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Two Steps Forward

How the Fed can save the earth

A healthy financial system requires being ready for whatever Mother Nature throws our way.

Planet money

GreenBiz photocollage

Sometimes, good things happen in Washington, D.C.

That may seem a jarring statement in light of the hideousness taking place there over the past few days (and weeks and months), but I’m not referring to that — or, for that matter, to anything having to do with Congress, the White House or politics in general.

I’m referring to the Federal Reserve System.

Just before Christmas, America’s central bank took a major step, albeit long overdue: It recognized the threat that the climate crisis poses to the nation’s — and the world’s — financial system. It did that in part by becoming a member of the Network of Central Banks and Supervisors for Greening the Financial System, or NGFS.

The group, launched in 2017, aims "to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development." That is, its goal is to help central banks and other regulatory bodies exchange ideas and research on how to mitigate climate risk within banks and other financial systems. NGFS membership has grown from eight central banks three years ago to 83 banks across five continents, from Canada to Colombia to Cambodia.

That the United States has joined is no small change.

A healthy financial system requires being ready for whatever Mother Nature throws our way.

For those who have long forgotten macroeconomics 101, the Fed and its kin perform a number of important functions, none more important than promoting the stability of the U.S. financial system by minimizing and containing systemic risks. It has a number of tools — carrots and sticks — to do that, from adjusting interest rates to supervising and regulating banks to ensure the safety of the U.S. financial system and to protect consumers’ credit rights.

The Fed’s recognition of the threat of climate disruptions to the nation’s banks is huge, although it is arguably late to the game. A variety of governmental and nongovernmental experts around the world have been warning for years that national and global banks, insurers and other financial institutions could be in for a rough ride in a climate-changing world, as their customers endure shutdowns and disruptions. Not surprisingly, the U.S. government has been largely mum on the subject over the past few years.

That changed in September, when the federal Commodity Futures Trading Commission (CFTC) published a report examining climate risk management in the U.S. financial system. It found that "climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy" and suggested that financial markets don’t accurately reflect the serious emerging risks posed by climate change.

The risks, said the CFTC, include "disorderly price adjustments in various asset classes" that could disrupt "the proper functioning of financial markets." In addition, it said, the process of combating climate change itself — which, it notes, demands a large-scale transition to a net-zero-emissions economy — "will pose risks to the financial system if markets and market participants prove unable to adapt to rapid changes in policy, technology and consumer preferences." Financial system stress, in turn, "may further exacerbate disruptions in economic activity, for example, by limiting the availability of credit or reducing access to certain financial products, such as hedging instruments and insurance."

Meanwhile, in November, in its semiannual report on financial stability, the Fed suggested that banks and other financial firms provide more disclosure about how their investments could be affected by more frequent and severe weather and could improve the pricing of climate risks, "thereby reducing the probability of sudden changes in asset prices."

By December, the Fed had rolled out "a spate of new ideas and endeavors that highlight the risks of climate change to our financial system," as the Natural Resources Defense Council’s Sarah Dougherty wrote.

It’s still early days. The Federal Reserve is only just dipping its toes in these warming waters. "As we develop our understanding of how best to assess the impact of climate change on the financial system, we look forward to continuing and deepening our discussions with our NGFS colleagues from around the world," Jerome Powell, chair of the Fed, said in a statement last month.

But the recognition of this emerging reality — that there’s a cascading effect on the nation’s financial system from extreme weather, not to mention another pandemic or other disruption — is a small but mighty leap forward.

The Fed and other central banks won’t end the climate crisis on their own, but by leveraging the massive power of global financial markets to align with the risks posed by a changing climate, they can avoid crashing the economy, help align price signals with emerging realities and send an unambiguous message: A healthy financial system requires being ready for whatever Mother Nature throws our way.

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