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How Climate Change Puts Our Financial System at Risk

The climate crisis threatens the stability of our entire economy. Here's what climate-related financial risk is and what the Biden administration can do about it.

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Climate & the Financial System Executive Branch
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The climate crisis threatens the stability of our entire economy. And it will only get worse. From the record-breaking fires ravaging the west, to the torrential downpours swamping the New York City subway—climate impacts are undeniable, they’re getting more expensive every year, and they could push us into a climate-fueled economic crash. 

But Wall Street continues to bankroll climate pollution. Despite the mounting impacts of the climate crisis, big banks and financial institutions are dumping increasingly large amounts of money into fossil fuel projects and companies. Since the Paris Climate Agreement was adopted in 2015, the world’s largest 60 banks have funneled an additional $3.8 trillion into fossil fuels. As Bill McKibben put it, “Money is the oxygen on which the fire of global warming burns,” and banks are keeping the oxygen spigots wide open. 

Thankfully, the Biden Administration is pursuing an all-of-government approach to tackling the climate crisis. This approach must include federal financial regulators using their authority to rein in the damage Wall Street is causing and mitigate the risk climate change poses to our economy. 

The Problem: The Wall-Street-Funded Climate Crisis Is Threatening the Stability of Our Financial System

The mounting impacts of climate change pose substantial risks to the stability of our financial system (the institutions where we exchange money), and thus, our entire economy. A recent study estimated that unchecked climate change will reduce global economic output 11-14% by 2050, approximately $23T a year. Climate change poses risks to the financial sector in two big ways: 

Physical risk: With a hotter and more volatile climate, droughts decrease crop yields, undermining farmers’ abilities to pay their loans; fires destroy homes, wiping out the value of real estate; floods swamp cities, grinding economic activity in entire regions to a halt. These direct threats to our infrastructure and systems are known as “physical risks.”

Transition risk: Inherent economic changes associated with the needed transition away from a fossil-fuel-based economy to one powered instead by clean energy will pose challenges to companies heavily reliant on fossil fuel investments if not managed properly. As entire classes of commodities decrease in value, this can cause a shock to the financial system. These risks are known as “transition risks.” 

Experts have warned that left unchecked, these risks could drag us into a recession “like we’ve never seen before.” And without policy intervention, these costs will be borne most heavily by low-income and communities of color, who are the most exposed to climate disaster, the most financially vulnerable to its impacts, and the most likely to suffer long-term consequences from an economic downturn.

The Solution: Federal Financial Regulators Have the Power to Help

Luckily, the Biden administration can help. In the wake of the 2008 recession, Congress passed the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”, for short), designed to help federal regulators prevent another financial collapse. In the bill, Congress authorized regulators to take action against emerging challenges. Climate change is the mother of all emerging challenges. And the bill delegates significant discretionary power to regulatory agencies about exactly how to address these risks. 

Now, it is incumbent on President Biden and his administration to leverage this authority to protect our communities and economy from Wall Street’s risky behavior. The private sector is not acting on its own—on the contrary, U.S. banks JPMorgan Chase, Citigroup, Wells Fargo, and Bank of America have been the world’s largest funders of fossil fuels in the years since the Paris Agreement was signed. So now, federal regulators must act as Congress intended, and rein in this risk to protect the stability of our financial system. 

Now, it is incumbent on President Biden and his administration to leverage this authority to protect our communities and economy from Wall Street’s risky behavior.

Which Agencies Can Help: 

Several federal agencies have a role to play. In particular, Dodd-Frank created the “Financial Stability Oversight Council” (known as FSOC), made up of the Department of the Treasury and several independent federal agencies, including: the Federal Reserve, the Office of the Comptroller of the Currency, the Consumer Financial Protection Bureau, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Federal Housing Finance Agency, and the National Credit Union Administration. The Department of Labor will likely also have a critical role. Each of these agencies must assess what tools are available to them to identify and mitigate climate-related financial risk.

What Tools Can Agencies Use to Mitigate Climate-Related Financial Risk: 

The tools available to agencies fall into several buckets. Agencies can require that companies publicly disclose information about their own climate risk, update rules so that financial actors can take climate into account when making decisions, require financial institutions to include climate assessments in internal planning processes, ensure that banks with a lot of fossil fuel exposure have more capacity to face the risks, limit the amount of fossil fuel exposure any one institution can have, and more. 

For example, the Securities and Exchange Commission (SEC) has already begun the process of requiring publicly traded companies to disclose climate-related information about themselves such that investors can determine how much risk they wish to take on. The rule they put forward should require companies to disclose the greenhouse pollution that they generate directly (known as Scope 1 emissions), the pollution from the power that they purchase (Scope 2 emissions), and the pollution that they finance (Scope 3 emissions).

The Department of Labor can also help by updating its environmental, social, and governance (ESG) guidance to ensure that the process of selecting pension plans for employees can factor in climate risk. 

The Federal Reserve (“the Fed”) also has a critically important role to play. As the institution charged with setting our monetary policy and regulating some of our largest financial institutions, the Fed has unparalleled influence. And while the Fed has taken some steps to identify and address climate-related financial risk, such as joining the Network for Greening the Financial System (an international group of central banks committed to addressing climate-related risk), the agency must take additional action. At a minimum, this must include policies to help identify how much risk domestic banks are facing, and to set up a system of incentives that aligns with a safe climate and a strong economy. These policies can and should include implementing climate stress tests to examine whether individual financial institutions are prepared for the climate impacts to come, requiring that banks hold more capital if they continue to invest in risky fossil fuel assets, and, ultimately, limiting how much pollution banks can finance. 

Every agency will have a different set of tools that can be used to help investors, shareholders, and bank managers assess and address climate risk. But we must use every tool, and we must use them now. 

President Biden must ensure that any candidate nominated for the Fed is committed to using every tool that the Fed has available to prevent a climate-fueled economic crash.

Download our memo now to learn why action by the Fed is essential, as well as five critical steps the next Fed Chair must take to protect our financial stability and confront Wall Street’s climate-risky behavior.

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