The Fed’s Climate Complacency
The US Federal Reserve’s new “pilot climate scenario analysis” will rely on models that are likely to understate both the risks of climate change and the opportunities offered by the transition to net-zero emissions. Far from being mere technical details, such modeling flaws could lead to disaster.
LONDON – The US Federal Reserve is being dangerously complacent about climate change. While it understandably does not want to take the lead on an issue that remains so politically polarizing in the United States, the limited actions it has taken fall woefully short of what is needed.
Worse, its new “pilot climate scenario analysis” exercise with six major banks is likely to understate both the risks of climate change and the opportunities offered by the transition to net-zero emissions. Having failed to absorb the lessons from similar exercises by central banks in Europe and elsewhere, the Fed is relying on scenarios created by the Network for Greening the Financial System (NFGS), despite a growing recognition that these rest on flawed foundations.
Central banks have long conceded that crucial risks are missing from the mainstream integrated assessment models (IAMs) that they use. Yet they fail to admit that these gaps leave their analyses systematically biased against climate action. They have ignored trenchant critiques from eminent economists such as Nicholas Stern and Joseph E. Stiglitz, who note that “IAMs have very limited value … They fail to provide much in the way of useful guidance, either for the intensity of action, or for the policies that deliver the desired outcomes.”
The increasing frequency and severity of extreme weather events is now too obvious for central banks to ignore. Yet while the Fed’s exercise will include a scenario in which a major hurricane hits the US East Coast, its NGFS-style modeling will omit many critical factors and processes. Disruptive shifts in politics, policy, financial markets, and technology will all be glossed over. The complex interactions between climate-driven events and human behavior, involving tipping points and non-linear changes or discrete jumps in climate-risk probabilities – will barely be captured.
This means that possibilities such as a prolonged war in Ukraine, a return of White House climate denialism, a renewables trade war with China, recessions, or stock-market crashes are nowhere to seen. Nor are more positive possibilities, such as a surge in the popularity of progressive green politics, an explosion in electric-vehicles sales as they reach price parity with internal combustion engine vehicles, or continued rapid technological progress.
Far from being mere technical details, these kinds of modeling flaws could lead to disaster. The NGFS scenarios would have us believe that in a “business as usual world” heading to 3° Celsius warming, global GDP in 2050 would be only around 4% lower (implying a loss of less than two year’s growth) than in a world where we have achieved net-zero emissions and kept warming within 1.5°C. No wonder central banks foresee only modest financial losses. Yet this outlook contrasts starkly with climate scientists’ frantic warnings about the enormous damage that continued global warming will do.
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Compounding the problem, the NGFS scenarios downplay the potential benefits of the net-zero transition. In fact, they suggest that it will lead to higher inflation and lower growth, while ignoring the possibility that green technological progress will lower prices and boost growth.
This brings us to another problem with the Fed’s climate-scenario exercise: It will do little to help banks meet the NGFS’s own call for them to consider climate risks and opportunities in all their decision-making. Banks in Europe have already cast doubt on the usefulness of their local supervisory exercises, and a similar reaction is likely in the US. Scenarios that are woefully inadequate for assessing long-term systemic risk obviously are even less useful for stress-testing specific banks.
Having issued their own net-zero pledges, banks are under more immediate pressure to develop and execute their transition plans. Many have already committed to interim targets such as halving the emissions that they are financing by 2030, implying reductions of 8% per year. Such robust changes will transform their strategies, business models, and credit and investment decisions.
These developments ought to force a radical shift in climate-scenario analyses. There is a glaring need not only for more realistic long-term scenarios, but also for more suitable short-term and bespoke scenarios. These would be profoundly different from the NGFS scenarios. But, again, the Fed seems not to have gotten the memo. Although it has shortened the time horizon for its exercise from 2050 to 2032, it is sticking with the NGFS.
This makes little sense. For scenarios extending less than ten years, global warming is not a risk; it is a near certainty. The crucial uncertainties are those stemming from extreme weather events and transition risks involving the interplay of geopolitics, local climate policies, and financial-market volatility. True, the NGFS has announced plans to address this gap by developing short-term scenarios. But it remains to be seen whether these will be able to meet banks’ immediate needs. Most likely, banks in the US and elsewhere will be forced to take the initiative themselves.
But this points to another problem with the Fed’s incremental approach. More bespoke scenarios will shift the focus toward banks’ own risks, and away from those of the broader system. Individual banks are concerned not just with their own climate footprints and supply chains, but also with the behavior of their competitors (and hence their relative performance). While banks certainly run a risk in “going green” too slowly, they may also face a risk of moving too fast, because if everyone else fails to meet their net-zero goals, their green loans and investments may turn out to be loss-making.
The Fed deserves credit for putting climate-scenario analysis on the agenda. But in prescribing scenarios that fail to capture the realities of climate change, it risks distracting banks from the urgent task of reallocating capital flows.