As the world suffers from the combined impacts of accelerating climate change and the Covid-19 pandemic, Congress is now debating how to close gaps in funding for clean energy infrastructure, health care, and other long-neglected problems. This critical debate should not distract us from the storm clouds on the horizon posed by climate-related financial risks—risks that cannot be mitigated by public investments alone.
In a May 2021 executive order, President Biden recognized the need to address climate-related financial risk and its drivers (i.e., fossil fuels) and called for Treasury Secretary Janet Yellen and financial regulators to produce a plan to address the problem by mid-November. To prevent a climate-related financial shock, Yellen must call for financial regulators to use tools already in the federal regulatory arsenal and avoid repeating the mistakes that led to the financial crash of 2008.
Treating Fossil Fuel Expansion as a Systemic Risk
A scientific consensus has emerged that the key to preserving a habitable planet is stopping fossil fuel industry expansion. Fatih Birol, the International Energy Agency’s executive director, summarizes this consensus as follows: “If governments are serious about the climate crisis, there can be no new investments in oil, gas and coal, [starting] . . . this year .”
Unfortunately, banks are not heeding this imperative. A recent study found that the world’s 60 largest banks have pumped over U.S. $3.8 trillion into expanding fossil fuels since the 2015 Paris Agreement on Climate Change.
This lending is not just an environmental disaster; it threatens our financial system. Just as bank financing of subprime mortgage assets in the early 2000s helped lead to the 2008 crash, today’s fossil fuel assets in bank portfolios represent a bubble that will likely burst, causing tremendous economic harm, without government intervention.
Bank financing of fossil fuels creates the specter of rapid and widespread asset deflation in two ways: First, asset prices do not fully reflect the risks of devaluation of fossil fuels, as they lose their central role in powering the economy (these are known as “transition risks”). Second, prices fail to take into account the acute and chronic impacts of climate change, such as monster storms and melting permafrost, that destroy fossil fuel infrastructure and lead to costly spills of oil, coal slurry, and other toxic materials (“physical risks”).
Opportunity for Near-Term Progress
Fortunately, much can be done to address these financial risks without congressional action. Under the Dodd-Frank Act, passed in response to the 2008 financial crisis, the Federal Reserve, the Office of the Comptroller of the Currency, and other bank regulators have the authority and duty to address systemic financial risks. Prudential tools available to regulators, including stress tests, supervisory guidance, bank examinations and capital requirements, are just as useful for addressing climate-related risks as for other risks. Unfortunately, unlike their counterparts in Europe and Japan, U.S. bank regulators have not yet used their powers to deal with the problem. Yellen can put the U.S. on track.
Part of the reason for U.S. regulators’ slowness to act is resistance from the banks to the Dodd-Frank reforms. Since Dodd-Frank was enacted, banks have worked with allies in Congress and regulatory agencies to weaken its key provisions. Now, once again, the financial marketplace suffers from a lack of bank transparency and weak regulatory oversight. The recent collapse of the hedge fund Archegos Capital, and the resulting multi-billion-dollar losses at two major banks, highlight these weaknesses.
Yellen now can restore transparency and oversight for the benefit of the planet and financial system. Banks can be expected, however, to resist any efforts to confront the buildup of fossil fuel assets in their portfolios. This will be a critical moment for her to point to the lessons from 2008 and reject banks’ arguments about their ability to regulate their own behavior.
Awareness Will Not Necessarily Change Bank Behavior
It is widely understood that excessive bank risk-taking in the housing market in the early 2000s was the primary cause of the 2008 financial crash and its massive economic damage, including the highest rates of unemployment and home foreclosures since the Great Depression. Research shows that bank executives were likely aware that housing-related securities were overvalued, but they nonetheless proceeded with reckless lending.
Bank executives’ lack of fear of consequences turned out to be valid: The federal government ultimately provided hundreds of billions of dollars in bailouts to banks and their unsecured creditors. Unfortunately, for everyone besides the privileged few, this excessive bank risk-taking had enormous adverse consequences. Much of the damage remains today in the form of reduced household wealth.
As banks now engage in even more dangerous bets on fossil fuels, Yellen must reject their claims that they are now committed to sound banking practices and avoiding another financial crash. Her climate risk strategy must state clearly, citing the 2008 experience, that the only way to avoid continued buildup of climate-related financial risk is with aggressive bank supervision and regulation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
John Kostyack is principal at Kostyack Strategies, a consultancy helping mission-driven organizations achieve their climate change and clean energy policy goals. He previously led the National Whistleblower Center and Wind Solar Alliance and served as vice president at National Wildlife Federation.