Federal Reserve Board to Kick Off Climate Scenario Analysis in 2023

On September 29, 2022, the Federal Reserve Board (Federal Reserve) announced in a press release that six of the largest US banks will participate in a climate scenario analysis pilot to assess financial risks. The pilot, which will be launched in early 2023, is designed to enhance the ability of supervisors and firms to measure and manage climate-related financial risks. This marks the first time the Federal Reserve has publicly announced a climate scenario analysis program for supervised financial institutions, following the precedent set by European supervisors such as the Bank of England (BoE) and European Central Bank (ECB), each of whom launched similar programs in 2021 and 2022, respectively.

The announcement comes with little surprise—Federal Reserve Vice Chair of Supervision Michael Barr previewed the Federal Reserve’s plans earlier this month, stating it intended to “launch a pilot micro-prudential scenario analysis exercise to better assess the long-term, climate-related financial risks facing the largest institutions.” Moreover, as discussed in a previous advisory, the Federal Reserve has recently been signaling that it intends to play a major role in addressing climate-related impacts to the financial system.

Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo will undergo the climate scenario analysis exercise, which will assess the resilience of financial institutions under different hypothetical climate scenarios. The Federal Reserve said it will release details of the financial, economic and climate variables comprising the climate scenario narratives at the pilot launch. During the pilot, the firms will undertake an analysis of the impact of the scenarios on their respective business strategies and portfolios. The Federal Reserve will review the findings and “engage with those firms to build capacity to manage climate-related financial risks.” The Federal Reserve did not specify what form that engagement might take and whether the focus would be on the specific firms, the overall economy and its financial stability, or both. The Federal Reserve plans to publish aggregate findings from the pilot, but will not release firm-specific information.

In its announcement, and as foreshadowed by Federal Reserve Governor Lael Brainard in February of 2021,¹ the Federal Reserve distinguished climate scenario analysis from its annual bank stress tests—in which the Federal Reserve tests large banks’ strength against hypothetical recessions—and the results of which directly inform how much capital each firm must hold. The Federal Reserve emphasized that the pilot will be strictly for information gathering purposes, calling it “exploratory in nature,” and that it will not have capital consequences.

The pilot is expected to conclude by the end of 2023. The Federal Reserve has promised to provide additional details on how the pilot will be conducted, including the scenarios that will be used, in the coming months.

While the Federal Reserve’s pilot is limited to six banks, climate scenario analysis is likely to be a reality for other financial institutions in the near future. The Office of the Comptroller of the Currency (OCC) and Federal Deposition Insurance Corporation (FDIC) each have issued proposed principles for how large financial institutions (over $100 billion in total consolidated assets) manage climate-related financial risk. Both the FDIC’s and OCC’s proposed principles include recommendations that large financial institutions implement climate scenario analyses to forecast the potential impact on their institution of changes in the economy or financial systems resulting from climate-related risk. In a speech to the American Bankers Association earlier this week, FDIC Acting Chairman Martin Gruenberg reiterated his agency’s view that large banks should implement climate scenario analysis. Notably, he stressed that such exercises are appropriate for “large institutions, particularly for those that cross multiple communities,” and they are “not intended for smaller institutions.” He also reiterated that, as the Federal Reserve has attempted to make clear, climate scenario analysis “is not a stress testing exercise and will not have regulatory capital implications.”

Thus, while the industry awaits further word from the Federal Reserve on how the exercises will be conducted, financial institutions—particularly those “large banks” in the intended audience for the FDIC and OCC proposed principles—should look at the scenarios used in the BoE’s 2021 Climate Biennial Exploratory Scenario (CBES), as well as the results of that exercise. Of note, in discussing climate scenario analysis at the 2021 Federal Reserve Stress Testing Research Conference in October 2021, Governor Brainard explicitly stated that the Federal Reserve is “actively learning” from other financial regulators, including the BoE, in developing scenario analysis.

The CBES was launched in June 2021 and results were released at the end of May of 2022. Under the CBES, certain of the UK’s largest financial institutions conducted an intensive climate-related stress test, which was aimed at measuring the financial exposures of participants and the financial system to climate-related risks, understanding the challenges to participants’ business models from these risks, and engaging with participants to assist them in enhancing their management of climate-related financial risks. Like the Federal Reserve pilot, the CBES exercise was focused on information-gathering, and is not intended to be used by the BoE to set capital requirements. While there are some differences between the CBES and the little we know about the Federal Reserve’s pilot, such as the participants in the exercise (the CBES exercise included large UK banking groups and building societies (i.e., mutual organizations), as well as large UK life insurers and general insurers), the CBES may provide somewhat of a crystal ball in how the Federal Reserve will proceed with its pilot.

The CBES required participants to explore transition risks (risks that arise as the economy seeks to move from carbon-intensive to carbon-neutral) and physical risks (risks associated with higher global temperatures and resulting weather and climatic events) over three different 30-year scenarios: (1) Early Action—the transition to a net-zero economy starts in 2021; (2) Late Action—policy to start the transition to a net-zero economy is delayed until 2031; and (3) No Additional Action—no new policies to transition to a net-zero economy. According to the BoE, “the scenarios are plausible representations of what might happen based on different future paths of governments’ climate policies (policies aimed at limiting the rise in global temperature).” For the bank participants in the CBES, the key consideration was on the credit risk associated with the banking book under each scenario. A key metric of that risk to be determined was the cumulative total of provisions against credit-impaired loans at various points in the scenarios. Trade book risk was out of scope. This is likely because of the difficulty—or impossibility—in performing such analyses when assets in the trading book may be held only for days or less. 

Among the key lessons learned from the CBES, the BoE found that:

• Climate risks captured in the CBES scenarios are likely to create a persistent and material annual drag on bank and insurer profits of 10-15% on average;
• Projected climate risk impacts were highest for banks’ wholesale and mortgage exposures;
• By bank customer sector, the largest proportion of projected corporate credit losses were mining (including extraction of petroleum and natural gas), manufacturing, transport, and wholesale and retail trade; and
• Projected bank credit losses were greatest in the Late Action scenario, with loss rates more than doubling as a result of climate risks.²

Another key finding from the CBES was the “lack of data on many key factors that participants need to understand to manage climate risks.” According to the BoE, this was a recurrent theme among participants. Moreover, there was a “range in the quality of different approaches taken across organisations to the assessment and modelling of these risks.” Thus, the US regulators are likely to learn from the data quality issues that hampered the BoE CBES and insist—maybe not in the Federal Reserve’s inaugural climate scenario analyses, but eventually—that financial institutions use more relevant and consistent data and employ enhanced analyses. Ultimately, the BoE determined that all participating firms have more work to do with respect to improving their climate risk management capabilities, and the BoE vowed to engage with firms to help them “target their efforts, and share good practices identified in this exercise.”

Conclusion

While much is still unknown about what the future holds for climate-related regulations and supervisory expectations, the Federal Reserve’s pilot announcement makes clear that changes are on the horizon, particularly for larger financial institutions. Financial institutions of all sizes are encouraged not to delay in incorporating climate risk into their enterprise-wide risk assessments and risk mitigation frameworks. If financial institutions have not done so already, they should promptly begin a serious consideration of their climate-related risk assessment and risk management approaches, and consider whether their current corporate governance framework allows for appropriate monitoring, reporting and decision-making with respect to climate-related risks as well as climate-related opportunities.

Arnold & Porter's Financial Services and Securities Groups have partnered with our Environmental Practice Group to monitor ESG developments in the financial services sector and to develop best practices for the firm's financial institution clients. If financial institutions are seeking advice on how to incorporate ESG factors—including climate-related factors—into their business strategy, risk management or disclosure processes, please contact any author of this Advisory, or your regular Arnold & Porter contact.

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