Priorities for the next Federal Reserve chair: assertively take on climate-related risk

President Biden has taken important first steps toward bringing financial flows in line with the Paris Agreement and his own target of a 50–52 percent cut in greenhouse gas pollution by 2030 through several executive orders: Biden’s January 2021 executive order mandated a whole-of-government approach to address climate risk, and a May 2021 Executive Order on Climate-Related Financial Risk instructed Treasury Secretary Janet Yellen to write a roadmap for addressing climate-related financial risk in consultation with financial regulators.

The Federal Reserve is a key agency for achieving both emissions and risk reduction goals, as both its regulatory and monetary policy missions require it to take on the issue of climate risk and the threat it presents to economic security. Climate change poses massive threats to the economy and financial stability that are scarcely being addressed by regulators or financial institutions themselves: The financial system is not prepared for, much less facilitating, the unprecedented economic transition we need to phase out fossil fuels rapidly and make the planet safe for both humanity and a healthy, stable economy. Instead, financial institutions are exacerbating the climate crisis by financing fossil fuels wildly in excess of science-based climate targets and those set by policymakers. The Federal Reserve chair must understand the gravity and urgency of climate threats—and the ways financial institutions are fueling climate-related threats to themselves, the financial system, and humanity—and be committed to using the Fed’s full range of authority to respond with the urgency and at the scale that the climate crisis demands.

The Federal Reserve’s only actions on climate to date include discussing climate risk in speeches, naming climate concerns in two reports (the November 2020 Financial Stability Report and the Supervision and Regulation Report), and establishing a Supervision Climate Committee. The Fed has taken no action to meaningfully mitigate climate risk. As a result, the Fed was awarded a D- score from the scoring system developed by interest group Positive Money, which takes into account central banks’ research and advocacy, monetary policy, financial policy, and to what extent banks lead by example. The Federal Reserve currently ranks 13th compared to the other G20 central banks, trailing behind the European Central Bank as well as the central banks of China, Brazil, and the UK.

To bring the Federal Reserve in line with international and domestic climate goals, the next Fed chair should pursue a robust climate agenda in regulatory and monetary policy.

In particular, the Fed should recognize that the climate crisis threatens the goals of its monetary policy mission, stable prices, and full employment. At a minimum, it should stop worsening the problem by disproportionately bailing out and propping up fossil fuel companies, as it did with COVID emergency lending facilities. Instead, the Fed should restrict fossil fuel bailouts or condition them on measures to align the businesses with climate targets and remediate environmental and equity harms while protecting workers.

The Fed’s monetary policy mission should also inform its approach to supervision and regulation of climate-related financial risk. If the Fed fails to respond adequately to climate-related threats, the physical harms of climate change alone will pose devastating challenges to the Fed’s efforts to maximize employment and maintain stable prices. A lack of assertive regulatory action will also invite financial instability and financial crises.

The Fed chair should lead a robust regulatory approach to climate that includes the following actions:

• Expressly adopt a precautionary principle on climate-related financial risks. The climate crisis poses a high likelihood of extreme harm, but there is deep uncertainty regarding when or where specific harms will materialize. This uncertainty is not a reason for inaction; it is cause to begin working to mitigate risks based on what we know rather than waiting for more information or better modeling. Regulators should continue developing a richer understanding of the issue even as they act.
• Integrate climate considerations into its implementation of the Community Reinvestment Act, fostering resilience and equitable, green investments in low- and moderate-income communities.
• Issue new supervisory guidance on climate-related financial risk. The Fed supervises the largest bank holding companies, as well as non-bank financial companies deemed systemically important by the Financial Stability Oversight Council (FSOC). It should issue supervisory guidance that educates banks and bank examiners on climate-related financial risk, identifies it as a serious threat to the safety and soundness of financial institutions, embraces a precautionary principle in mitigating it, and establishes the expectation that banks will incorporate climate risk management into their governance, strategy, and risk-management frameworks.
• Integrate climate into call reports and add a climate module to bank examinations, working with other bank regulators as needed.
• Run, and require banks to run, climate stress tests and scenario analyses. These exercises would help determine whether institutions are adequately prepared to withstand stresses from specific climate-related financial shocks in the near term (in the case of stress tests), and if they are preparing adequately for a broader set of risks, or are unsafely generating them, in the longer term (in the case of scenario analysis).
• Begin integrating climate-related risk into capital regulation, or rules regarding how much additional capital a bank must hold to offset the risk of its assets, and institute a new capital charge based on contributions to climate risk.
• Begin limiting exposures to climate-related financial risk. Early policies for consideration are restrictions on the riskiest assets (for example, the highest-emission assets or new fossil fuel production, which face very high risk of losing value soon in the clean energy transition and also contribute the most to longer-term risks by fueling climate change) and limits on concentrations of credit related to fossil fuels or in sectors most at risk from climate harms.
• Write a rule or guidance on how the Fed will supervise nonbanks that the FSOC designates as systemically important financial institutions (SIFIs) (this designation puts them under Fed supervision), including how it will supervise them on climate-related risks.
• Work with the FSOC to integrate climate into the criteria for SIFI designations. Among other climate-related reasons for designation, institutions substantially engaged in fossil fuel financing should be designated as SIFIs so that the Fed can both supervise them individually and attend to the macroprudential challenges of climate-related risk, including the need to maintain order in the financial system during the fossil fuel phaseout. The Fed should also push the FSOC to begin making designations again. (There are currently no SIFIs).

The Federal Reserve already holds significant power to shepherd the financial system in service of a green economy and away from catastrophic climate risk. The next Fed chair must assertively take on climate-related risk to maintain financial stability and protect the broader economy.