The Federal Reserve’s Climate Folly
The Senate is currently scheduled to vote to confirm current Federal Reserve FOMC member Lael Brainard to the powerful position of Vice Chairman of the Federal Reserve Board of Governors on April 25. She has been outspoken in defense of the Federal Reserve’s efforts to use its financial regulatory powers to fight climate change (see speeches here and here), though she has been less outspoken than fellow nominee Sarah Bloom Raskin, whose prominent climate advocacy doomed her chances with Joe Manchin and Senate Republicans.
In recent years, the Federal Reserve has established a Supervision Climate Committee, and has joined the Network of Central Banks and Supervisors for Greening the Financial System. The SEC has recently joined the party by proposing several ambitious climate disclosure requirements for large public companies. All of these efforts seem part of what former Fed chair and current Treasury Secretary Janet Yellen calls a “whole-of-government approach” to combating climate change.
While well-intentioned, I think these efforts are misguided and likely to do more harm than good. Proponents of financial regulatory action overstate the risks of climate change on systematic risk, and the threat to Federal Reserve independence is far greater than the potential emissions mitigation that could ensue.
The Case for Climate Change Action
Advocates for Federal Reserve action on the climate change are not dumb–they aren’t conjuring this proposal out of thin air. Climate change is real and its consequences will be felt throughout the financial sector. Specifically, they identify two climate-changed induced concerns: physical risks and transition risks.
Let’s start with physical risks. Climate change indisputably increases both the frequency and severity of storms and other natural disasters, which can destroy local economies and cause widespread bank defaults. An undercapitalized bank could go under, and drag others down with it, if it erroneously assumes that disasters will behave like they did in the 20th century.
Transition risk isn’t much more complicated. Banks may experience sudden and unexpected losses from government policies suddenly putting fossil fuel companies out of business, putting a big dent in the balance sheet of financial institutions that invested in them.
While responsible Federal Reserve nominees would never say this out loud, an added perk of financial regulatory action on climate change is it doesn’t need to go through the buzzsaw of Congress. With coal state Senator Joe Manchin controlling the pivotal 50th Senate seat, getting ambitious climate change regulation through Congress seems rather daunting (I think this is overstated, as Manchin has actually been fairly open to climate change action, but that’s a post for another time). Instead of waiting for Congress to get its act together, advocates argue, we should do everything we can with the tools that we have.
The Empirical Holes in the Case for Climate-Change Action
This case has a lot of merit to it–climate change is a serious problem that demands ambitious solutions–but sadly the data just doesn’t support the specific remedies the Federal Reserve proposes.
The storm argument is especially weak. Storms just don’t cause systematic risk One study from the Federal Reserve Bank of New York found that “FEMA disasters over the last quarter century had insignificant or small effects on U.S. banks’ performance”. [Full disclosure: I used to work in the same Financial Intermediation function at FRBNY as the authors of this study, but I had zero involvement with the paper–I just know the authors enough to say that they’re really bright people who did a super thorough job]. Their study is completely congruent with other papers, which generally find minimal effects of natural disasters on bank balance sheets. One paper the authors cite even found that storms have little effect even on banks in Caribbean nations, which are perhaps the most exposed places in the world to such occurrences.
How could this be? After all, storms indubitably cause large destruction and loan defaults–how could they not affect bank balance sheets? The simple truth is that banks are pretty good at pricing disaster risk. Premiums are higher in areas with high flood risk. Financial firms can offload their risk through reinsurance and other complicated products. In fact, because loan demand tends to rise after a disaster, bank balance sheets can actually improve after a large storm! Some could nitpick the study by saying that while storms have yet to cause damage, perhaps stronger storms in the future could. But it does appear that banks are taking this into account–after all, the best evidence does suggest that equity analysts and insurance companies are taking into account climate change in their risk analysis.
Brainard argues that this risk still demands action because quantifying and modeling the damage outcomes is “extremely difficult.” But that just begs the question as to why the Fed–with its platoons of economists–would be better at making those models than highly motivated financial analysts. Inquiring minds are curious.
Transition risk does pose a greater challenge–if the Biden administration banned fracking overnight, that probably would cause large losses. But that’s not how government works! The government tends to work through an extensive legislative or rule-making process, whose effects are then priced into security prices. There’s a reason why companies like Exxon trade at far lower price-to-earnings multiples than Amazon or Google–bankers have already priced in the likelihood that fossil fuels are less of a growth industry than other firms (the fossil fuel industry P/E ratio is 13.6, compared to over 22 for the S&P 500). But at a deeper level, it seems rather perverse for regulators to penalize or discourage legal activity on the chance that it may be made illegal or be penalized through legislative means later. That seems like an evergreen justification to do whatever the regulator wants–policy action could always penalize it in the future.
Moreover, it’s always worth remembering: the Federal Reserve’s job is not to prevent banks from taking losses. Losses are a normal and healthy part of the financial system. Their job is to prevent those losses from snowballing into a financial crisis. Merely proving that banks lose money from climate policy is wholly insufficient to justify regulatory action. And there’s strong reason to believe these losses aren’t tied to systematic losses. Climate change doesn’t increase storm frequency over night–while the effects are beginning to be felt now, they will gradually intensify over the coming century. But crises aren’t borne from bad bets made decades prior, where there’s plenty of time to unwind positions and cut your losses. For example, the 2008 crisis wasn’t formed from bad housing bets in the 1990s–it was from bad trades made in 2005-06. The time-scale climate operates on is thus a terrible fit for the five-year and ten-year balance sheet analysis the Fed uses.
More importantly, the Fed is a wholly inappropriate actor to combat climate change. The Federal Reserve is not an environmental agency. While they attempt to justify action on the grounds that it’s part of their financial stability mandate, I’d be shocked if a judge agreed with them following the inevitable flood of lawsuits that would follow any substantive action. I’d be really worried about the precedent it sets if the Fed tries to shoehorn political goals into its existing mandate–what if a Republican administration decided that the intermittency problems of renewable energy posed a financial risk and asked the Fed to cut off funding to solar firms? What if they decide codependency with China is a risk, and we should thus direct funding towards favored domestic firms through lower reserve requirements? We need the Fed to stay as far away from making capital allocation decisions–especially politicized ones such as climate change–as humanly possible. A tool is only valuable if you’re willing to let the other party use it too.
Some Final Thoughts
Perhaps this could all be worth it if the policy actually fought climate change. But somehow I doubt it will. Enhanced regulatory requirements for investing in fossil fuels is a hassle, and many banks will steer clear of them as a result, but I highly doubt that a few extra basis points in capital risk will substantially alter the energy composition of the country, let alone global emissions. In many cases, the effect could be sharply negative: imagine the fallout if the Fed had taken aggressive action to cut off fossil fuel suppliers back in 2019. After the Ukraine-induced gas price surge of March, political commentators from both sides of the aisle would be calling for fires en masse, and with good cause. Balancing the harms of emissions with the national security and economic benefits of domestic oil production is fundamentally a political question, not a technocratic economic question. The reason the Fed ought jealously protect its mandate from mission creep is that it can only perform its core duty–full employment and price stability–if it is not wrung through the political wringer. On the eve of Lael Brainard’s nomination, it is worth bearing in mind these concerns.
Prediction Markets is the musings of two 20-somethings on prediction markets, game theory, and macro economics. Subscribe to get data-driven hot takes delivered to your inbox weekly!