Climate Risk Stress Testing and the Role of Central Banks

Should central banks care about climate risk?

The Federal Reserve's recent release of its pilot climate scenario analysis exercise has sparked a heated debate on the role of central bankers in managing potential climate-change-driven financial risks. As providers of objective information that can assist policymakers, business leaders and households to assess threats and take appropriate mitigating actions, risk managers will play a central role in this debate.

But how important is it, really, for central banks to assess potential climate threats and, when necessary, to take corrective actions?

Proponents for regulatory climate risk stress testing argue that changes to the climate pose a significant challenge to the financial system – and therefore fall under the purview of the Fed and other central banks. They contend that the effects of physical risks (such as hurricanes and droughts) impact bank balance sheets. Moreover, they argue that steps taken to transition to a lower-carbon economy – including carbon taxes or government-imposed limits on emissions – could induce inflation and harm labor markets.

Given the Fed's dual mandate to ensure price stability and maximum employment, proponents say, failure to consider the economic impact of climate change would amount to regulatory negligence.

Detractors argue that climate risk policies are outside of the central bank’s responsibilities. They contend that it is not up to the Fed to decide which individual businesses or industries should have access to capital based on hypothetical scenarios. For example, they point out that while a company involved in the extraction of petroleum could see its value erode significantly with the introduction of a carbon tax, basing assessments of bank stability on the possibility of future public policy oversteps the Fed’s narrow mandate.

Cristian deRitis

Until carbon regulations become the law of the land, detractors elaborate, regulators should focus exclusively on more immediate threats – such as an energy price shock or a crash in the property market. Moreover, they argue, it may be difficult to measure and disentangle carbon-related activities within a business to which a bank lends. A company might be involved, for example, in both extraction of petroleum and carbon capture.

Narrow Mandate, Many Risks

While both sides in the debate have valid points, there is no denying that climatic events pose a potential threat to the financial system. This risk needs to be examined alongside other threats, such as cybersecurity, pandemics and geopolitical conflicts.

Regulators have a vested interest in understanding how changes in laws, taxes, duties and physical risks may impact bank balance sheets and capital standards over time. Conducting scenario analysis is a necessary step for regulators to assess potential threats. Disseminating information from their risk assessments is non-controversial and would assist both policymakers and banks with understanding the size and scope of the climate issue.

How this information is used is an important consideration as well. Jumping to conclusions based on the results of a single scenario analysis could have significant negative consequences over both the short and long term. If poorly designed, even policies put forward with the best of intentions may have catastrophic, unintended consequences.

History is filled with examples of such flawed policies. For instance, the installation of smokestacks during the Industrial Revolution were intended to decrease local air pollution – but ended up spreading pollution at higher altitude, leading to widespread acid rain.

The Fed’s Test

Like the Bank of England and other central banks, the Fed is taking an equilibrated approach to climate risk stress testing. It’s exercise is mandatory for the six largest banks in the U.S., and will consider both physical and transition risks related to climate change.

The physical risk portion of the test considers a scenario where the northeast U.S. is hit by a large hurricane. Banks need to estimate expected losses – both from this event and from another severe climatic event of their choosing – on their residential and commercial real estate portfolios.

The transition risk portion of the test requires institutions to estimate losses under two economic scenarios. The first assumes that current policies persist without any additional efforts to abate carbon emissions. The second scenario assumes that stringent climate policies are enacted to reduce net CO2 emissions to zero by 2050. The latter scenario also assumes a rapid advancement in technological climate solutions, including carbon dioxide removal technologies.

Under these scenarios, the Fed will provide specific assumptions for key economic variables like GDP and unemployment. To execute this exercise successfully, banks will have to take the limited number of provided economic inputs and expand them to other relevant indicators and regional geographies that are required by their credit loss models.

Results of the exercise will be shared with the public by the end of 2023 – but they will be aggregated and will not have any bearing on capital adequacy assessments. Based on the learnings of the exercise, scenario assumptions and instructions will be refined to produce more accurate and informative results in the future.  

Pandemic Lessons Learned

Pandemic stress testing informed the debate around public policy decisions (such as masking and vaccines), but the Fed played no role determining or dictating public policy. The same logic applies to climate risk stress testing.

As with COVID-19, there is a significant amount of uncertainty surrounding the impact of climate change on both the economy and on financial institutions, because of the large number of variables and the long-term time scale involved. However, this should not be used as an excuse for inaction.

Just as it was reasonable for financial institutions and regulators to consider the potential economic and credit impact of a pandemic scenario, it is prudent to consider the impact of varying climate scenarios.

Parting Thoughts

Central banks have a particular interest in understanding the threat that climate change poses to the financial system as a whole. They want to comprehend which individual banks may be most exposed to climate risks, so they may take corrective actions; even more importantly, regulators want to understand the systemic threats that may fly under the radar of individual bank analysis.

For example, the large hurricane striking the northeastern U.S. envisioned in the Fed’s stress test would likely lead to a sharp reduction in commercial real estate values and an increase in loan losses. An individual institution may be able to absorb these in isolation, but the simultaneous nature of the shock could create feedback effects that threaten the entire system.

Critics should not confuse scenario analysis and the provision of information related to climate risk with determining public policy. The Fed's mandate is to assess a wide range of potential threats, including climate change, and to then share objective information with stakeholders. It is up to policymakers to decide on the best course of action to mitigate and adapt to climate risk.

Literature often provides useful lessons for risk professionals. The “Ministry of the Future,” by Kim Stanley Robinson, provided a provocative fictional account of the expanded role that central banks could play in reacting to catastrophic climate events. The story envisioned that central banks (as quasi-independent institutions) may have more discretion at their disposal to address climate risk through monetary policy and regulatory oversight then politically-minded legislatures or other government institutions.

While such a story may seem far-fetched, given the level of scrutiny central banks face today, it underscores the important role that regulators have in highlighting salient risks that businesses, policymakers and households should consider.

The Fed's release of its first climate stress test scenario exercise is a step in the right direction. It highlights the importance of considering and managing climate risk in the financial system.

Risk professionals hold the unique position in this debate. As providers of objective information, they need to equip their institutions with the capability to run multiple scenarios across a wide spectrum of risks. A deeper understanding of the risks of climate change and the uncertainty of forecasts will lead to a more comprehensive discussion, allowing stakeholders to make more informed choices.

Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of model research and development, he specializes in the analysis of current and future economic conditions, consumer credit markets and housing. Before joining Moody's Analytics, he worked for Fannie Mae. In addition to his published research, Cristian is named on two U.S. patents for credit modeling techniques. He can be reached at cristian.deritis@moodys.com.