Supervising the Transition: How Banking Regulators Can Address the Coming Shift to Net-Zero Emissions
February 2, 2023
By Yevgeny Shrago, David Arkush
The financial system is invested in the appearance of taking climate change seriously, but its public commitments mask a failure to take meaningful action.
Financial institutions and regulators agree that climate change poses significant physical risks to markets, even as the ongoing clean energy transition creates risk for assets and lines of business that may rapidly lose value as political, economic, and technological developments render them obsolete. As customers, investors, and employees recognize these trends, they are starting to scrutinize whether and how banks are addressing climate-related risks. In response, US megabanks trumpet their commitment to reducing operational and financed emissions in line with science-based climate targets. Banks promise to reach “net zero” emissions by 2050, in order to meet the Paris Agreement goal of limiting global temperature increase to 1.5°C above pre-industrial levels. Following through on these commitments would strengthen the financial system against the ongoing and growing shocks created by both the climate crisis and the low-carbon energy transition.
But it appears these net-zero commitments are rarely worth the pixels they’re rendered on (Scott 2022). The largest American banks, all of which have committed to “net-zero” emissions by 2050 and announced initial plans to meet those commitments, remain the world’s biggest financiers of the fossil fuel projects that drive global emissions (Shraiman and Cushing 2022). None have stopped or pledged to stop financing new oil and gas production or infrastructure projects such as pipelines, even though such projects are incompatible with limiting global temperature rise to 1.5°C above pre-industrial levels. Taking advantage of the ill-defined “net” in net zero, most banks have given few, if any, specifics on how they will achieve the promised emission reductions, aside from noting vague plans to engage with borrowers and other clients on the issue. In short, despite making commitments to reduce emissions, banks continue to operate in ways that do not reflect these promises—or the growing risks posed by climate change and the clean energy transition.
US banking regulators have noticed this dangerous disconnect. In December 2021, the Office of the Comptroller of the Currency (OCC) became the first US regulator to issue guidance for large banks on addressing the risks posed by climate change (OCC 2021). The OCC’s draft principles for addressing climate risk state that “where banks engage in public communication of their climate-related strategies, boards and management should ensure that any public statements about their banks’ climate-related strategies and commitments are consistent with their internal strategies and risk appetite statements” (OCC 2021). The Federal Deposit Insurance Corporation (FDIC), another banking regulator, proposed guidance with similar language in March 2022 (FDIC 2022). In December 2022, the Federal Reserve joined its peer regulators in issuing “substantially similar” guidance with the same expectations regarding commitments (Board of Governors 2022).
Transition plans and climate commitments are within the purview of bank regulators, and their forthcoming scrutiny of voluntary climate commitments is an important first step. Climate commitments and transition plans can illuminate how well bank management understands climate risk and how effectively this group can implement a plan for handling such risk. To that end, the principles are a welcome and needed start. But regulators must complement them with more detailed guidance, as the principles fall far short of providing sufficient guidance for banks or examiners to assess whether a bank’s commitments and internal strategies are aligned, or what risks are revealed by any misalignment. Given the wide adoption of net-zero commitments and the lagging development of transition plans, regulators should provide detailed guidance on how they will assess alignment and how failure to achieve alignment raises concerns about a bank’s management and asset quality.
But regulators should not rely on banks meeting their voluntary commitments. The passage of the Inflation Reduction Act (IRA), along with a package of California legislative and regulatory enactments in August 2022, constitutes a major government effort to reshape the economy, and will hasten the clean energy transition. Modeling from the Princeton Net Zero Lab’s REPEAT Project predicts that the IRA will significantly reduce emissions by 2030 (Jenkins et al. 2022). Coupled with state level policies, the IRA is likely to reshape the economic landscape for energy producers and consumers in the US, which is the type of transition risk that both banks’ net-zero commitments and regulatory climate-related risk guidance are meant to address. Banking regulators should make sure banks are preparing for future disruptions instead of taking unnecessary risks for short-term gains.
Given the uncertainty and complexity inherent in both climate change and the energy transition, net-zero transition plans are a strong risk management and financial stability tool available to large banks and their regulators. To protect the banking system, regulators should encourage or even require large banks to adopt commitments to reach net-zero emissions by 2050 and credible transition plans to achieve that goal.