Principles for Climate Related Financial Risk Management for Large Financial Institutions – Federal Reserve Recommendations

We encouraged the Fed to incorporate an economy-wide approach that accounting for all climate-related risks, including those connected to global supply chain emissions in the agriculture, forestry, and other land use (AFOLU) sector.

Since deforestation both generates greenhouse gas emissions in the current year and reduces carbon storage capacity in future years, sectors with high deforestation risk have an outsized impact on climate change. Furthermore, the vast majority of tropical commodity greenhouse gas emissions are generated abroad in regions at high risk of deforestation, so derivatives in the forest, food, and land sector expose US investors potentially to funding related activities linked to illegality, environmental damage, climate change impacts, human rights abuses, and more. In fact, the US imported $618 billion in tropical commodities in 2020 alone ($76 billion in tropical agricultural commodities), and 40% of US GDP is exposed to climate-related risks from the land use sector.   In response to the Fed’s request for “public feedback on all aspects of climate-related financial risk as it may pertain to the derivatives markets, underlying commodities markets, registered entities, registrants, and other related market participants,” Climate Advisers submitted our comment intended to provide background on the climate-related financial risks in tropical commodity sectors and to advise on the questions posed by the Commission. In particular, Climate Advisers emphasized the following recommendations for the Federal Reserve Board to adopt:  

1. Domestic and International Recommendation – Incorporate forest, food, and land supply chains into climate-related financial risk guidelines

• Since sectors that represent about 40 percent of the U.S. economy are exposed to commodity-driven deforestation, all financial institutions should disclose how they are managing climate risks related to tropical deforestation in value chains. This is important because:
  • Deforestation both generates GHG emissions in the current year and reduces carbon storage capacity in future years, so institutions that finance sectors with high deforestation risk have an outsized impact on climate change.
  • Tropical supply chains for imports of beef, palm oil, soy, timber, natural rubber, cacao, and coffee operate in regions with elevated risk of deforestation, exposing financial institutions to particularly high risk of funding activities linked to illegal logging and deforestation, environmental damage, climate change impacts, human rights abuses, and biodiversity loss, as recognized by the $8.7 trillion Investors Policy Dialogue on Deforestation.
  • Given the systemic material economic risks to financial institutions if global temperatures are not limited to 1.5 degrees Celsius and the essential role of standing primary forests in internationally agreed upon pathways, specific regulations related to deforestation risks need to be clearly incorporated into any financial risk rulings.

2. Domestic Recommendation – Monetary policy – Greening the Asset Portfolio

• Once Treasury issues green or climate-certified (CBI) debt, the Fed can include these securities in their asset purchases (monetary policy).

3. Domestic Recommendation – Regulatory and Supervisory Responsibilities

• The Fed, the banks, and their clients should aim for data collection that is targeted and limited to data that is needed when deciding on an effective and efficient course of action to reduce climate-related and nature-related risks, including those from forest, food, and land supply chains.
• Given the extreme uncertainty introduced by planetary instability, it is not clear that stress tests based on unprecedented and unknown climate-related scenarios are comprehensive. If stress tests are used, they must include science-based catastrophic worst-case scenarios that are becoming increasingly likely as described in the climate science literature. There would also be value in scenario analyses and stress tests when used for purposes of communicating climate-related relevant information to the public. As a part of assessing climate-related financial risks, financial institutions should 3 monitor key forest ecosystems at particularly high risk of collapse and analyze potential impacts on financial stability. Climate Advisers has documented the material risks to U.S. financial stability that could result from continued deforestation and the potential collapse of the Amazon ecosystem, which some scientist estimate will occur when 25 percent of the Amazon is deforested.
• The Fed should require banks to monitor the supply chains of their clients for linkages to deforestation. Banks should require their clients to document progress in ending deforestation and decarbonizing food production, subject to deadlines. The Fed can help by publishing and disseminating information about best risk mitigation practices, and it can hold banks accountable for ensuring implementation at the firm level by enforcing strict deadlines.
• To accelerate transformational progress, executive compensation must be tied to bank and firm climate/food/forest performance metrics (greenhouse gas emissions reductions, acres of forests saved and/or reforested, see CDP Forest disclosures for more ideas).
• Firms and banks can maximize profit by leaning into climate opportunities and mitigating climate risks. However, consumers and investors should be provided with relevant information that allows them to accurately assess companies for how they are managing climate risks.
• The Fed’s priority should be the prevention of worst-case scenarios. To achieve this, the Fed must drive rapid progress with ending deforestation, and decarbonizing food production, distribution, and consumption, thus disincentivizing actions that encroach onto Indigenous Peoples’ territories and damage firm reputations. If the Fed needs a new mandate with sector-specific tools to mitigate risk in multiple societal systems, the Fed must help the public understand the need for congressional action on this issue.

4. Domestic Recommendation – Educating the Public

• The Fed should help with educating the public on the need for a forest, food, and land use sector that is compatible with the planetary boundaries while meeting human needs. The public should understand the role of the financial system as a catalyst and enabler of systemic change to protect U.S. financial stability. Above all, the public should understand the role of the Fed in guiding the financial system as it mitigates systemic risks.
• The Fed should help with educating the public on the role of Treasury in issuing green and climate-related securities to mitigate forest, food, and land use risks from climate change.
• The Fed should help with educating the public on the extreme planetary risks, worst case scenarios, and their consequences. Thus, Congress can act expeditiously to provide the Fed with the new mandates and sector-specific tools necessary to support the financial system in the process of funding the transition to a sustainable food/forestry system.

5. International Recommendation – Mandated G-SIFI Actions in Return for Reducing Some of the Current Burdensome Regulations of G-SIFIs

• Require G-SIFIs to include green covenants in loan contracts to incentivize an end to tropical deforestation by 2030.
• Encourage G-SIFIs to provide loans to client systemically important carbon emitters (SICEs) that are accelerating the transition to a sustainable food/forestry system, and to price the risks that SICEs impose when they are lagging.
• Require G-SIFIs to ensure that SICEs do not spend on lobbying against climate-related and nature-related government policies so that financing does not contribute to increasing systemic financial risk from climate change.
• Encourage pre-competitive collaborations with competitors, clients, researchers, and NGOs on R&D, creating and scaling new markets, food production, and delivery systems. 6. Supportive Action by the Regional Federal Reserve Banks
• Educate the public on the need for the Treasury to issue green or climate-certified (CBI) bonds.
• Educate the public on the implications of crossing multiple climate tipping points and the urgent need to prevent worst-case scenarios. • Educate the public on the role of the financial system and the Fed in financing the transition to a new sustainable food/forestry system.
• Collaborate with governments and NGOs on educating consumers and investors on how to participate in the new food/forestry system (buy organic, local, etc.).
• Green collateral lending policies.

Additional detail on these recommendations and more context around the significance of climate-related risks from commodity-driven deforestation can be found in our full comment letter.  

These recommendations would help the Fed to effectively meet the needs of financial institutions that are exposed to climate-related risks from deforestation. In this comment, we broadly explained the importance of forest protection and sustainable land management practices in protecting the stability of the U.S. financial system, we discuss the financially material risks posed by deforestation to financial institutions that lend across a range of industries, and we recommend actions for the Fed to consider going forward.  

This comment letter was developed by Carolin Schellhorn Ph.D., Assistant Professor of Finance at Saint Joseph’s University; Niamh McCarthy, Director of Climate-Related Risk at Climate Advisers; and Matt Piotrowski, Senior Director of Policy and Research at Climate Advisers.