If the Federal Reserve were to implement climate change stress tests for banks, what would the final framework likely include, and which sectors would likely see the highest impact?
FORMER HEAD OF AUDIT GROUP AT NATIONAL BANKING REGULATION & SUPERVISION AGENCY
A climate change stress test framework would likely include two key risk categories: physical risks that arise from extreme climate events and transition risks resulting from shifting to a low carbon economy. The former will impact banks’ own ESG practices, resulting in changes in physical resources (e.g. green buildings, cloud computing). The impact of the latter is more important for banks, as it will force banks to adjust their loan portfolios. Climate risks will be a key part of credit management, and the climate effects of loans will be assessed thoroughly by banks in addition to traditional creditworthiness assessment methods. So, any sector with high climate risk and/or fails in ESG will face tougher terms for getting loans. I expect the oil and gas sectors to be affected the most.
CIO OF A POLICY & POLITICAL EVENT-DRIVEN HEDGE FUND
It is highly unlikely that this framework would be applied at the Fed, as it would be litigated and ultimately defeated. If applied, it would certainly involve allocation of credit to favored industries like renewables, battery and carbon capture, or hydrogen technologies, and it would penalize lending and capital allocation to oil and gas. Supporting industries like grid management would benefit too. The implementation timeline is highly unclear. Most likely outcome is that the Fed will publish a white paper on this issue and cover the topic in the Jackson Hole conference in August 2022, but the actual implementation never really starts, when Democrats lose speaker of the House and perhaps the US Senate in the Nov 2022 elections. There would be intense lobbying even before the election.
FOUNDER & PRINCIPAL OF AN ENVIRONMENTAL SUSTAINABILITY AND GLOBAL RESOURCES STRATEGY AND INVESTMENT MANAGEMENT PRACTICE
The first step: measure the climate risk factor. Fed proposes using stranded asset portfolio returns as a proxy measure of transition risks. 2nd step: estimate the time-varying climate betas of financial institutions. Fed estimates dynamically by using the DCB model to incorporate time-varying volatility & correlation. 3rd step: compute the CRISKs, the capital shortfall of financial institutions in a climate stress scenario based on the same methodology as SRISK, but the climate factor is added as the second factor. Fed uses this procedure to study the climate risks of large global banks in the U.S., U.K., Canada, Japan, and France in the collapse in fossil fuel prices in ’20. Fed documents a substantial rise in climate betas & CRISKs across banks during 2020 when energy prices collapsed.