Climate change and the transition to a sustainable economy have important implications for the financial system. The financial system can be a powerful enabler to help the private sector manage climate-related risks and invest in the transition. It is vitally important to strengthen the U.S. financial system to meet the challenge of climate change.

Meeting the Challenge of Climate Change
Climate change is one of the major challenges of our time.2 There is growing evidence that extreme weather events related to climate change are on the rise — droughts, wildfires, hurricanes, and heatwaves are all becoming more common.3 Climate-related events are already adversely affecting the lives of many Americans. The economic and financial impacts are also increasingly evident: we are already seeing elevated financial losses associated with an increased frequency and intensity of extreme weather events.4 Some have described Pacific Gas and Electric's bankruptcy as the first climate-related bankruptcy of a major US corporation.5

Average annual insured weather-related catastrophe losses have increased over the past decade.6 With losses increasing, insurers are incorporating the impact of climate change into their underwriting assumptions, pricing, and investment decisions. Climate change is also likely to have a notable impact on coverage availability.7 Some insurers have discontinued policies in fire-prone areas, which, in turn, is changing the costs of homeownership and the risk profiles of previously underwritten mortgages.8

Similarly, mortgages in coastal areas are vulnerable to hurricanes and sea level rise. New mortgages issued for U.S. coastal homes have, in aggregate, exceeded $60 billion annually in recent years.9 Recent research suggests that lenders hit by hurricanes, particularly in areas not typically affected by natural disasters, tend subsequently to securitize more of their mortgage loans, which could have higher climate risks, higher borrower defaults, and lower collateral values.10 Homeowners could also face increased hardship, since many homeowner insurance policies exclude flooding.11

Just as there are risks, there are also promising opportunities for private-sector investments in low-carbon innovation, infrastructure, energy, and transportation. With support from accounting standard setters, credit rating agencies, and regulators, the financial system can provide useful signals to help the private sector manage climate risks and facilitate a smooth transition.12

Climate Risks and Financial Stability
Climate change could pose important risks to financial stability. That is true for both physical and transition risks. A lack of clarity about true exposures to specific climate risks for physical and financial assets, coupled with uncertainty about the size and timing of these risks, creates vulnerabilities to abrupt repricing events.13 For example, a shift in the perceived frequency or severity of climate-related events, such as storms, floods, or wildfires, could rapidly change perceptions of risk and lead to rapid repricing of assets.14 Similarly, changes in investor expectations about future climate policies could lead to rapid and unexpected price changes that ripple through the financial system.15

Assessing climate risk effects is complex because the predicted path of climate change is nonlinear and has likely tipping points, beyond which changes in climate conditions could occur rapidly, and climate forecasts based on historical data are no longer relevant.16 This uncertainty in climate forecasts may reduce the accuracy of risk models used by investors, risk managers, asset managers, financial infrastructures, and leveraged financial institutions.

With accounting standards and disclosure frameworks for climate risk in the early stages of development and adoption, investors may lack transparency around the range of climate-related exposures facing financial firms, and non-financial short-term investors may be disinclined to fully price in longer-term climate effects.17 Some studies suggest that even well-informed investors may underestimate the likelihood of large shocks related to climate.18 Combined with the uncertainty in the timing and magnitude of climate change itself, this mispricing could lead to financial volatility as conditions evolve and perceptions shift.

Consistent, comparable, and actionable disclosures are critical to understanding firms' exposures to climate risks and to accurately pricing that risk. The Task Force on Climate-Related Financial Disclosures (TCFD), a private sector-led initiative with support from the Financial Stability Board, provides a consistent global framework for companies and other organizations to improve standardization of climate-related financial disclosures. As of October 2020, nearly 1,500 organizations with a combined market capitalization of $12.6 trillion, including financial institutions that own or manage assets of $150 trillion, had expressed their support for the TCFD framework. This support signifies strong demand from the private sector and investors for greater transparency around climate-related risks to better inform decisionmaking.19

We are improving our understanding of climate risks and their impact on financial stability through staff research and engagement with other central banks on topics like climate scenario analysis. One useful approach to assessing the effect of climate-related risks is through scenario analysis of how the financial system is exposed and how it may respond to climate-related risks. Climate scenario analysis 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.20 In part because of the different nature of climate-related risks relative to financial and economic downturns and the significantly longer planning horizon, this is distinct from established regulatory stress tests at banks, which are used to assess capital adequacy over a relatively short horizon.

Measuring, Modelling, and Managing Climate Risk in the Banking System
Supervisors are responsible for ensuring that supervised institutions are resilient to all material risks, including those associated with climate change. The economic and financial market consequences of climate change and the accompanying economic transition will have direct implications for bank balance sheets, strategies, and operations, and could increase credit, market, liquidity, or operational risk at banks. These climate-related developments may affect the creditworthiness of corporate, household, and government borrowers.21 Climate-related risks may reduce a borrower's repayment capacity or the value of assets collateralizing a loan, exposing banking institutions to losses. Similarly, climate-related risks may impact the level and volatility of asset prices, thus affecting the value of a bank's portfolios. Severe weather events may disrupt a bank's data centers or operations and impede its ability to provide financial services to customers.