By Mike Gullette
ABA Viewpoint
As banks and the broader business community wait for the SEC’s proposed rule to require many climate-related disclosures, debate over the rulemaking and its potential impact continue to grow. Key questions over the legality and the practicality of the proposed requirements, especially over the disclosure of greenhouse gas emission measurements, are compounded by questions about how a final rule might interact with climate reporting standards that the International Sustainability Standards Board expects to finalize by the end of the second quarter.
Regardless of the ISSB standards, recent messages coming from the Federal Reserve indicate that climate-related financial risks facing banks in the U.S. may be significantly smaller than the SEC rulemaking suggests. In his May 11 address at Banco Espana in Madrid, Spain, Fed Governor Christopher Waller addressed both physical and transitional climate risks, summing up how he sees them from a prudential standpoint:
I don’t see a need for special treatment for climate-related risks in our financial stability monitoring and policies. As policymakers, we must balance the broad set of risks we face, and we have a responsibility to prioritize using evidence and analysis. Based on what I’ve seen so far, I believe that placing an outsized focus on climate-related risks is not needed, and the Federal Reserve should focus on more near-term and material risks in keeping with our mandate.
This appears to be the first time that a top Fed official has publicly made the case for why climate risk is not likely to pose a serious risk to U.S. banks or U.S. financial stability. Prior to his 2020 appointment as governor, Waller served as EVP and director of research at the Federal Reserve Bank of St. Louis and his overall points are consistent with key points included in a recent staff report from the Federal Reserve Bank of New York, which is the epicenter of climate-related research and activities among the Federal Reserve banks. Taking a realistic look at how climate change translates into risk to a bank or to the financial system in general, ABA’s key takeaways from the paper include (among other things):
- An appreciation that the average maturity of banks’ exposures is necessary to assess borrowers’ ability to repay. (See pages 2-3.) Seemingly missing in many discussions related to climate-related risks facing banks is that their loan portfolios are generally short- to medium-term, while climate risks generally are considered long-term in nature. Banks adjust their underwriting standards and portfolio allocations as they see the risks changing over time and as existing loan facilities mature. The natural lending process would thus ensure climate risks are priced into their loans like any other risks. This is a big difference from climate-related financial risks within equity investments, such as common and preferred stock. It would be appropriate to assume equity interests to be perpetual or otherwise long-term. Such is not the case for credit facilities.
- Banks will adjust their balance sheets dynamically to climate risk, whereby prudential regulatory bodies appear to emphasize static balance sheet analysis. (See page 18.) As noted above, banks normally adjust their portfolio allocations based on their normal ongoing risk management process. In about 80 percent of the cases, however, currently proposed stress testing and scenario analyses do not recognize that. Any current overweighting of lending to at-risk industries is erroneously assumed to be blindly maintained over the long term. This puts into question any efforts that may separately consider integrating climate risk into regulatory capital calculations.
- Imposition of a $100 carbon tax is not a likely outcome. (See page 12.) consistent with question three of Acting Comptroller of the Currency Michael Hsu’s 2021 paper “Five Climate Questions Every Bank Board Should Ask,” many believe estimating the impact of a theoretical carbon tax or carbon price to be a way to estimate transition risk. In such an exercise, loans to companies that manufacture, sell or otherwise rely on fossil fuels (as opposed to sustainable energy sources) would be at higher risk. With a low assumed carbon price, the measured risk is low. With a high carbon price, the risk is high. Many believe that a $100 per ton price (a high price) is the appropriate measure. The New York Fed staff paper questions this, however, as the adverse short-term impacts to the general economy will likely be significant. In other words, it is highly unlikely such a tax would be enacted in a quick fashion. Moreover, there is a strong argument to make that that if a carbon tax were enacted with significant transition, banks would naturally react under the same dynamic portfolio analysis processes as described above, and the staff paper seems to agree.
Given this new perspective on climate-related financial risk, there appears to be a wide expectation gap among certain policymakers and other stakeholders on the level of transition risk banks face. So it’s a relief that the SEC may pause on issuing its final rule, as the extent of required disclosure will likely depend on the perceived level of risk. Such a pause may also allow it to consider disclosure standards expected to be issued by the International Sustainability Standards Board (ISSB) by the end of June. ISSB standards are likely to be required with the European Union’s Corporate Sustainability Reporting Directive and, practically speaking, become a de facto standard for large banks. While the ISSB has publicly shown sympathy toward concerns regarding key issues, such as materiality and scalability, how those issues are addressed within the final standard, as well as to specific requirements related to scenario analysis modeling remain big question marks. Further, both the SEC and the ISSB must address whether and how the costly process to measure and disclose “Scope 3” financed emissions significantly helps investors forecast financial performance.
In the meantime, studies like the New York Fed’s staff paper hold the potential to compel a more realistic and sober discussion on these important issues.
