Market News

 March 27, 2019
Fed research: climate change could spur financial crisis

 Financial risk associated with climate change could undermine the stability of the financial system, according to a research letter by a member of the Federal Reserve Bank of San Francisco.

The financial and economic risks of climate change are already being considered by central banks in other countries and are increasingly a concern for the Federal Reserve Bank, said Glenn D. Rudebusch, a senior policy advisor and executive vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco. His letter was posted on the bank's website on Monday.

His research highlighted the economic risks associated with climate change, risks that were detailed in the Fourth National Climate Assessment released by U.S. government agencies last year that argued climate inaction would be far costlier to the national economy than climate mitigation.

"Without substantial and sustained global mitigation and regional adaptation efforts, climate change is expected to cause growing losses to American infrastructure and property and impede the rate of economic growth over this century," Rudebusch said, adding that risks to the economy include business interruptions resulting in loan defaults and bankruptcies caused by storms, droughts, wildfires, and other extreme events.

Rudebusch said even financial firms with limited carbon emissions could face substantial climate risk exposure, through mortgages and business loans in coastal communities across the globe.

"In response, the financial supervisory authorities in a number of countries have encouraged financial institutions to disclose any climate-related financial risks and to conduct 'climate stress tests' to assess their solvency across a range of future climate change alternatives," he said.

An international group of 18 central banks and bank supervisors organized as the Network for Greening the Financial System, acknowledged in October 2018 that climate-related risks are a source of financial risk and clarified that central banks must ensure financial systems are resilient to climate-related risks.

A letter from 20 U.S. senators to Federal Reserve Chair Jerome Powell, the head of the Federal Deposit Insurance Corporation and the comptroller of currency in January urged them to remember that their agencies are responsible for protecting the stability of the U.S. financial system and urged urgiedng them to ensure the nation's financial system is ready for climate change. The senators also urged the heads of the agencies to join with global peers to ensure the financial system is resilient to climate-related risks.

"U.S. regulators must take stock of these risks and require greater transparency and preparation from supervised financial institutions as we confront the growing impacts of climate change," the senators wrote in the letter.

"We request detailed information on the steps each of your organizations have taken to identify and manage climate-related risks in the U.S. financial system. However, we have seen no evidence that your agencies have seriously considered the financial risks of climate change or incorporated those risks into your supervision of financial institutions," said the senators, who gave the agency chairs until Feb. 15 to respond to several climate change-related questions.

Powell, chair of the Federal Reserve, told legislators in February the inquiry about climate change was a "fair question" to ask and promised to look into it.

Even climate solutions, such as a transition to a low-carbon economy, involve financial risks, Rudebusch said in his letter, including losses by companies that depend on fossil fuels.

He also said the financial system could be affected if municipalities are forced to use taxpayer money to protect their citizens from climate impacts.

"On top of these direct effects, climate adaptation---with spending on equipment such as air conditioners and resilient infrastructure including seawalls and fortified transportation systems---is expected to increasingly divert resources from productive capital accumulation," Rudebusch said.

Many municipalities, including New York City, Baltimore, Rhode Island and several cities in Colorado, California and elsewhere have filed lawsuits against major oil companies to hold them accountable for climate impacts. The suits seek compensation from the industry to pay for improvements to infrastructure needed to protect their residents.

Financial policy isn't generally affected by individual weather or other climate-related events, but Rudebusch said that could change as climate change intensifies.

"Climate change could cause such shocks to grow in size and frequency and their disruptive effects could become more persistent and harder to ignore," he said, adding that would signal a significant change, since monetary policy decisions often overlook short-term disturbances.

On the other hand, he said long-term factors could also become more relevant because central banks often consider policy implications of short-term events.

Rudebusch said economists view the growing losses to American infrastructure and property as the result of a fundamental market failure, meaning carbon fuel prices do not properly account for climate change costs.

"Businesses and households that produce greenhouse gas emissions, say, by driving cars or generating electricity, do not pay for the losses and damage caused by that pollution. Therefore, they have no direct incentive to switch to a low-carbon technology that would curtail emissions," he said.

But while some have suggested a carbon tax would add incentive to transition from a high- to a low-carbon economy, others say it won't be enough.

"Instead, a comprehensive set of government policies may be required, including clean-energy and carbon-capture research and development incentives, energy efficiency standards, and low-carbon public investment," wrote Rudebusch.

Although the consequences of climate change are relevant for the Fed's monetary and financial policies, Rudebusch said issues like supporting environmental sustainability and limiting climate change are not directly included in the Fed's statutory mandate.

But with looming climate impacts, he called on economists---particularly those at central banks---to contribute more to research on the economic and financial hazards of climate change.