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Financial regulators, international organizations, market participants and others have directed significant attention in recent years towards developing an understanding of the implications of climate change for the financial sector and financial stability.1 Climate change-related financial risks pose both micro- and macroprudential concerns, but analysis and research is at an early stage.2 This Note describes an approach to understanding how risks arising from climate change may affect financial stability, and connects this discussion to the financial stability monitoring framework described in the Federal Reserve's Financial Stability Reports.3 That framework distinguishes between shocks to the financial system and economy, which are difficult to predict, and vulnerabilities, which are underlying features of an economic or financial system that can amplify the negative effects of shocks. We describe how climate-related risks may emerge both as shocks and as vulnerabilities that could amplify the effects of climate-change related shocks or other shocks.4

This analysis offers a way to assess the financial stability impact of risks resulting from climate change as information on the nature, extent, and timing of those risks improves. Our approach to describing climate-related financial stability risks is complementary to, though both simpler and broader than, the existing international typology described in Carney (2015).

Climate Change Notes Pdf Download

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We offer three main conclusions. First, the Federal Reserve's financial stability monitoring framework is flexible enough to broadly incorporate many key elements of climate-related risks. Second, although we believe that climate change increases financial stability risks, more research and analysis is needed to incorporate these risks fully into financial stability monitoring, including substantial improvements in data and models. Third, domestic and international transparency efforts around climate-related financial exposures may help clarify the nature and scope of financial stability risks related to climate change.

At a broad level, climate change refers to changes in the usual conditions of nature of the Earth's oceans, fresh water, and atmosphere.5 These changes include, for example, increases in average global temperatures, the frequency and severity of major storms, and the level or acidity of oceans, among many other effects. There is a strong scientific consensus that the global climate has already changed substantially over the past century and that future changes should be expected as human-caused emissions of greenhouse gases continue. Greenhouse gases in the Earth's atmosphere, such as carbon dioxide and methane, block solar radiation reflected from the Earth's surface, thereby raising global temperatures. The higher the concentration of these gases, the greater their effect on climate.

Despite the scientific consensus on trends in and causes of climate change, the exact timing and precise magnitudes of future climate outcomes remain uncertain.6 We refer to this range of possible future physical outcomes arising from climate change as climate risks. Researchers continue to further develop and refine climate and econometric models that forecast the path of climate change, but much uncertainty remains.

By themselves, climate-related economic or financial risks need not affect financial stability; the economy can experience a decline in output, and investors can experience losses, without these effects being amplified by the financial system. Under some conditions, however, these risks could increase financial-system vulnerabilities through losses to levered financial intermediaries, disruption in financial market functioning, or sudden repricing of large classes of assets.

This cascade of consequences fits within the Federal Reserve's financial stability monitoring framework in two ways (see Fig. 2). First, climate risks can manifest as shocks to the financial system.10 Acute hazards, such as storms, floods, or wildfires, can quickly change or reveal new information about future economic conditions or the value of real or financial assets.11 With the potential for sudden large shifts in perceptions of risk, chronic hazards (like a slow increase in mean temperatures, or rising sea levels) could produce abrupt repricing events, if investor expectations or sentiment about the physical risks change abruptly. While these examples focus on physical risks, shocks to the financial system may emerge from a broader set of climate risks. These additional risks include the emergence of climate-related liability risks or future changes in climate policies. Like all financial shocks, it is difficult to predict how and when these broader set of climate risks may be realized as financial shocks.

Second, climate risks can also increase financial system vulnerabilities that could transmit and amplify shocks. The examples below illustrate features of climate change that increase the probability of asset mispricing and higher nonfinancial and financial leverage, which interconnectedness and reduced diversification could amplify:

Insurance markets: Under many scenarios, climate change also increases the frequency and severity of natural disasters such as wildfires and major storms.21 These disasters, in turn, could damage physical assets and create growing disruptions to local economic activity, raising the cost of insuring highly exposed properties and businesses. As a result, the price of that coverage would rise, and insurers' willingness to offer policies on some properties would fall. The risk of business defaults following natural disasters could increase as firms tend towards lower levels of insurance coverage. This pullback in insurance coverage could be a financial system vulnerability with a variety of second-order effects, many of which are beginning to be visible in the property and casualty insurance markets of some states.22

In principle, quantifying climate-related risks should be similar to quantifying other financial stability risks. In practice, however, climate-related risks face several challenges to measurement beyond those associated with conventional financial system vulnerabilities and potential shocks, and which will require investment to address. These climate-related features impair not only estimation and modeling at the level of the overall economy, but also the analysis of region-, sector-, asset-, institution-, and investor-level exposures. Investment in data procurement, and careful analysis of climate-related data to describe specific economic and financial risks, is critical to addressing these challenges and producing high-quality research on climate-related outcomes.

A fundamental challenge relates to merging and cleaning climate-related data for use in economic models.24 Availability of sufficiently granular spatiotemporal and climate-related financial data is limited, including information on exposure to physical hazards or the emission levels of activities associated with particular investments or financial institutions. Investors or researchers hoping to assess the financial impacts of climate-related risks must often use proxies involving spatiotemporal weather data. Weather data collection is uneven across countries, making comparable assessments of climate-related risks from one data set alone difficult. Because these data sources are often partial, multiple data sources are often necessary to examine a specific climate-related financial risk.

Models that seek to link climate directly to economic output involve a separate set of challenges. Climate models typically simulate the interaction of a wide range of variables over many decades. In addition, the effects of climate change on economic activity may involve heterogeneous local or regional effects. These factors introduce uncertainty into even short- and medium-term projections, making aggregate climate models an imprecise source of information for near-term economic estimates and risk assessment.25, 26

Other modelling challenges include estimation of the effects of efforts to mitigate the physical effects of climate change. Mitigation efforts to reduce physical risks may have a long delay between implementation and the full effects; governments incur mitigation costs up front, but realize the benefits from mitigation gradually over time. Different economies, geographies, and sectors are also likely to face distinct risks from climate change, each taking actions that affect one another. Climate models can be insufficiently granular to support conclusions about these jurisdiction-specific impacts and their interactions, and historical weather data may not accurately reflect economic impacts under a new climate regime.

A final set of challenges are essentially logistical. Although the public sector generates a range of weather and climate data, much of that data resides across agencies and jurisdictions, leaving researchers to clean, process, and merge the data separately and independently. Once a data set is complete, analysis may be especially computationally intensive, requiring expertise and resources beyond the reach of many smaller research institutions. Several private firms have launched services to fill this gap, focusing on geographic exposures to more severe weather events, but generally remain available only to those who purchase them.

These challenges impede understanding of the linkages among climate, economic, financial, and financial stability risks described above (see also Fig. 1 and Fig. 2). They also have consequences for financial markets, as investors and institutions seek to incorporate climate change into pricing, investment, and risk management decisions.

This Note describes examples of financial stability risks arising from climate change, and how these risks can emerge as either shocks or vulnerabilities in the Federal Reserve's financial stability monitoring framework used in the Federal Reserve's Financial Stability Reports. Research to better understand the financial and financial stability risks of climate change continues to grow rapidly. More specifically, deeper analysis of the specific channels by which climate-related risks create hidden vulnerabilities in the financial sector will be an especially important topic for exploration. Continued research investments in this area will require a broad range of research and modelling approaches and tools and new sources of data. We believe these investments over time will increase policymakers' ability to monitor the relationship between climate change and financial stability. 006ab0faaa