Federal Reserve Releases Research on Approaches for Assessing Climate-Related Financial Stability Risks

On July 5, 2022, staff of the Board of Governors of the Federal Reserve System (“Federal Reserve”) released a report analyzing potential approaches for assessing climate-related financial stability risks (the “Report”).¹ The Report establishes a detailed definition of climate-related risk and explores how such risks can affect the US financial system. It surveys half a dozen approaches to analyzing and estimating climate-related financial stability risks and suggests that regulators will need to use multiple approaches and fill significant gaps in climate data to be able to adequately assess such risks.

In this Legal Update, we summarize some of the key points of the Report and consider how regulators might use it as they develop climate-risk management expectations for financial institutions.

Climate-Related Financial Stability Risk

The Report defines climate-related financial stability risk as any risk that may result from climate change that could potentially impact the safety and soundness of the US financial system. It divides climate-related financial stability risks into physical risk and transition risk, which is common in definitions of climate-related financial risk in the United States. It recognizes in a footnote that climate-related risk also includes litigation risk but does not further address this aspect of the definition.

The Report further divides physical risk into chronic physical risks (e.g., sea level rise) and acute physical risks (e.g., wildfires). Similarly, it divides transition risk into policy risk (e.g., climate policy that induces a change in location for a business), technological risks (e.g., stranded assets), and preference risks (e.g., increased investor demand for sustainable products). These divisions are consistent with those used by the Financial Stability Board (“FSB”) in a similar document issued earlier this year.²

Approaches

The Report examines more than half a dozen approaches to analyzing and estimating climate-related financial stability risks. These approaches are considered at a relatively high level, and the analysis is conceptual and qualitative in nature. Most of the discussion is beyond the ken of a lawyer or compliance officer, but there is a notable discussion of the use of scenario analysis, stress testing and sensitivity analysis to estimate a range of economic and financial outcomes from climate change. The Report explains several of the use cases for these techniques in the banking and insurance sectors and concludes that this approach provides the key benefit of addressing the uncertainty that is inherent to climate-related risks. However, it notes that quantitative analysts have used these techniques with only some industries, asset classes, and time horizons, and there remain significant data limitations that may make it difficult to use these techniques to assess the entire US financial system. Further, the Report notes that these techniques are still in the early stages of development and have not conclusively resolved concerns with uncertainty in selection of model assumptions.

The Report concludes that no one approach will address all challenges to analyzing and estimating climate-related financial stability risks. It recommends that further research be undertaken on certain approaches that overcome inherent and data-driven limitations and that new approaches be developed that better address the dynamic nature of climate change. With respect to scenario analysis, stress testing and sensitivity analysis, the Report suggests that standardized collection of climate data from financial institutions may help to address some of the data challenges, but even that may not address second-round/interconnectedness effects of climate change.

Conclusion

The Report is noteworthy for recognizing the limitations that exist in all current approaches to analyzing and estimating climate-related financial risks. While the availability of data is often cited as a primary concern, other key issues remain, such as the selection of models and assumptions. To avoid wasted time and effort, regulators and policymakers should address these concerns simultaneously and in a coordinated manner that seeks to minimize the burden on financial institutions.³

Further, most approaches are limited to some extent by the large degree of uncertainty associated with their results. For regulators and policymakers that are acting on results (or expecting financial institutions to act on these results), it is important to understand this uncertainty and avoid the error of attributing false precision to any quantitative value. This is particularly true for regulators seeking to use data to justify significant expansions of their regulatory domains.⁴

¹ Climate-related Financial Stability Risks for the United States: Methods and Applications, Finance and Economics Discussion Series (July 5, 2022), https://www.federalreserve.gov/econres/feds/climate-related-financial-stability-risks-for-the-united-states.htm.

² See our Legal Update on the FSB’s report: https://www.mayerbrown.com/en/perspectives-events/publications/2022/05/fsb-releases-report-on-approaches-to-climaterelated-risks.

³ See our earlier Legal Update on principles for ESG regulation: https://www.mayerbrown.com/en/perspectives-events/publications/2022/06/principles-for-us-esg-regulation-released-by-american-bankers-association.

⁴ See our Legal Update on this issue: https://www.mayerbrown.com/en/perspectives-events/publications/2022/07/supreme-court-decision-in-west-virginia-v-epa-casts-doubt-on-secs-climate-proposal-and-other-regulatory-initiatives.