Central banks and regulatory authorities are progressively integrating climate risks into their activities.
The Network for Greening the Financial System was established in 2017 to mobilize finance for transitioning and managing climate risk. Now with 108 central bank members, the network signifies the importance central banks are placing on the risk posed by climate change and their role in driving the environmental, social and governance transition in the financial sector.
European central banks have led the way in developing stress testing and scenario analysis tools to assess risks. The European Central Bank conducted an economy-wide stress test in September 2021. It found the short-term cost of transitioning to net-zero carbon dioxide emissions is far exceeded by the long-term benefits of turning to a more sustainable financial sector and economy. Failure to transition could have severe consequences for financial stability across the banking and corporate sector, yet a huge portion of banks still fail to disclose whether climate and environmental risks have a material impact on their risk profile, despite increasing regulation.
The U.S. lags behind Europe in establishing and integrating ESG regulation into financial markets. The Federal Reserve has not yet developed scenario analysis or stress-testing tools to integrate and understand climate risk. When Sarah Bloom Raskin, former Fed board member, withdrew her nomination to become the Fed’s vice chair for supervision, it was a setback for supporters of incorporating climate-change risks into regulation. Raskin has been vocal about the need for regulators to proactively tackle financial risks caused by climate change. Her withdrawal shows how politically delicate the subject is for central banks and regulators, and the need to tread carefully when it comes to transitioning “dirty” industries to net zero.
Further, the U.S. generally relies on a market-led approach to establishing green products in portfolios and investments. But this approach has flaws. For instance, BlackRock recently acknowledged it has retreated on its climate pledges. The company informed the chairman of Texas’s oil and gas regulator that it is “supportive of the oil and gas industry and merely offers ESG energy-related investments because of client demand.” That further shows the delicate nature of the transition away from dirty industries and indicates that investors and asset managers remain lukewarm on taking real action, reiterating the need for a stronger regulatory approach.
Nevertheless, Jerome Powell, the Fed chairman, has acknowledged that climate change is a significant risk to financial stability. The central bank is requesting information from banks on the actions they are taking to mitigate climate change-related risks on their balance sheets. The Federal Reserve Bank of New York has also produced a report developing a stress-testing procedure.
This step suggests movement toward American climate risk assessment tools. Disclosure frameworks and reporting requirements are where the U.S. is now taking steps to integrate ESG regulatory practice and catch up with the European Union’s regulatory-driven approach. This reveals the necessity of reporting how banks understand climate risk, set targets and drive ESG investments and products.
In a landmark decision, the Securities and Exchange Commission has introduced a draft rule to set a mandate that listed companies on American exchanges disclose their current levels of carbon emissions and their risk exposure. Many U.S. asset managers surveyed by the Official Monetary and Financial Institutions Forum use the recommendations of the Task Force on Climate-related Financial Disclosures, which have become mandatory in certain jurisdictions.
The SEC’s disclosure rule is likely to include the task force’s recommendations. At the international level, this is one of the most influential standards of the last few years, and its inclusion by the SEC would be a huge step toward market convergence of standards and frameworks.
Data is a key tool and remains a huge challenge for the global financial market. Central banks, investors and regulators report that gaps in appropriate, accessible and comparable data are a major obstacle to adopting reporting requirements.
For small and medium-sized enterprises, collecting, analyzing and reporting emissions data creates a financial burden because they often do not have the resources required for the task. This obstacle will become easier to navigate as more organizations begin reporting this information as demand for data will grow. Until then, however, it is down to central banks and regulators to lead by example.
Strong climate policy, regulatory frameworks and continued development of stress-testing tools by central banks are essential for transitioning to carbon neutrality. The U.S. has some catching up to do in this area, but there are signs that it can become a leader in its own right if regulators are committed.
