Photo by Etienne Martin on Unsplash

The U.S. Federal Reserve Board announced Thursday that it will launch a pilot climate scenario analysis with six large banks, aimed at assessing the resilience of the financial institutions to various climate scenarios, and enhancing the ability of supervisors and firms to measure and manage climate-related financial risks.

The banks participating in the climate risk exercise include Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo (WFC).

The Fed’s exercise comes as central bankers globally are increasing the use of stress tests to assess the resilience of banking and financial systems to climate-related risks. The European Central Bank (ECB) and Bank of England (BoE) recently released results from their own climate stress tests, with the ECB highlighting an urgent need for banks to accelerate the incorporation of climate risk into their risk management frameworks and finding significant exposure to emissions-heavy industries, while the BoE found that banks and insurers will likely to be able to absorb the transition and physical costs of climate change, but will face significant financial headwinds.

Under the Fed’s new exercise, the banks will analyze the impact of scenarios encompassing a series of climate, economic, and financial variables. The Fed will reviews the banks analyses, engage with the firms to build climate risk management capacity, and publish aggregate-level insights from the pilot.

The exercise follows the release late last year of a report by the U.S. Financial Stability Oversight Council (FSOC), which includes the Federal Reserve as a member, identifying climate change as an emerging and increasing threat to the U.S.’ financial stability, and calling on federal agencies to take action to address the threat. The council’s key recommendations included using scenario analysis to assess climate-related financial risks to financial stability, and evaluating the need for new regulations to account for these risks.

The Fed is also a member of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), a coalition of central banks established to strengthen the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development. Central banks’ climate stress tests often use scenarios proposed by NGFS, which reflect a range of possible future climate policies, physical risks, including heat, drought and floods, and short and long-term risks stemming from the transition to a greener economy such as increasing carbon prices.

The Fed stressed that the exercise is distinct from its bank stress tests, which assess whether large banks have enough capital to continue lending during severe recessions, noting that the climate scenario pilot will not have capital or supervisory implications.

The exercise is expected to launch in early 2023, and to conclude around the end of the year.

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