The Implications of Climate Change for Financial Stability, Nov. 2020: Board of Governors of the Federal Reserve System

October 26, 2020

FED_Implications_of_Climate_Change_for_Financial_Stability

"Climate change adds a layer of economic uncertainty and risk that we have only begun to incorporate into our analysis of financial stability. Different sectors of the economy and geographic regions face different risks that will diverge from historical patterns."

"Acute hazards, such as storms, floods, droughts, or wildfires, can quickly alter, or reveal new information about, future economic conditions or the value of real or financial assets. Moreover, in the presence of rapid shifts in public perceptions of risk, chronic hazards (like a slow rise in sea levels) have the potential to produce similar abrupt repricing events. These repricing events and direct losses associated with climate hazards can result in an increased frequency and severity of financial shocks; the timing and repercussions of these shocks are difficult to predict in advance."

"Features of climate change can also increase financial system vulnerabilities, as illustrated in the figure. Opacity of exposures and heterogeneous beliefs of market participants about exposures to climate risks can lead to mispricing of assets and the risk of downward price shocks. Similarly, uncertainty about the timing and intensity of severe weather events and disasters, as well as the poorly under- stood relationships between these events and economic outcomes, could lead to abrupt repricing of assets."

"Climate risks thus create new vulnerabilities associated with nonfinancial and financial leverage."

"In regions affected by severe events, households and businesses could become overlevered if the value of their assets or income prospects become impaired. Levered financial institutions may be exposed to losses from disasters made more likely by climate change that are not accurately reflected in current financial models; for example, financial models may lack sufficient geographical granularity to accurately connect local physical damages to financial exposures."

"The financial system is also vulnerable to amplification effects of these damages if contracts are incomplete and do not capture all damages and if poorly understood financial exposures cause spillover effects or financial contagion." - Board of Governors of the Federal Reserve System