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Climate and Financial Stability

May 7, 2021

The below was originally published through The Public Purse on March 29, 2021.


In last week’s House and Senate hearings, Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen were each repeatedly questioned about financial regulation and managing the risks of extreme weather events and other natural disasters.  While Chair Powell asserted that the Federal Reserve was early in its approach to this question, he did comment that they are considering adding those risks to the stress tests banks already perform. 

Ahead of the hearings, Senator Pat Toomey (R PA), ranking member of the Senate Banking, Housing and Urban Affairs Committee, along with five colleagues, sent a letter to Chair Powell expressing concern that the Federal Reserve “may be preparing to use financial regulation and supervision to further environmental policy objectives.” The letter further states “…recent actions suggest that the Federal Reserve may be considering using its financial regulatory authority to play an indirect role in regulating climate change.” In the hearing, Chair Powell explained that anything they come up with only applies to the banks the Federal Reserve oversees.

Whether you agree or disagree, the focus on the impact of our changing climate on economic and financial systems is increasing.  Lael Brainard, who is a member of the Board of Governors of the Federal Reserve, announced the establishment of a “Financial Stability Climate Committee” which will engage the twelve reserve banks around the US. 

Secretary Yellen, who’s role includes heading the Financial Stability Oversight Council (FSOC), advocated for better data and quality financial disclosures.  Answering members’ worries that FSOC would punish the oil and gas industries, she was quite clear that FSOC does not intend, nor has a role telling banks what kind of lending to do. 

Last week, the SEC invited comment on Climate Change disclosures.  More detail on the SEC’s enhanced focus on climate risk can be found here.  The CFTC (Commodity Futures Trading Commission) too, has established a Climate Risk Unit to examine the role of derivatives in “understanding, pricing and addressing climate-related risk and transitioning to a low-carbon economy”.  The CFTC had published a report in September 2020 “Managing Climate Risk in the U.S. Financial System”.

The Climate Bonds Initiative penned this commentary in January summarizing central banks’ views.  At the beginning of March, Martin Wolf, economics and finance opinion writer for the FT wrote: “Humanity is a cuckoo in the planetary nest”.  (There is likely a paywall here, but we quote.).  “Today, human beings and the livestock we rear for food make up 96 percent of the mass of all mammals on the planet….Extinction rates are also thought to be 100-1000 times higher than their background rate over the past tens of millions of years.”  He cited Sir Partha Dasgupta of Cambridge University who has written a “definitive study of the economics of biodiversity” that “it is no longer possible…to exclude nature from our economic analysis.”

McKinsey’s “America 2021” released February 18, 2021 asserted “infrastructure assets are vulnerable to storms, wildfires, extreme heat, floods and other physical hazards associated with climate change. The McKinsey analysis suggests that through 2050, the typical US utility could suffer some $1.7 billion in costs and lost revenues due to storm damage.” (We include a link to the recent World Economic Forum’s Global Risks Report 2021 for those who wish to read further.)

The Bank for International Settlements (BIS) issued a report in January, 2020, highlighting the point that central banks, designated to be watchdogs for price stability and smooth operations of the world’s financial systems, would be negligent if they ignored climate change.  (One only needs to search the word “climate” on the BIS website to learn what the various central bankers around the world think about climate change and financial stability.) In a recent New York Times editorial, Ezra Klein, cited the BIS report: “Climate-related risks will remain largely unhedgeable as long as systemwide action is not undertaken” and continued, “If you know anything about financial regulators, you know the word ‘unhedgeable’ is an alarm bell shrieking into the night.” 

If there’s still a question whether severe weather/natural disasters affect our financial systems, consider the following events:

  • High winds and sandstorms are implicated in the stranding of the Ever Given, one of the world’s largest container ships, in the Suez Canal.  The eventhas backed up more than 100 vessels stuck at either end waiting to get through the Canal.  Passage through the Canal accounts for about 10% of global trade. 
  • An earthquake in Japan in February halted production at the Hitachinaka chip factory for several days and was unfortunately followed by an electrical fire last week that devastated that plant.  These events have hurt the auto manufacturing supply system around the world. Ironically, an earthquake in March, 2011 took that same plant offline for several months. (More detail here.)
  • The freeze and blackout in Texas in February caused supply chain disruptionin plastics – used for auto production, computers, medical face shields and smartphones.  The freeze shuttered more production than Hurricane Harvey, which hit the Gulf Coast four years ago.  And in 2011, Texas suffered a cold snap, preceded by “the worst cold Texas experienced in living memory: in 1989 temperatures and electricity generation (as a percentage of peak demand) dropped even further than they did in 2011,” according to Klein’s editorial cited above. (See an additional supply chain article here.)
  • Two years ago, in March/April, Iowa, Wisconsin, Nebraska, South Dakota and Missouri were heavily flooded, destroying post-harvest grain, not to mention contamination of drinking water from the toxic waste near numerous Superfund sites.  (We wrote about this hereand related articles here and here.) 

A few more words about the Texas freeze: 

  • We credit Bob Bunting, CEO and Chairman of the Climate Adaptation Center, Inc.for a heads up and easy explainer on the coming Polar Vortex in January: “Better Bundle Up! The Polar Vortex is Coming!” on January 27, 2021. 
  • If you follow the path the maps provided in that article, you can see how far south the push of cold air can go.  Infrastructure in much of the southern US is built to deal with peak demand in the summer months, but is not hardened to handle the consequences of periodic intense cold or peaking demand during a cold snap. 
    • How we should cover that risk (e.g., periodic winter peak demand in traditionally warm climates) is a question that will be debated heavily over the next weeks and months; we cannot answer that here.  But we are reminded of the controversies surrounding construction of protective levees around New Orleans by the Army Corps of Engineers.  The issue is not who to blame, but to what level of risk should we now build? 
    • Hurricane Katrina in August, 2005 led to more than 1,800 deaths, displaced about half the former population of New Orleans and led to a population surge in Baton Rouge and Houston.  We would put this in the category of major economic events and some local and regional banks did have difficulty making and clearing payments on time.
    • The changing “jet stream” was also implicated in Hurricanes Sandy and Irene, which caused record-breaking flood in eastern New York and Vermont.  Hurricane watchers typically consider the probability of landfall and strength of wind.  But when the jet stream holds a storm in place over land, the amount of rainfall that will soak a given area is intensified.  This type of destruction differs from the more familiar one where we anticipate the consequences of a hurricane based on the “category” assigned to a storm — which relates to wind speed. Katrina was classified as “Category 3”, Irene and Sandy came in as Category 1 storms.  In Vermont, roads were washed out for weeks from Hurricane Irene, preventing many from getting to work.  The Superstorm Sandy surge flooded areas in New York harbor unexpectedly, causing significant damage.  (You can find a good summary here.)
  • Unfortunately, many leaders offered quick explanations of the disaster in Texas, in ways that veered into political interests rather than evidence and science.  Here are two articles about misinformation being promoted during the freezing weather in Texas, Louisiana and Arkansas: T&D World, February 17, 2021 “Blackout Misconceptions: People on Social Media Become Overnight Power Experts”, and SmartCities Dive, February 18, 2021 “Power sector experts fight misinformation around Texas outages
  • We point out that the nuclear plant, South Texas #1 was out of service due to the freeze on February 16thand 17th, returning to 36% power on the 18th before coming fully on line again on the 19th.   That outage alone removed 1,280 MW power from the grid.  (You can source daily reports on nuclear power plants here.) We also credit @JesseJenkins for valuable data and links. 
  • By now, most readers know that Texas is the only state with its own “reliability council”, the Electric Reliability Council of Texas (ERCOT), whereas other regions are comprised of larger geographic groupings reaching into Canada.  The North American Electric Reliability Corporation (NERC)  is responsible for managing reliability, effectiveness and efficiency of the electric grid.  We cite a few passages concerning Texas and also their governance from NERC’s December 2020 “2020 Long-Term Reliability Assessment”:
  • In the report’s Executive Summary (see page 6), two regions were called out for concern: The Western Interconnection and Texas.  Concerning Texas, we quote: 
    • “reduced availability of operating reserves over a range of several hours around the time of peak demand in summer.”  They also found that available reserves were declining in March and October – to become months that see the “lowest peak-day reserves during the year”.  
    • Page 8, blue box, describes the governing constraints under which NERC operates: The NERC is “prohibited by Section 215 of the 2005 Federal Power Act from adopting standards that require adequate resources be in place or order construction of generation or transmission.  Resource adequacy and the construction of bulk power facilities is fully within state and/or provincial jurisdiction and authority.” 

Sound risk management dictates that in the face of re-occurring high-risk events, policy-managers should maintain a cushion of reserves (whether monetary, electrical or PPE inventory, to name a few).  Adequate reserve margins figured heavily in the post-Great Recession stress tests for banks.  Reserve margins are key indicators for electric system reliability as well.  Adequate reserve margins help protect our systems from unexpected disasters – which, paradoxically, can be expected to occur regularly, but unpredictably — such as a ship getting stuck in the Suez Canal or a devastating fire in a key production plant in Japan. 

Is it time to re-think our federal system?

  • Um, yes.  Extreme weather events and pandemics share an important feature:  they do not respect politically drawn boundaries. 
  • The logistics of managing vaccine production, distribution and implementation varies widely in quality and sophistication across the federal government, states, counties and cities.  Given international travel and trade, global spread does not abide boundaries either, no matter the restrictions.  Managing across civic boundaries could save lives and shorten the economic and financial impact of pandemic. 
  • As far as extreme weather and natural disaster events, we can factually document that they are recurring with greater frequency.  (The Asia Development Bank published this reportin 2015.) We can describe probabilities that hurricanes or floods may happen here, or there, but without precise locational certainty.  But what if the source of the catastrophe is up-river or worse, miles away? And what if a nearby Superfund site is breached, contaminating water supply, a problem that cuts across many agencies federal, state, local?
  • Disasters caused by events across political boundaries beg for better regional, national and global solutions. 

Interestingly, climate change denial and failure to social distance are linked

Patrick Sharkey, professor of sociology and public affairs at Princeton University’s Woodrow Wilson School of Public and International Affairs, recently penned an article on Vox.com entitled “The U.S. has a collective action problem that’s larger than the coronavirus crisis.”  In it, he comments “One of the strongest and most robust predictors of social distancing behavior is found in attitudes toward another major challenge facing the United States: climate change.”  Better collective action could have prevented deaths and loss of property in the Texas freeze.  Lives and livelihoods could have been saved with better coordination in our COVID response.  Both affect our financial systems as well.

 


Click here to view the original post through The Public Purse, published on March 29, 2021.

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