Many of the questions Jerome Powell faced at his Senate confirmation hearing last week would have been familiar to any Federal Reserve chair on Capitol Hill: Where is the economy heading? What about inflation? How fast could interest rates rise?
But Powell, who is seeking his second term, also confronted a question that underscored the profound changes that could be ahead for both the economy and the powerful financial institution he leads: How does the Fed plan to address the economic risks posed by climate change?
Around the world, central bankers have begun to factor such risks into their decision-making process aimed at maintaining the safety and stability of their economies. In 2019, the Swedish Central Bank sold off bonds it held in the Canadian province of Alberta and parts of Australia, citing the risk posed by the economies’ high greenhouse gas emissions. The central banks of China, India, South Korea and New Zealand have sought to increase their purchases of “green” bonds. Last year, the Bank of France announced it would end investments in coal and reduce its oil and gas holdings by 2024. And the Bank of England last year embarked on its first comprehensive “stress test” of the British financial system’s ability to manage climate change and the transition to a net-zero economy, with publication of the results expected in May.
But the U.S. Federal Reserve under Powell, who took over as chairman in 2018 after being tapped by President Donald Trump, has done little beyond acknowledging the risks of climate change and studying its role. In a report card last year, progressive environmental groups led by Oil Change International concluded that the Federal Reserve, arguably the most powerful central bank in the world, had done less on climate than any other major central bank.
“Our role on climate change is a limited one, but it’s an important one,” Powell said at last Tuesday’s Senate Banking Committee hearing. “It is to ensure that the banking institutions that we regulate understand their risks and can manage them.”
President Joe Biden, facing pressure from progressives, expressed confidence that Powell would act on climate in November when nominating him to serve a second four-year term. “He’s made clear to me a top priority will be to accelerate the Fed’s effort to address and mitigate the risks… that climate change poses to our financial system and our economy,” Biden said.
But several Democratic Senators remain unconvinced. “The world is running out of time to deal with the climate crisis, and the Fed has an important role to play here, and I hope the Fed will step up,” said Sen. Elizabeth Warren (D-Mass.), after grilling Powell during his confirmation hearing. She has called Powell “dangerous,” and has vowed to oppose his confirmation.
Powell, a Republican and former Wall Street banker who was originally appointed to the Fed in 2012 by President Barack Obama, is expected to have enough bipartisan support to win confirmation. And with pressure building domestically and internationally for financial regulators to take a more active role in addressing climate change, Powell almost certainly will be the federal reserve chairman who sets the institution’s course in a critical decade for the drive to a net-zero carbon economy.
For Ever-Evolving Fed, Climate is a New Challenge
When the Federal Reserve was established more than a century ago, its primary purpose was to maintain the safety and soundness of the then-shaky American banking system. But over the years, its role has expanded and evolved to encompass shepherding the economy as a whole.
During the Great Depression, Congress gave the Fed more power to control the quantity of money available in the economy. The reserve later played a crucial role in financing military spending by the United States and its allies in World War II. In the late 1970s, after oil shocks rocked the global economy, the Fed finally (and many experts think belatedly) stepped in with high interest rates to curb double-digit inflation. After the stock market crash of 1987 and the terrorist attacks of 2001, the Fed injected money into the economy and set low interest rates to spur recovery.
“The President has very little effect on the economy,” Nobel Prize-winning economist Robert Fogel said in 2004. “If you want to put blame or credit, the main person who influences the business cycle is the Head of the Federal Reserve Bank.”
The economic collapse of 2008 was a turning point that led to even more responsibilities for the Fed and for central bankers around the world. They couldn’t stabilize the economy with low interest rates alone; the rates already were at or near zero. The Fed and other central bankers turned to making large-scale purchases of bonds and mortgage-backed securities—a process known as “quantitative easing”—to increase money supply and boost economic activity. The Fed initiated more quantitative easing to address the slowdown caused by Covid.
Meanwhile, a consensus grew among policymakers around the world that central banks had to do more than respond to crises: They should be heading crises off. In the United States, the Dodd-Frank banking reform law of 2010 included new mandates for the Fed to probe the resilience of the financial system.
For example, banks had long conducted “stress tests” internally, using hypothetical scenarios to assess whether they could withstand a crisis. Now, the Fed and other central bankers were required to conduct system-wide stress tests to gauge the resilience of large banks. Since 2013, the Fed has conducted regular stress tests in which banks provide information on how their balance sheets would be affected by shocks like high inflation, high unemployment or recession. Banks that fail stress tests can be subject to restrictions until they build up their capital reserves.
As central bankers’ powers expanded, it wasn’t long before climate action advocates, international bodies such as the G20 Sustainable Finance Working Group and central bankers themselves began to talk about the role national financial institutions and regulators could play, perhaps using new tools such as quantitative easing and stress testing, to head off the global financial instability that could result from climate change.
Citing heatwaves in North America, typhoons in Southeast Asia and droughts in Africa and Australia, Mark Carney, then-governor of the Bank of England, and François Villeroy de Galhau, governor of the Bank of France, issued a call to action in a 2019 open letter.
“The enormous human and financial costs of climate change are having a devastating effect on our collective wellbeing,” they wrote. “As financial policymakers and prudential supervisors, we cannot ignore the obvious risks before our eyes.”
Powell: ‘Stick to Our Knitting’
Central bankers around the world have taken the first tentative steps toward integrating climate change into their decision-making.
The Bank of France was the first to conduct a system-wide climate stress test in 2020. The Bank of England followed last year with what it described as a “learning exercise,” which would not be used to set new capital requirements. The Bank of England has said it does not plan to publish data for individual firms, but will release aggregate results of the exercise in May. (Activists said they feel these efforts don’t go far enough; they’d like to see the stress tests used to make it more expensive for banks to lend to fossil fuel companies and carbon-intensive projects.)
Last month, the Bank of Japan offered $18 billion worth of loans to financial institutions, in the first of what it anticipates will be twice-yearly auctions to promote activities to fight climate change. The zero-interest loans can be rolled over until 2030 so that banks that boost their green and sustainable lending, in essence, providing a kind of “green” quantitative easing.
The European Central Bank (ECB), already a large buyer of green bonds, plans its first climate stress test this year. ECB President Christine Lagarde has gone further, saying that climate should be a consideration in the setting of monetary policy.
“Obviously, climate change has an impact on price stability,” she said in an interview last year. “It will have an impact on agricultural production, it will have an impact on where people live, it will have an impact on not only the way we live, but the cost of living, and that clearly has to be embedded into the analysis that we conduct.”
Lagarde added, “There are some traditional thinkers who believe that central banks should altogether stay out of that business and exclusively concentrate on inflation, and price stability. I strongly disagree with that myself.”
But at the Fed, Powell has taken an opposite view, saying flatly at a forum last year that climate change is not a factor in deciding monetary policy. He said the Fed is studying the climate implications for its role as a supervisor and regulator of financial institutions. He has created two internal committees to explore the issue, and the Fed has joined the Network for Greening the Financial System, the international organization of central bankers that is studying their role in climate change. But he has not committed to conducting a climate stress test or other steps.
At last week’s confirmation hearing, while Democrats pressed Powell on his plans for action on climate change, Republicans repeatedly admonished him to steer clear of what they called “political” issues, including climate change.
“What I worry the most about with the Fed is the mission creep that I think clouds and frankly complicates the main mission of price stability, if you’re having to sit around and hire people that are going to assess climate risk,” said Sen. Kevin Cramer (R-N.D.)
Cramer, whose state is the nation’s No. 2 oil producer, blasted the idea of a climate stress test. “The natural outcome is that we’re going to somewhat transfer our climate guilt to other countries who don’t have our environmental and labor standards,” he said.
Powell’s response was sure to throw cold water on anyone’s hopes that the Fed would take a leading role in addressing climate change. “I agree with your principle, which is that we’ve got to stick to our knitting,” he said. “Climate is appropriate for us as an issue to the extent it fits within our existing mandates, in the sense of it’s another risk over time that banks are going to run. But the broader answer to climate change has to come from legislators and the private sector.”
Powell also said the possibility of financial instability resulting from the physical risks of climate change “doesn’t seem likely in the near term.”
Lael Brainard, a member of the Federal Reserve’s Board of Governors who is Biden’s pick for vice chairwoman, is seen as more open to integrating climate change into decision-making. But at her Senate confirmation hearing last Thursday, she stopped short of endorsing climate stress tests. Instead, she discussed how the central bank might provide guidance to large institutions.
“We would not tell banks which sectors to lend to or which sectors to not lend to,” she said, “but we do want to make sure they are measuring, monitoring and managing their material risks.”
What Can the Fed Do?
In addition to Powell’s reticence, the Fed’s history and unique legal framework make it harder for the U.S. central bank to engage in climate activity as aggressively as central bankers elsewhere in the world, some experts point out.
For example, the European Central Bank, established in 1998, explicitly mandates that consideration be given to the environment in executing monetary policy. The Fed’s mandate on monetary policy, in contrast, is focused narrowly on promoting “the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Bank of England has a specific mandate of “supporting the economic policy of Her Majesty’s Government.” But law and policy concerning the Federal Reserve has been aimed at maintaining its independence from the executive branch and thereby, the Biden administration’s climate policy.
“When people look around the world and say, ‘It seems like a lot of central banks are doing something, why not the Fed?,’ it’s because it doesn’t have that relationship to the executive branch. In fact, it’s quite the opposite,” said Christina Parajon Skinner, a professor of legal studies and business ethics at the University of Pennsylvania’s Wharton School.
Skinner said she wouldn’t be surprised if the Fed uses climate scenario analysis in the future, although she believes it wouldn’t have the authority to make it the basis for forcing action by financial institutions.
“The central banks are extremely powerful institutions, and they’ve become more and more powerful since the financial crisis,” Skinner said. “And they’re very effective institutions. So if you want an expedient result, the Fed is a place that people look to, not just for climate change, but for a lot of different policy issues. We are at a moment in time that the central banks are being sort of pulled to the center of many different debates that take them pretty far outside of their traditional wheelhouse.”
Still, many believe that the Federal Reserve could go further to address climate change using its current legal authority. While some activists would like to see the Fed aggressively encourage the financing of clean energy, while making lending for fossil fuel projects more costly by setting high capital standards, others believe the Fed could have an impact through less prescriptive steps. David Jones, who, as California’s insurance commissioner from 2011 to 2018, spearheaded greater disclosure requirements in that industry, said the Fed could immediately improve climate risk disclosure by banks, as well as conduct a climate stress test, perhaps borrowing from scenarios the European banks already have carried out.
“It’s financial regulatory malpractice not to take up the best practices available now to address climate change and climate risk,” said Jones, who now directs the Climate Risk Initiative at the University of California, Berkeley.
In any case, the pressure for action is building. The Financial Stability Oversight Council, a board of federal and state financial regulators and experts established under the Dodd-Frank law, released a report in October identifying climate change as an “emerging and increasing threat” to U.S. financial stability. One of its main recommendations was that the Fed and other financial regulators increase their internal capacity, bringing aboard personnel and know-how to address climate risks.
Biden made a trio of nominations on Friday that are widely seen as attempting to move the Fed in a more progressive direction. His naming of two black economists, Lisa Cook and Philip Jefferson, as his choices to fill open seats on the Fed board, and nomination of former fed governor Sarah Bloom Raskin to be the first woman in the Fed’s top job regulating banks came after a push by Democratic lawmakers for more diversity—and more openness to ideas like addressing climate change—at the Fed.
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Ceres, the investor activist coalition, earlier this month issued more than a dozen recommendations for the Fed and other financial regulators, including providing guidance to financial institutions on identifying and monitoring climate risks. The Comptroller of the Currency, another agency that shares responsibility for bank regulation, took a step in that direction last month by issuing draft rules for the nation’s largest banks on how to engage in climate-related risk management.
Ceres has analyzed the risks for U.S. financial institutions from both the physical impact of climate change and the so-called “transitional” risk, the risk that their holdings in carbon-intensive industries will suddenly lose value as the world transitions from fossil fuels to clean energy sources. It found that the biggest banks are carrying more than $500 billion of climate risk exposure as a result of investments in sectors that have inadequately prepared for emissions reductions in line with the Paris climate accord. In addition, major U.S. banks could lose more than $250 billion annually because of climate change impacts such as supply chain disruptions and lowered productivity as a result of events like coastal flooding and power outages, Ceres concluded. Those findings were echoed in a report last fall by the Federal Reserve Bank of New York, which found that the indirect climate risk exposure for banks that lend to the oil and gas industry could be “economically substantial.”
The report last week by the National Oceanic and Atmospheric Administration saying that $145 billion in damages and 688 deaths in the United States were directly attributable to weather disasters in 2021, adds to the urgency for action by the Fed, said Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets.
“The world is literally on fire,” said Rothstein. “If the job of the Federal Reserve is the safety and soundness of our economy, and a full-growth economy and low unemployment, our economy cannot achieve those without addressing climate risks.”
A vote on Powell’s nomination is expected in the coming weeks in the Senate, where he can be confirmed with a simple majority.