WASHINGTON— Federal Reserve Gov. Lael Brainard said Thursday that the central bank is moving forward with an exercise to measure the impact of climate change on financial institutions and markets.
Subjecting banks to “scenario analysis” should help with risk identification and management as firms account for the physical risk of global warming, such as severe weather events, and the transition risk that will come from changing consumer behaviors and government policies, Brainard said in remarks at a Federal Reserve Bank of Boston conference on stress testing.
“Although we should be humble about what the first generation of climate scenario analysis is likely to deliver, the challenges we face should not deter us from building the foundations now,” Brainard said.
Brainard’s comments follow those of Fed Chair Jerome Powell at a hearing in the House Financial Services Committee last week, in which he said that “scenario analysis is almost certainly going to be one of the principal tools” to ensure that the banks the Fed supervises are capable of managing possible climate change risks.
The Fed has previously emphasized that scenario analysis
Brainard also added that she expects the Fed’s scenario analysis will accompany supervisory guidance for large banks to assist in the central bank’s efforts to “appropriately measure, monitor and manage material climate-related risks.”
However, there are a number of challenges with modeling climate risk, Brainard said, most notably the uncertainty about how climate change might develop over time.
“Climate scenario analysis faces the challenge of having to consider plausible but novel combinations of risks that are associated with substantial uncertainty,” she said. Unlike modeling economic downturns as the Fed does in its stress testing regime, “there may not be analogous historical precedents to draw on in the formulation of appropriate climate scenarios and the quantification of their effects on different asset classes, regions and sectors,” Brainard said.
The Fed will have to undertake “substantial work” to address data gaps to make scenario analysis effective, Brainard said, adding that the Fed is “gathering key data resources” in its effort to model climate change for banks.
But the Fed already has one key resource: Several other countries are much further ahead in developing scenario analysis and climate stress tests — an experience the Fed can learn from, Brainard said.
“To better understand these connections, several foreign regulators have already undertaken climate scenario analysis, affording us the opportunity to learn from their experiences,” she said. “It will be helpful to move ahead with the first generation of climate scenario analysis to identify risks and potential issues and to inform subsequent refinements to our models and data.”
