“We are not, and will not be, a climate policy-maker.” Fed chair Jerome Powell asserted that the Fed must address climate-related threats for financial stability. Still, it is up to elected political officials to take the lead in tackling the climate crisis that represents an increasing threat to central banks across the globe. Despite facing a period when economies grapple with high inflation and rising interest rate, expanding awareness to incorporate climate risks into their decision-making processes increases. What role do Central Banks have concerning their monetary policies and approaches to banking supervision in the face of climate change?
The physical risks of climate change are having and will continue to have a substantial negative impact on financial assets and firms across the globe. Central banks cannot ignore the growing climate crisis's consequences and have giant steps towards defining their role and focus while dealing with simultaneous geopolitical and economic threats through monetary policies. However, they have a central role in using their regulatory powers to influence financial institutes to disclose climate risks, including setting guidelines for risk management, stress testing and transparency when reporting on climate risks. The U.S. and European central bankers appreciate their core responsibility are managing systemic financial risks. Beyond that, there are some essential divergences concerning regulatory actions addressing climate risk in the financial system.
United States of America
During this economic testing period, the Fed is under the spotlight to preserve the U.S. economy. Few believe that the Fed should take a climate policymaking role. Iterated by Jay Powell with the Fed mounting to a defence of the Central Bank's independence from political activities at a time when U.S. President Biden's Inflation Reduction Act is creating unease across the globe, and Republican lawmakers have indicted the Fed for overreaching its mandate. Christina Parajon Skinner, a business and legal professor at the Wharton School of the University of Pennsylvania, states, "The Fed has really, I wouldn't say, stepped back, but I think it's become more discerning and more judicious in terms of what's on the table for its approach to climate change." The Fed Vice Chair for Supervision, Michael Barr, said, "The Fed has narrow, but important, responsibilities regarding climate-related financial risks - to ensure that banks understand and manage their material risks, including the financial risks from climate change."
The Fed must go deeper to prevent harmful climate implications on the financial sector. Climate change's increasing frequency and severity, such as Hurricane Ian in September 2022, could make properties uninsurable and trigger billions in bank losses. Powell's take on climate risk is relatively narrow. Under the Dodd-Frank Act, the Fed cannot be negligent to climate change with the authority and responsibility to mitigate climate-related physical risks. Despite the strict approach by Powell, the Fed has taken proactive baby steps by aligning financial regulation with climate risk incorporation. The Fed highlights this by conducting a pilot climate scenario analysis (CSA) with six of the largest U.S. big banks. Including Bank of America Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; J.P. Morgan Chase & Co.; Morgan Stanley; and Wells Fargo & Company this year to ensure financial institutes manage all material risks related to climate change.
Leading the charge of remitting includes the policing of climate risk; in contrast, the European Central Bank (ECB) has been confronting climate risks longer than the Fed. The ECB is seemingly unconcerned by Powell's argument that climate policy is not the responsibility of central banks. The ECB justifies its approach by noting that the Bank's statute requires it to support the European Union's economic policies and maintain price stability. Actions of announcing that it expects banks to meet supervisory expectations for climate risk by the end of 2024. Furthermore, the ECB published its climate risk stress tests in 2022, with support from ECB's Executive Board Member Isabel Schnabel, who believes the ECB needs to intensify its efforts to support the green transition." Yet, the ECB had aimed to make its holdings of corporate bonds more climate-friendly by putting more weight on climate-related criteria when it made new purchases. However, because it has stopped increasing its net bond holdings, this policy has "lost much of its punch", Schnabel added. The ECB may soon be challenged in court for overstepping its mandate.
The Bank of England (BoE) continues to emphasise that climate risk is a strategic priority for the banking system by setting out to study climate-related risks and how they can be accounted for PRA regulated firms. Although conducting several climate stress tests, annual solvency stress tests and biennial exploratory scenarios (BES) to explore potential climate risk gaps caused by climate change, the BoE believe that existing capital rules capture some of the longer-term fallout but may be incomplete due to estimating climate risks as capabilities and regime gaps create uncertainty over whether banks and insurers are sufficiently capitalised for.
Estimating that climate risk is still in its relative infancy, a short-term priority of the BoE is to focus on ensuring firms progress in addressing any 'capacity gaps' to improve their management of climate risks setting priorities for firms to improve data availability.
To take a step further, the BoE will also examine whether a macroprudential response will be necessary to understand climate risks that remain largely unquantifiable. The BofE believes that the existing timescale over which banks and insurers hold capital is appropriate for climate risks. Still, it is alarming that the BofE acknowledged that the actions taken now would influence how serious climate risks will develop, with companies needing to review their risk modelling concerning climate risks and identify any capability gaps.
The German government is pursuing the goal of establishing Germany as a leading centre for sustainable finance with its Sustainable Finance Strategy led by the implications of climate change and climate policy prompted by the Bundesbank, Germany's Central Bank, to be one of the founding members of the Network for Greening the Financial System (NGFS) and successful procurement of two dedicated providers of climate-related data by the Bundesbank laid the foundation for climate-related disclosures throughout the Eurosystem.
The Bundesbank continues to liaise closely with the data providers to guarantee that the data are implemented smoothly. Despite stretching the use of traditional risk models, the Bundesbank is increasing the employment of stress tests for examining climate-related risks. From the most recent stress test, the importance of climate risks is mainly seen as low to moderate, with transition risks more significant than physical risks. Most institutions currently incorporate climate risks at most indirectly in risk management. The Bundesbank plans to gradually expand its reporting on climate-related risks throughout the risk management cycle. Still, progress in improving data availability and cooperation with other Eurosystem central banks is essential.
To address climate risk measurements, the Banque de France (BdF) and the Autorité de Contrôle Prudentiel et de Résolution (ACPR) have developed regular assessments to monitor climate commitments of French financial institutions to cover between 80% and 85% of total French financial institutions' exposures. Starting in 2018, the Central Bank conducted climate risk exposure of French financial institutions and, in 2020, carried out the first climate stress test involving French banks and insurers. When the BdF and ACPR decided to create stress tests for climate change-related risk, they faced some complex intellectual and practical challenges. Both institutes produced the most rigorous assessment of the French financial sector's climate risk exposure.
To meet the tightening climate targets, the Banque de France has proposed three changes to the current approach to reach climate targets. First, a shift from voluntary to mandatory climate disclosure. Second, a change from climate-related stress tests to green prudential capital and third, a move towards collective governance of green finance in France. 'We are now focusing efforts on improving our diagnostics and taking action quickly as possible, whether in terms of executing climate stress tests or greening monetary policy, in conjunction with the Eurosystem,' said Emmanuelle Assouan, Managing Director, Directorate General Financial Stability and Operations, and Chair of the Banque de France Climate Change Centre. The BdF and the ACPR will continue to pursue overall action with further work on developing climate stress tests and scenarios.
‘There is a clear danger that different approaches to climate risks in different jurisdictions will create competitive distortions.’ recalled the chairman of NatWest Group, Howard Davies. Bankers need clarification soon to understand regulators' positions.
Central banks remain somewhat fractured from one another when tackling climate risk. As banks have to look more closely at climate factors when making decisions, central banks' divergences are of increasing concern for the global financial sector, even looking at whether bespoke capital buffers are needed for climate risks. Overall, central banks are playing an increasing role in shaping the work of risk managers when assessing climate risk. Central banks' main actions are promoting climate-related disclosure, encouraging more vigorous risk management practices, and providing guidance to navigate the complex landscape of climate-related risks. However, a similar broad consensus by central banks to tackle climate risk is the need for data and the need to dictate the determinations of climate regulatory powers for banks to withstand and incorporate climate considerations into decision-making processes by being able to withstand the impact of climate change.
To support financial institutes in understanding regulatory changes and provide granular data, and practical financial tools are intrinsic to this. Climate X's Spectra platform is a tool that offers coherent data for strengthening climate financial risk disclosures and plans for financial institutes. Whether companies need to consider scenario analyses, risk assessments, and stress tests, climate change's increasing frequency and severity will force central banks not to evade the climate crisis.
- Bank of England (2023) Bank of England report on climate-related risks and the regulatory capital frameworks. https://www.bankofengland.co.uk/prudential-regulation/publication/2023/report-on-climate-related-risks-and-the-regulatory-capital-frameworks
- Banque de France (2023) Responsible investment: the Banque de France steps up its climate commitments. https://www.banque-france.fr/sites/default/files/medias/documents/cp_2023-03-30_ra-isr-2022_en.pdf
- Bloomberg (2023) Powell Vows to Limit Fed’s Climate Role to Protect Independence. https://www.bloomberg.com/news/articles/2023-01-10/powell-vows-to-limit-fed-s-climate-role-to-protect-independence
- Commodity Futures Trading Commission (2023) Dodd-Frank Act. https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm
- Climate Home News (2022) Hurricane Ian could push insurers out of Florida. https://www.climatechangenews.com/2022/10/21/hurricane-ian-could-push-insurers-out-of-florida/
- Deutsche Bundesbank (2022) Climate-rRelated Disclosures by the Deutsche Bundesbank 2022. https://www.bundesbank.de/content/838206
- Deutsche Bundesbank (2023) Climate-Related Disclosures by the Deutsche Bundesbank 2023. https://www.bundesbank.de/resource/blob/906622/96d5120f93da926fb175fe937b9f775b/mL/2023-klimabericht-data.pdf
- European Central Bank (2022) 2022 Climate Risk Stress Test. https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.climate_stress_test_report.20220708~2e3cc0999f.en.pdf
- European Central Bank (2022) ECB sets deadlines for banks to deal with climate risks. https://www.bankingsupervision.europa.eu/press/pr/date/2022/html/ssm.pr221102~2f7070c567.en.html
- European Central Bank (2023) Monetary policy tightening and the green transition. https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230110~21c89bef1b.en.html
- Financial Times (2023) Fed will not become a ‘climate policymaker’, says Jay Powell. https://www.ft.com/content/6abb5562-59a0-49a7-8cc0-8fb48e5d6fe9?sharetype=blocked
- Reuters (2023) Fed wants climate risk analysis from 6 largest U.S. banks by July 31. https://www.reuters.com/business/sustainable-business/fed-wants-climate-risk-analysis-6-largest-us-banks-by-july-31-2023-01-17/
- The Asset (2023) Central banks’ green divergence offers little hope. https://www.theasset.com/article-esg/48498/central-banks-green-divergence-offers-little-hope
- The Federal Reserve (2023) Panel on "Central Bank Independence and the Mandate—Evolving Views." https://www.federalreserve.gov/newsevents/speech/powell20230110a.htm
- The Federal Reserve (2023) Pilot Climate Scenario Analysis (CSA) Exercise: Participant Instructions. https://www.federalreserve.gov/publications/climate-scenario-analysis-exercise-instructions.htm
- The Guardian (2023) The climate crisis threatens economic stability – why are central bankers divided? https://www.theguardian.com/business/2023/jan/20/climate-economic-stability-central-bankers
- The London School of Economics and Political Science (2023) Sustainable central banking: clear green water between the Fed and the ECB?. https://www.lse.ac.uk/granthaminstitute/news/sustainable-central-banking-clear-green-water-between-the-fed-and-the-ecb/