Climate Risk and the Fed: Preparing for an Uncertain Certainty

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Climate Risk and the Fed: Preparing for an Uncertain Certainty

Mary C. Daly, President and Chief Executive Officer

Federal Reserve Bank of San Francisco

Peterson Institute for International Economics1

June 22, 2021

11:00 AM EDT

Remarks as prepared for delivery.

Economies are, in many ways, perpetually evolving; adapting to new conditions and moving from one steady state to another. As these transitions occur, the path forward is often hazy. We can see the world shifting around us, but we're not completely sure where we'll end up. All we know for certain is that change is on the horizon.

Society has faced many of these uncertain certainties: industrialization, globalization, the digital revolution. It's increasingly clear that climate change is another one. While the severity and scope remain unclear, the consensus is that a changing climate poses a significant risk to the global economy and financial system.2 And we know from experience that ignoring these risks or failing to prepare for them will make the transformation more turbulent and the destination less hospitable.

As monetary policymakers, our job is to navigate this uncertainty. We need to anticipate the changes before us and understand their implications.

1 I am grateful to Stephie Fried and Fernanda Nechio of the Federal Reserve Bank of San Francisco for assistance in preparing this text.

2 See, for example, USGCRP (2018), Auffhammer (2018), Hsiang and Kopp (2018), Hsiang et al. (2017), Brunetti et al. (2021), Rudebusch (2021). See also Brainard (2021) for related discussion.

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Today,FINAL I will talk about how the Federal Reserve Bank of San Francisco and the Federal Reserve more broadly think about climate risk and its implications for the economy.

But before I go any further, it's a good time to remind you that the views I will express today are my own and do not necessarily reflect those of anyone else within the Federal Reserve System.

Preparing for Uncertainty

Now, at this point, most people understand that their future, and the futures of their children and grandchildren, will be affected by climate change.3 Indeed, in a 2019 Pew Research survey, 62 percent of Americans said that climate change is having at least some effect on their local communities.4

But the future is a far-off place. And as humans, it can be tempting to discount or simply ignore it. Unfortunately, that makes the path to change more treacherous. The better we understand the challenges and opportunities of climate change, the better we'll be able to manage them.

For many people, that future is already here. Drought and wildfires in California and the Pacific Northwest, ice storms in Texas, floods in the Midwest, and hurricanes in the South have already cost lives, destroyed

3 Defined as the current andprojected trend toward higher average temperatures and the environmental shifts that result, such as melting ice caps, rising sea levels, more frequent severe storms, and changes in the pattern and predictability of rainfall (IPCC 2020, USGCRP 2018).

4 Funk and Hefferon (2019).

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property,FINAL and displaced communities, sometimes permanently.5 Assessing climate risk means understanding the likely frequency and severity of these kinds of physical disruptions.

But physical risks are only part of the story. A complete picture has to recognize the preparations-precautionary or proactive-that individuals, businesses, and governments are making to manage the expected risks. These are especially uncertain since they depend on the awareness and reactions of individuals, communities, and societies.

Early data tell us that adjustments are already under way. As the frequency of climate-related events has increased, insurers and financial institutions have taken notice. They're much less likely to shake off storms, fires, and floods as occasional or "freak" occurrences. Instead, they're recognizing them as indicative of a more recurrent pattern that demands higher compensation or different treatment.

The economic impact is tangible. It's already harder and more expensive to insure real estate in risk-prone areas like Florida, Louisiana, Texas, and California.6 Individuals and businesses in those areas are increasingly on the hook for property damage. This limits their ability to get loans or attract investors, curtails production, and affects decisions about the location of current and future operations. It also leaves property owners and the banks that hold their mortgages with stranded assets: real estate investments that can no longer deliver their projected rate of return.

5 For research on extreme events and their economic effects, see Aylward and Oliveira (2020), Bakkensen and Barrage (2020), Gallagher (2014), Tran and Wilson (2020), Deryugina (2017), and Fried (2021).

6 See, for example, Flavelle (2019), Grimaldi et al. (2020), Sheehan (2020). 3

FINAL These dynamics aren't limited to businesses and households in areas prone to destructive weather events. We're seeing them in parts of the country facing less conspicuous climate effects, like prolonged extreme temperatures and unpredictable rainfall. The outcomes may seem less acute than fires or hurricanes, but they affect business operations in equally crucial ways-for example, by influencing which crops can be grown or how may months of the year people can work outside. These kinds of shifts are already being factored into businesses' and insurers' assessments of risk.7

All of this highlights an important reality. The risks from climate change aren't an isolated problem relevant only to a few sectors or parts of the country. Large swaths of the nation and a wide range of industries are vulnerable to disruption.8

Of course, nowhere are these risks more acute than in the sectors of the economy that produce and use carbon-based energy. The global and increasingly domestic momentum to "go green" is prompting consumers and businesses to decarbonize and shift to more environmentally neutral forms of energy.9 These changes can lead to mispriced assets or misallocated capital, especially for entities operating globally. We're already seeing corporations take notice. A growing number of them are including climate risk assessments in their daily business planning and financial disclosures. In many cases, this

7 Brunetti et al. (2021).

8 These industries include the agricultural and resource sectors, leisure activities, various manufacturing industries, and the financial institutions that support their operation. (USGCRP 2018).

9 Fried, Novan, and Peterman (2021).

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isFINALhappening in the absence of regulatory requirements or government mandates.10

Many sectors are feeling the strain, including energy, automobiles, and construction. Firms in these carbon-heavy sectors could see declines in asset prices, income, and profitability.11 Understandably, communities and businesses that rely on these industries are worried; they're thinking about falling production, stranded assets, and, ultimately, stranded people.

Their fears aren't unfounded. We don't have to go back very far in our history to see the devastating impact economic shifts can have on whole segments of society. Think back to the 1980s wave of globalization. The view of most economists, including me, was that freer trade would be an unqualified win for the aggregate economy, raising output, driving growth, lowering inflation, and ultimately delivering higher GDP per capita.12 And globalization has led to many good things-just not across the board.13

Industries that had once been at the heart of the U.S. economy became less profitable and less viable. Workers displaced from downsized and closing businesses found it hard to transition to alternative employment with similar pay. Some remained idle for the rest of their working lives. While new jobs and industries emerged, they often went to other people, in other places, far from the communities hardest hit by globalization. Thirty years later, many of

10 See the work by the TaskForce on Climate-Related Financial Disclosures (https://www.fsb-tcfd.org/) and CDP (https://www.cdp.net/en/climate).

11 Rudebusch (2021), Brunetti et al. (2021).

12 Alston, Kearl, and Vaughan (1992).

13 See, for example, Broda and Weinstein (2006), Ebenstein et al. (2014), Caliendo and Parro (2015), and Hummels, Munch, and Xiang (2018).

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