By Jeffrey Karp, Senior Counsel, and Edward Mahaffey, Law Clerk
On May 20, 2021, President Biden issued an Executive Order on Climate-Related Financial Risk. The Executive Order seeks "to advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk." According to the president, the Order is necessary due to "[t]he failure of financial institutions to appropriately and adequately account for and measure these physical and transition risks," which "threatens the competitiveness of U.S. companies and markets, the life savings and pensions of U.S. workers and families, and the ability of U.S. financial institutions to serve communities." Physical risks are damages caused by an increase in the frequency or severity of weather events or other climate shifts. Transition risks are more indirect; they arise from changes in policy, technology, or consumer behavior that lead to a lower-carbon economy.
The Executive Order includes provisions that place implementation responsibilities on various government agencies, but one of its most potentially significant aspects addresses areas in which the administration’s direct authority is limited. That is, the Order seeks to encourage financial regulators to assess climate-related financial risk, consider ways to enhance climate-related disclosures by regulated entities, share information with each other, and identify other ways to incorporate climate risk into their regulatory activities.
An entity that is well-positioned to help accomplish these objectives is the Federal Reserve (Fed), given its powers to assess risks to the financial stability of the Federal Government and the nation’s financial system, and its authority to regulate member banks’ activities. Although the president appoints the Federal Reserve Board members, the Board is an independent agency, accountable to Congress rather than the President. The Executive Order’s financial-regulator provisions thus do not mention the Fed directly. Instead, the Order provides that "[t]he Secretary of the Treasury, as the Chair of the Financial Stability Oversight Council (FSOC), shall engage with FSOC members to consider" these assessments, disclosure rules, and other regulatory approaches. The FSOC’s members include Fed Chairman Jerome Powell, as well as the heads of such agencies as the Bureau of Consumer Financial Protection, Securities and Exchange Commission, Federal Deposit Insurance Corporation, and Commodity Futures Trading Commission.
When the Order was issued, the Fed already was focused on potential climate-related impacts on member banks. Although rules had not been issued yet, the Board of Governors was taking a more active role as its members had become increasingly cognizant of the potential negative effects from climate change on the nation’s banking systems.
Developments at the Fed
In December 2020, the Federal Reserve joined the Network for Greening the Financial System, an international organization of central banks and other regulators that seeks to address the economic effects of climate change through research and developing recommendations. Shortly after the change in administrations, the Fed announced the formation of its own Supervision Climate Committee, to be chaired by a senior level official from the New York bank, to study the consequences of climate change for the financial system due to its potential impact on individual companies.
In a February 2021 speech, Federal Reserve Board Governor Lael Brainard discussed the two different kinds of risks referenced in the Executive Order that climate change poses to the financial system, physical and transition risks. Both types of risks, she said, "could materialize as traditional financial risks to supervised institutions, including through increased credit, market, operational, reputational, and liquidity risk."
According to Governor Brainard, a key difficulty both kinds of risks pose to financial institutions and regulators is their uncertainty: "While the scientific evidence for climate change is unequivocal, estimates of the magnitude of climate-related financial risks are highly uncertain." Thus, she stated that better data, disclosures, and modelling techniques are necessary, including "scenario analysis," which identifies climate-related physical and transition risk factors facing financial firms, formulates appropriate stresses of those risk factors under different scenarios, and measures their effects on individual firms and the financial system as a whole.
Thus, on March 23, Governor Brainard announced the Fed’s establishment of the Financial Stability Climate Committee (FSCC), the purpose of which is "to identify, assess, and address climate-related risks to financial stability." The Governor distinguished the FSCC’s function from that of the previously created Supervision Climate Committee (SCC): "The FSCC will approach this work from a macroprudential perspective – that is, one that considers the potential for complex interactions across the financial system." The SCC’s approach is "microprudential," concerned with risks at the level of individual firms.
On the same day as Governor Brainard announced the FSCC,’s formation, Fed Chairman Jerome Powell testified before the House Financial Services Committee. Although the Chairman initially was tentative in discussing the Fed’s approach to climate-related risks ("We actually are just in the very early stages of considering stress scenarios"), he also stated definitively that the Fed’s study of climate-related risks should be considered part of the Fed’s general mandate to manage financial risks rather than a new endeavor.
More recently, according to Reuters, the Fed has been privately asking member banks what steps they are taking to mitigate climate-related financial risks from their loans.
Republican members of Congress have pushed back against the Fed including climate-related considerations as part of its supervisory role over member banks. In December 2020, 47 Republican members of Congress sent a letter to Chairman Powell, expressing "concerns about the Federal Reserve Board potentially introducing climate change scenarios into its supervisory stress tests of regulated banks." They asserted that "methodological challenges could negatively impact the effectiveness and reliability of climate change stress testing" and opined "that introducing climate change scenarios into stress tests could accelerate the ill-advised pattern of ‘de-banking’ legally operating businesses in industries, such as coal and oil and gas, that are politically unpopular to certain vocal policymakers."
Subsequently, on March 29, 2021, Senator Pat Toomey (R-Pa), in a letter to the Federal Reserve Bank of San Francisco (FRBSF), denounced the FRBSF’s "pivot…toward publishing politically-charged research on environmental, social, and governance (ESG) topics like climate change and racial justice." The Senator contended that the Fed’s involvement was duplicative of the roles of other federal agencies, and incompatible with its independent and nonpartisan role. Mr. Toomey also asserted that engaging in such activities exceeds the scope of the Fed’s mission, and "only Congress has the authority to reform the Federal Reserve or modify its mission."
Created by an act of Congress in 1913, the Federal Reserve System is not controlled directly by the U.S. Government, and is classified as an independent government agency. As Chairman Powell noted in his testimony, the Fed’s climate risk concerns are one aspect of its broader responsibilities to assess risks to the financial system.
While climate change stress testing may present methodological challenges, other central banks also are conducting such testing. Thus, the Fed can make methodological adjustments as appropriate based on its own experience and recommendations from other central banks. Moreover, the Fed does not appear to be backing away from its study of climate-related risks facing the nation’s financial system. According to Reuters, recently the Fed has been privately asking member banks what steps they are taking to mitigate climate-related financial risks from their loans.
Nonetheless, given that climate-related issues are indeed politically charged, the Fed’s analytical methods and ultimately its decision-making regarding climate risks that fulfill the objectives of the Executive Order are likely to continue to be held under a microscope.
 Id., § 3.