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The Early Days are Over

When it comes to climate risk, the latest IPCC report shows why regulators must make sure banks are safe, not sorry

By Yevgeny Shrago

In what’s becoming an unfortunate tradition, the Intergovernmental Panel on Climate Change’s (IPCC) latest report raised a new set of alarms about the accelerating climate crisis. This report, on climate impacts and adaptation, warns that the harms of climate change have developed faster than even the IPCC scientists had predicted. 

This development underscores why banks and regulators can’t maintain their slow-moving approach to addressing climate-related risk. As residents of this rapidly warming planet, they’re exposed to these rapidly growing threats. There’s little benefit to delaying action to gather more data and build better models when climate science tells a consistent story: things will be worse than we think, sooner than we expect. 

The only sensible response? A precautionary approach that reduces obvious risks and builds resilience now, to avoid an overwhelming shock later. 

Climate Change: Worse Than We Thought, Faster Than We Expected

The IPCC report provides the most detailed look yet at the magnitude of the threat that global warming poses to the planet. Its findings go beyond the flooding, wildfires, and hurricanes that we are all familiar with and enumerates the harder to see, yet perhaps more devastating effects of drought, famine, and ecosystem collapse. It also documents how advanced the crisis already is: millions of people were displaced by climate-fueled disasters in 2019 alone.

The scientists’ conclusion? The effects of global warming today, at 2°F warming above pre-industrial levels, are “much more widespread and much more negative than expected.” 

Things will only get worse if global greenhouse gas emissions continue on their current trajectory, which would put warming at between 3.6°F and 5.4°F by mid-century. At those temperatures, the report notes that billions of people may suffer from water scarcity and flooding may render many coastal communities uninhabitable. And while an end to emissions will stop warming, it will not reverse the changes it wreaks. 

So far, billions of dollars have already been spent on climate adaptation to address existing damage. But there’s a sharp limit to how much we can adapt if temperatures cross the 2.7°F red line set by the Paris Agreement. Even worse, the report warns that much of the climate adaptation that communities rely on today is a temporary patch that threatens to make things worse in the future. 

The report makes it clear that under-mitigated climate change will radically transform every aspect of society. It’s incumbent on banks and their regulators to take that lesson to heart. 

No More Time for Early Days

Over the last few years, most regulators have recognized, at least in principle, that climate change poses a threat to banks and the financial system. But not nearly enough progress has been made on moving from acknowledgment of the problem to actually managing the risks. The European Central Bank has found that, although most banks view climate change as a material risk, 90% of their practices aren’t in line with regulatory expectations on how to address it.

Too often, banks and regulators still cite the need for more data and better models as a reason for slow, limited action on climate-related risk. Recently re-nominated Federal Reserve Board Chair Jerome Powell has referred to it as “early days” on tackling climate change at the Fed and has declined to provide a timeline for additional action.

This attitude turns the inability to model climate change based on historic experience from a problem requiring a creative solution into an excuse to delay addressing climate-related risk. But the IPCC report shows why that logic is backwards: every delay leaves banks vulnerable to ever worsening climate impacts. 

Better Safe Than Sorry

A much better way of dealing with residual uncertainty about climate risk is a precautionary approach. Based on considerations favored by the IPCC, it favors preventing adverse effects that are potentially catastrophic or irreversible, even in the absence of scientific certainty about their impacts. The IPCC report should leave no more doubts about the catastrophic, irreversible threats that banks face. 

Under this approach, banks and regulators would prioritize reducing risk, even where they could not exactly quantify its magnitude or probability. A lack of data or models would become a spur to action, not an excuse for maintaining the status quo.

A bank adopting the precautionary approach would take on less climate risk than its models deem acceptable because it knows that the risks will likely be worse than the models predict. It would recognize that hedging and insurance will be of less value than they are regarding other risks because the company providing the hedge or the insurance is subject to all the same global climate threats as everyone else. And it would pay special attention to mitigating low-probability, high magnitude threats, since rising temperatures will make those threats more common.

Part of this approach would require banks to plan for inevitable failures of their proactive risk management. That means investing in resilience to protect a bank’s physical operations from climate disasters that could knock them out. It also means holding more capital where loans carry climate risk, to shore up the resilience of the balance sheet.

The IPCC report also makes clear that there is only one solution to the threat of climate change: a rapid, orderly transition away from fossil fuels and other high emissions activities. Prudent risk management by banks entails preparing for this possibility. 

Under a precautionary approach, that means reducing the risk that banks are taking by financing high emissions activities beyond what’s in line with science-based targets. Major banks worldwide have already committed to reaching net zero emissions by 2050, and some are now adopting interim 2030 targets for emissions reductions. All banks need to be ready for this possibility, whether or not they have made their own commitments.

Herding Banks

Individual bank action isn’t enough to make this change happen. What’s dangerous for the financial system may be profitable for one bank, at least in the short term. Regulators and legislators have a critical role to play in protecting the financial system by directing banks to adopt a precautionary approach and preparing them for the net zero transition.

Policymakers also need to cushion vulnerable communities from the negative effects of climate risk management. Already, we’re seeing insurers withdraw from climate-impacted areas, which means banks will follow close behind. The areas are often home to communities that have been the victims of generations of racial and economic discrimination. 

Banking regulators must prevent their charges from recreating and reinforcing the harms of that discrimination with their climate risk management decisions. They must also work with legislators to shape the rules for bank behavior and direct the credit and investment that those vulnerable communities need for climate adaptation and recovery, as well as a just transition away from fossil fuels.

Regulators should keep in mind UN Secretary General Antonio Guterres’s reaction to the IPCC report in mind: “delay means death.” That is true not just for millions of people globally, but for banks, the financial system, and the economy. The time for action is now, not tomorrow.