May 3, 2024 Daniel Sufranski, The Sunrise Project   One starting point in assessing central banks’ role with respect to climate policy is what central banks themselves think their role is. Admittedly, this approach is more limiting than others, such as beginning with the franchise nature of the banking system. Nevertheless, thinking through the full implications of this restrictive framework can be helpful and is, perhaps, more manageable, even if incomplete. To some extent, evaluating how central banks view their own role is an institution- and jurisdiction-specific inquiry. For that reason, and because of my own background, I will focus on the Fed, as well as the other U.S. federal banking agencies. Though the Fed has made clear that it “[is] not, and will not be, a ‘climate policymaker,’” it acknowledges that it does have a “narrow, but important” role to play. Specifically, it must address climate-related financial risks to the safety and soundness of individual banks and financial stability, while maintaining an independent monetary policy, consistent with its statutory authority and mandates. As a practical matter, the approach has been one of risk management. Again, the Fed views its role as limited. Of particular note, it has differentiated itself from peers such as the Bank of England and the European Central Bank, which have broader mandates to support the general economic policies of their respective jurisdictions. It reportedly has also emphasized the narrowness of its mandate when opposing stronger global standards on climate-related financial risks. But the Fed’s narrow but important role will require more than a narrow risk management approach. To succeed on its own terms—to mitigate risks to safety and soundness of individual institutions and broad financial stability—the Fed will have to adopt a long-term, macroprudential approach that incorporates transition plans. Monetary policy will also need to consider climate change for the Fed to achieve its “narrow” regulatory and supervisory objectives. Together, these realities also illuminate what “climate policy” means and does not mean with respect to central bank actions.

Climate-Related Financial Risk Management

Many climate-related risks fall squarely within the Fed’s supervisory and regulatory remit. To their credit, the Fed and its fellow federal banking agencies, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, have recognized in their Principles for Climate-Related Financial Risk Management (climate principles) that “[t]he financial impacts that result from the economic effects of climate change and the transition to a lower carbon economy pose an emerging risk to the safety and soundness of financial institutions and the financial stability of the United States.” Along with the Basel Committee on Banking Supervision (BCBS), they have acknowledged that climate-related financial risks can arise through traditional risk categories. Following this logic, the Fed and the other federal banking agencies should be using available supervisory and regulatory tools to address both micro- and macroprudential climate-related risks. Commentators have explained that the Fed and the other banking agencies have many options to deal with climate-related financial risks, such as climate-adjusted capital requirements and requiring divestitures from fossil-intensive industries. Furthermore, general references to “risks,” such as requirements to “maintain capital commensurate with the level and nature of all risks to which [a bank] is exposed” and mandatory safety and soundness standards to “have internal controls that are appropriate to the . . . nature, scope, and risk of [an institution’s] activities” now appear to incorporate climate-related financial risks. The federal banking agencies also have longstanding broad powers to address safety and soundness concerns that they have claimed for themselves in other contexts – indeed, in all aspects of banking. As one court put it, this expansive authority to address unsafe or unsound practices is consistent with “the purposes of the banking acts . . . to commit the progressive definition and eradication of such practices to the expertise of the appropriate regulatory agencies.” Unsafe or unsound practices do not require actual losses. If certain criteria are met, the potential for an “abnormal risk of loss or damage to an institution, its shareholders, or the Deposit Insurance Fund” is enough. Notably, a determination that a bank is engaging in unsafe or unsound practice is grounds for formal enforcement actions, including cease-and-desist orders and monetary penalties. Such enforcement actions do not require a violation of law or a breach of fiduciary duty. A determination that a practice is unsafe or unsound, as the agencies have interpreted that term, is sufficient. The Fed and the other federal banking agencies should be using this and other powers now rather than waiting for a crisis to arrive.

Managing Unmanageable Risks

Instead of using all available tools to reduce climate-related financial risks, the Fed’s approach has focused on risk management—in other words, the management of risks rather than their elimination. This approach implicitly treats climate change itself – not just the resulting financial risks – as just another risk to be managed rather than the existential threat it is. Climate-related financial risks may appear as nothing special – some additional credit risk here, some more operational risk there. Unlike traditional threats to the financial system, however, the climate dynamics that cause the financial risks are irreversible, and the decisions central bankers make today will help determine whether we cross cataclysmic tipping points. There is no reason to think that the financial system will recover either. Some economists have convinced themselves that modern society, including its economies and financial systems, can largely withstand even extreme climate change. Those conclusions rest on unrealistic models and assumptions. Even the Network for Greening the Financial System (NGFS) cautions that its own climate “scenarios do not account for every potential implication of climate change” and that “users may need to adapt the intensity of the scenarios” with respect to “tipping points, physical impacts that are not captured at present, societal impacts such as migration influenced by climate change, compound risks, the calibration of physical damages, technology assumptions, government policy changes and financial sector dynamics.” Climate science and common sense make clear that an individual bank cannot manage all the risks of climate change. No risk management processes can protect a bank from the financial risks of climate catastrophe. For this reason, an approach based on banks’ internal risk management is inconsistent with the Fed’s “narrow, but important” supervisory and financial stability role with respect to climate-related financial risks. Central banks and supervisors must grapple with wider concerns, including the fact that allowing banks to finance fossil fuel emissions not only creates risks for the climate, but also for other banks and financial stability more broadly. “Double materiality,” which considers climate’s impacts on a bank as well as a bank’s impact on the climate, matters for the Fed’s “narrow, but important” role because banks’ impact on the climate creates risk to other banks and itself. For that reason, central banks and supervisors cannot ignore banks’ contributions to climate change. A long-term, macroprudential approach that considers the impact of any institution’s activities on its own safety and soundness as well as the financial system as a whole is necessary because a short-term microprudential approach of managing climate-related financial risks will fail on its own terms. Such efforts are complicated by the fact that the activities that cause climate change are ingrained in the functioning of the financial system. While U.S. regulators consider climate-related financial risks to be emerging risks, some of the activities that create those risks, such as lending to oil and gas companies, are far from novel. If the full extent of climate-related financial risks and the existential threat that climate change poses were well-understood before fossil fuels became a central feature of the global economy and everyday life, it is difficult to imagine the Fed taking the same approach it has thus far. With that caveat in mind, efforts to keep risks from entering the financial system in the first place provide some insight on possible options. Compare, for example, the response to crypto-assets, a serious risk to be sure, with the response to climate change. The Fed and the other federal banking agencies sometimes appear to view crypto-assets as the more serious concern. They have rightly announced that “issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.” They also have told banks to check with them before engaging in any crypto-asset activities, even while acknowledging that certain crypto-asset activities are generally legally permissible. At the international level, the BCBS, of which the federal banking agencies are members, has established a 1250% risk weight for certain crypto-asset exposures, meaning that banks would have to maintain one dollar of capital for every dollar of exposure (i.e., a one-for-one capital requirement), as the global standard. The federal banking agencies have stopped far short of taking a similarly precautionary approach to climate-related financial risks. Indeed, if the Fed is serious about risks to the safety and soundness of individual institutions and the stability of the financial system, it should be asking whether financing an existential threat, which necessarily implies threats to any given bank, shareholders, and the Deposit Insurance Fund, can be consistent with safe and sound bank practices. It should also be considering direct credit regulation, whether tools such as activities restrictions and divestitures should be deployed, and how to best implement Paris-aligned transition plan requirements. It may be easier to stop banks from getting into something risky than it is to get them out. However, climate change, again, poses an “existential risk to our future economy and way of life.” The resulting climate-related financial risks warrant more caution than the Fed has shown.

Monetary Policy, Briefly

Climate change also implicates monetary policy. Though the Fed’s “narrow, but important” view of its own role often seems focused solely on supervisory and regulatory responsibilities, it has not been completely silent on the interaction between climate change and monetary policy objectives. Unlike central banks in other jurisdictions, however, the Fed has not yet addressed in any meaningful way the manner in which climate change implicates its monetary policy objectives or authorities. This includes, for example, the fact that fossil fuel prices are volatile and contribute to inflation, frustrating the Fed’s price stability goals. And high interest rates have a disproportionate impact on renewable energy due to the high upfront costs involved, potentially extending reliance on price destabilizing fossil fuels. Moreover, Chair Powell recently acknowledged that insurance premiums, which are themselves rising due to climate change and increases in natural disasters, are a significant contributor to overall inflation. Though he stopped short of examining the roots of this phenomenon, the continued financing of and support for fossil fuel activities exacerbate climate change, increase physical risks, and make price stability more difficult to achieve. Even if the Fed wants to focus on climate change solely with respect to its supervisory role, it must consider interactions with monetary policy. Recent experience has shown that the Fed’s monetary policy decisions, banks’ risk management shortcomings, and supervision breakdowns can combine to result in bank failures. In the same way that banks’ financing decisions affect other banks, the Fed’s monetary policy decisions, from interest rate targets to collateral eligibility, impact the safety and soundness of individual institutions and the stability of the financial system by amplifying or mitigating climate-related financial risks. Therefore, even if the Fed only considers its supervisory role with respect to climate risks, it must consider the climate-related financial risks it is creating for financial institutions and the financial system through its monetary policy operations. While some of this work may happen naturally (e.g., if banks transition away from fossil fuels, fewer fossil fuel assets will be available as collateral for discount window purposes), the Fed must keep these risks in mind with respect to all aspects of its monetary policy decisions, including when responding to emergencies.

Addressing Climate Risks vs. Engaging in Climate Policy

While the Fed is not the appropriate institution to be setting broad climate goals for the U.S., its actions affect climate change and thus the risks that society will face. The impacts include, but are not limited to, the climate-related financial risks that the Fed acknowledges are squarely within its remit. And if the Fed takes its statutory mandates seriously, it will almost certainly take actions that opponents will describe as “climate policy.” Neither monetary nor regulatory policy is ever neutral, and the Fed should not operate under the misconception that climate policy means only, or any, policies that mitigate climate change or climate-related financial risks. If explicitly incorporating climate-related financial risks into risk weights for regulatory capital purposes is climate policy, so is ignoring them. If prohibiting fossil fuel assets as discount window collateral is climate policy, so is accepting them. If using supervisory and regulatory authorities to minimize climate-related financial risks by limiting fossil fuel financing is climate policy, so is permitting unchecked financing of fossil fuels and climate-related financial risks. None of these actions, however, are “climate policy” if undertaken pursuant to the Fed’s mandates. Chair Powell has said that “without explicit congressional legislation, it would be inappropriate for us to use our monetary policy or supervisory tools to promote a greener economy or to achieve other climate-based goals.” Left unaddressed is whether, in the absence of explicit congressional legislation, it is appropriate for the Fed not to use every tool Congress has already given it to mitigate climate-related financial risks and achieve its supervisory, regulatory, and monetary policy objectives. Business as usual on the part of the Fed will push the country and the world toward catastrophic climate risks and frustrate its “narrow, but important” role.

Looking Ahead

Managing climate-related financial risks will require the Fed to go beyond a typical risk management approach. The Fed’s observation that other central banks have broader mandates that incorporate general economic goals has an interesting implication: having recognized climate-related financial risks, the Fed should address them even if doing so were inconsistent with the administration’s goals. The Fed may not succeed on its own terms if the rest of the government and the world do not address climate change, but it must make every effort to pursue its microprudential, macroprudential, and monetary policy goals. Granted, there are some complications. A sudden and disorderly transition away from fossil fuels, though certainly preferable to catastrophic climate change, may lead to its own risks, including a stranded asset-driven financial crisis. For that reason the Fed, and all central banks and supervisors, should require banks to adopt Paris Agreement-aligned transitions plans that address the micro- and macroprudential risks facing the financial system as soon as possible. The longer they wait, the more abrupt and disruptive the transition will have to be.