Supervising the Transition

According to this report by legal and policy experts at the Roosevelt Institute, without appropriate oversight US banks are “highly unlikely” to meet their climate commitments, and “immediate and serious regulatory attention” is required to protect the financial system from the resulting systemic risks. The authors recommend the Federal Reserve makes use of financial stability powers to establish prudential standards that direct systemically important banks to adopt transition plans.

The authors propose that banking regulators use their authority to avoid a “climate Minsky moment” and ensure banks are preparing for the possible financial disruptions stemming from climate policy reform, rather than sacrificing long-term strategy for short-term gains. The passage of the Inflation Reduction Act is likely to hasten the clean energy transition and substantially alter the value of high-emitting assets, demonstrating how quickly economic and policy landscapes can shift, as well as the importance of decarbonising asset portfolios in time to avoid rapid write-downs and possible future fire-sale dynamics.

Despite recognising the danger of climate-related risks, large banks are acting in direct contradiction of their public net-zero commitments by funding new fossil fuel projects, and the authors say this may indicate serious issues in the sector’s governance processes, relationship to risk, and abilities to implement strategic plans, and may even constitute fraud. The report sets out a three-pronged response for regulators to ensure alignment of banks’ internal strategies with their public commitments, and to guard against excessive transition and climate-related risk in the banking sector.

Firstly, regulators should assess banks’ climate commitments and transition plans, to understand whether a bank’s assets are overly exposed to transition risk and gain insight into a bank’s governance strategies. If the management team cannot execute its commitments to build transition-robust business models, regulators should scrutinise its ability to successfully guide other strategic initiatives.

Secondly, financial regulators must provide detailed supervisory guidelines which outline the criteria for assessing the credibility of net-zero transition strategies. Internal strategies should only be considered aligned with commitments to achieve net-zero by 2050 if two conditions are met. The strategy must reflect climate science and technological realities, which implies no funding to new fossil fuel projects and no overreliance on unproven negative emissions technologies or carbon offsets. It must also contain tools to track progress and make strategic adjustments if its goals are not being met. This requires realistic granular milestones, continuous tracking of borrower progress and effective plans for handling non-performance.

Finally, US regulators and the Federal Reserve should make use of their mandates to encourage or direct banks to adopt net-zero transition plans, as these plans are the best tools for managing the transition risk associated with high-emitting sectors and addressing the systemic risk caused by the continuing contribution made by banks towards climate risk. Transition planning should take a “whole of business” approach, in which management incentives are aligned with the plan, other conflicting strategic priorities are avoided and emissions metrics are integrated into risk management toolkits.