:

• Acknowledge that climate change poses risks to financial market stability and immediately begin assessing their This includes building awareness of regional climate vulnerabilities, and conducting the needed research.
• Integrate climate change into their prudential supervision and regulation of systemically important financial institutions to ensure they adequately address climate change as a part of their risk management and are well prepared for transition One clear opportunity is to require financial institutions to conduct climate stress tests. Another opportunity is to work with the SEC and other agencies to require banks to assess and disclose climate risks, including carbon emissions from their lending and investment activities. Finally, the Fed should coordinate with its global counterparts to define activities that are likely to exacerbate climate risks.
• Explore how climate risks can be addressed through monetary policy to keep the economy resilient in the face of disruptive This policy assessment should include considering the climate impacts of injecting more liquidity into the economy, and integrating climate risk into collateral frameworks and economic outlook assessments.
• Explore the integration of climate risk into the community reinvestment process to bolster the resilience of low-income communities to climate
• Join efforts, such as the Network for the Greening the Financial System, and to allow for globally coordinated efforts on climate risks.

When you put all these pieces together, it becomes pretty clear: climate change is an economic issue we can’t afford to ignore.

This isn’t just a concern for the Twelfth District. Or even the United States. Countries around the world are dealing with the economic impacts of climate change. And conferences like this are essential to understanding the challenges that lie ahead—for all of us.

Ultimately, this is our job. The San Francisco Fed is a public service organization. We’re responsible for the people and the communities we serve. So, we have to get out in front of this issue and do what we do best.

Convene the best people and ideas. Study data and conduct research.

Talk to the communities we serve—and really listen when they tell us what they need.

Mary Daly
President and CEO, Federal Reserve Bank of San Francisco
“Why climate change matters to us,” November 2019

The Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation should:

• Coordinate with each other and all banking regulators to ensure that climate change is integrated into the financial supervision This integration could include jointly issuing a bulletin highlighting the wide ranging ways that climate risks could impact financial performance and outlining principles to help financial institutions prudently manage them.
• (OCC) update the Comptroller’s Handbook to issue enhanced guidance on climate risk to examiners, to be used in supervision of financial They should also integrate climate-risk supervision into the examiner education process.
• (FDIC) closely monitor the impacts of climate risk on bank lending and investments activities and explore how to integrate climate risk into the risk-based premium system for the Deposit Insurance Fund.

The Securities and Exchange Commission should:

• Analyze climate risk impacts on the securities markets and on the SEC mandate, and consider establishing a cross-divisional taskforce to allow for coordinated responses.
• Make clear that consideration of material environmental, social and governance (ESG) risk factors, such as climate change, is consistent with investor fiduciary duty.
• Issue rules mandating corporate climate risk disclosure, building on the framework established by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). In the short term, the SEC should enforce the existing regulations and interpretive guidance on climate risk.
• Direct the Public Company Accounting Oversight Board (PCAOB), overseen by the SEC, to assess whether firm audits adequately detect climate risks, and issue guidance to help auditors better understand how climate risk affects audits and The PCAOB should also assess existing standards to identify when amendments and updates may be needed, and issue such amendments.
• Encourage the Financial Accounting Standards Board to drive consistency in the way that climate risk is disclosed in financial statements.
• Issue guidance encouraging credit raters to provide more disclosure on how climate risk factors are factored in ratings They could also examine the extent to which climate risk is considered by credit raters, and summarize findings in annual examination reports.

The Commodity Futures Trading Commission should:

• Upon receiving the Climate-Related Market Risk Subcommittee’s report, engage other financial regulators on climate change.
• Use the report’s recommendations to enhance oversight of climate risk in the commodities and derivatives market.

State and federal insurance regulators should:

• Acknowledge the material risks climate change poses to the insurance sector and pledge coordinated action to address them.
• Assess the adequacy of current insurer actions for addressing climate risks.
• Join the Sustainable Insurance Forum.
• Require insurance companies to conduct climate risk stress tests and scenario analyses to evaluate potential financial exposure to climate change risks.
• Require insurers to integrate climate change into their Enterprise Risk Management (ERM) and Own Risk and Solvency Assessments (ORSA) processes.
• (State regulators) require insurance companies to assess and manage their climate risk exposure through their investments, and examine how climate trends affect company holdings and long-term solvency.
• (State regulators) encourage insurers to develop products for the new technologies, practices and business models that will emerge in response to climate risk that are responsive to both risks and opportunities.
• (State regulators) mandate insurer climate risk disclosure using the TCFD recommendations.
• Assess the sector’s vulnerabilities to climate change, and report findings to the Financial Stability Oversight Council.

We purport to modernize, without mentioning what may be the single most momentous risk to face markets since the financial crisis. Where we should be showing leadership, we are conspicuously silent. In so doing, we risk falling behind international efforts and putting U.S. companies at a competitive disadvantage globally.

Allison Herren Lee
Commissioner, Securities and Exchange Commission “‘Modernizing’ Regulation S-K: Ignoring the elephant in the room,” January 2020

The Federal Housing Finance Authority, responsible for government-sponsored mortgage giants Freddie Mae and Fannie Mae, should:

• Acknowledge the impacts of climate risk on the housing market.
• Conduct research to examine the impacts of climate risk on the mortgage holdings of Government-Sponsored Enterprises, particularly Fannie Mae and Freddie Mac.
• Launch a formal effort to develop strategies to address climate risk, being particularly aware of the impacts on vulnerable communities disproportionately threatened by climate change.

The Financial Stability Oversight Council, whose mandate is to identify risks to financial stability, should:

• Identify climate risk as a vulnerability and make recommendations on regulations that relevant agencies could adopt.
• Coordinate regulatory actions on climate change and the integration of efforts by all financial regulators addressing climate risk to allow for overall financial stability.

In the crowded regulatory and supervisory space, there is limited scope for focusing attention on new issues but climate risks need immediate action in order to limit or reverse the impact of some of the negative trends under way. It is incumbent on supervisors to put in place the necessary measures for insurers to address any significant risks that could adversely affect policyholders and financial stability. In previous financial crises, events once deemed implausible have materialized. Climate change poses the same threat.

Bank of International Settlements
“Turning up the heat: Climate risk assessments in the insurance sector,” 2019

Conclusion

Ceres knows that climate change is the biggest sustainability issue of our time, affecting everything from our financial markets, to our political security to our very existence on earth. For over three decades, Ceres has worked with companies, investors and policy makers to drive the consideration of climate change as a financial risk, and foster the uptake of climate solutions. We also believe that legislative action on climate changezosuch as a carbon price—is necessary to move the U.S. economy towards a competitive and prosperous net-zero carbon future.

But while policymakers at the federal, state and global levels need to take the lead in tackling the climate crisis, U.S. financial regulators themselves have critical roles to play in keeping a now-weakened economy resilient in the face of ongoing and future climate shocks. Rather than standing back, they should seize the opportunity in this moment of potential economic transformation to join global peers and develop a playbook for climate action. With global emissions and average temperatures still rising, watching and waiting are no longer responsible options, and will in fact guarantee the worst. And, unlike in the possible resolution to the COVID-19 pandemic, there will never be vaccines developed to protect against climate risk. But the good news is: we already have all the tools and knowledge in the financial markets to take sound preventative action.

Climate change presents risks to both the future and today—unless regulators act boldly, now.

The complete publication, including footnotes, is available here.