The Fed Is Not a Climate Regulator

On Tuesday, January 11, the Senate Banking Committee held a hearing on the re-nomination of Jerome Powell to be Federal Reserve chairman. If Powell is confirmed, the Fed will attempt to squeeze fossil-fuel companies out of U.S. credit markets, The Wall Street Journal editorial board warned on the same day.

Powell wants banks to use “climate stress tests” when deciding on loan applications. In the abstract, that might seem sensible. Extreme weather events such as hurricanes, floods, and wildfires inflict property damages and financial losses on companies. Climate change may increase the frequency and severity of extreme weather. So, one might suppose, banks should “consider” borrowers’ climate risk exposure when assessing credit worthiness, setting interest rates, and establishing collateral requirements.

One massive problem with Powell’s proposal is that it is extremely difficult for scientists, much less bank executives, to isolate climate change risks from plain old climate risks for specific companies operating in specific locations. For example, was the deep-winter freeze that shut down substantial portions of the Texas power grid in February 2021 in spite of global warming or because of it? Depends on which scientist you ask. The Fed has no qualifications to referee much less “settle” the debate.

And even if such knowledge were available, extreme weather and rising temperatures pose no danger to bank balance sheets. As the Journal reminds us, “A New York Federal Reserve Bank staff study last fall found that banks benefit from extreme weather events because they spur increased lending.” From the Journal’s editorial on the study last November:

Examining disasters declared by the Federal Emergency Management Agency from 1995 to 2018, the [New York] Fed staff found “insignificant or small effects on U.S. banks’ performance.” Disasters boosted loan demand, which offset losses and boosted income. Income at larger banks increased the more exposure they had to disasters.

Local banks tend to avoid mortgage lending where floods are more common than flood maps would predict, which suggests “that local knowledge may also mitigate disaster impacts,” say the authors. Unlike the federal flood insurance program, banks have a financial motive to accurately calibrate disaster risks.

A more plausible rationale for stress testing is that climate policy can affect bank profits or even solvency, because aggressive climate policies could put some of the banks’ biggest borrowers—namely, fossil fuel companies—out of business.  

However, that rationale is hollow. Banks don’t need to be told by the Fed that climate campaigners want to bankrupt ExxonMobil. The real point of stress testing is not to identify banks’ climate policy risks but to intensify fossil fuel companies’ climate policy risks. In the Journal’s words:

Instead, the left wants the Fed to use stress tests to make banks reduce and eventually eliminate financing for coal, natural gas and oil development. Banks would have to adjust their balance sheets to take account of the risks from government climate policies like mandates, regulation or carbon taxes. To pass the climate stress tests, banks would have to liquidate fossil-fuel assets.

Let’s consider that for a moment. Denying credit to fossil-fuel companies, or just increasing their borrowing costs, would reduce their profitability and growth potential. Choking off their access to credit would also scare away investors, which would depress stock prices. As the companies’ capital and credit ratings decline, so would their ability to stave off or withstand hostile litigation, punitive regulation, carbon taxes, and other political attacks. At the end of the day, fossil-fuel company stockholders could lose their shirts. In Climate Speak, such deliberate destruction of private equity is called “protecting shareholder value.”

Congress has never passed a statute authorizing the Fed to require banks to perform climate stress tests. In fact, Powell’s proposal calls to mind Operation Choke Point, the Obama administration’s unlawful policy of pressuring banks to deny credit to legal enterprises such a coin dealers, gun dealers, and payday lenders. In a March 2021 Senate Banking Committee hearing, American Enterprise Institute economist Benjamin Zycher cautioned:

Proposals that the Federal Reserve enforce a mandate that financial institutions evaluate climate “risks” represent a blatant effort to distort the allocation of capital away from economic sectors disfavored by certain political interest groups pursuing ideological agendas. This would represent the return of Operation Choke Point, a past attempt to politicize access to credit, one deeply corrosive of our legal and constitutional institutions.

At this week’s hearing, Ranking Member Sen. Patrick Toomey (R-PA) put Powell on notice that he was playing with fire. The Fed, Toomey explained, operates on the basis of an implicit bargain: The Fed enjoys “political independence” provided it engages solely “in areas in which it has a mandate.” Toomey continued:

The Fed does not have a mandate to advance politically-charged causes that are irrelevant to its mandate, like addressing global warming or advancing so-called racial justice. … Let me be clear—if this politicization continues unchecked—it will not end well for the Fed or for independently driven monetary policy. As the Fed’s leader, I hope you take this seriously and rein it in to protect the Fed’s legitimacy and independence.

There is one stress test that would align with the Fed’s statutory objectives—a test assessing the financial risks to borrowers and, thus, to banks from inflation induced by $3 trillion-per-year federal deficit spending. Not that I would support such a mandate, but at least a stress test organized around the concepts of deficit spending and inflation would lend substance to the Fed’s reputed political independence, and it might induce other Democratic senators to acknowledge the fiscal responsibility concerns raised by Joe Manchin (WV) and Kyrsten Sinema (AZ).

In any event, substituting climate goals for the Fed’s traditional focus on economic growth and price stability is a bigger threat to U.S. financial stability than climate change. For example, the Journal observes, “One irony is that government anti-carbon policies are driving what some economists call ‘greenflation’—an increase in commodity and energy prices on everything from oil and gas to lithium and copper.” Greenflation has two causes:

Investment in fossil fuels has fallen sharply even though consumer demand hasn’t. Behold Europe’s climate crack-up, which has resulted in soaring energy costs. Meantime, government policies have boosted demand for green energy, but the supply of minerals needed to make batteries for electric cars, solar panels and wind turbines is lagging, driving prices higher.

Climate policy depresses fossil fuel supply relative to consumer demand while ramping up industrial demand for energy transition minerals (such as lithium, cobalt, copper, and rare earths) relative to supply. Climate policy also decreases the supply of fossil energy faster than it increases the supply of renewable energy.

Those results should surprise no one. The mining and processing infrastructure required to replace a fuel-intensive with a mineral-intensive energy system do not yet exist. Nor does an efficient permitting system capable of speedily approving billion-dollar mining projects and thousands of new wind and solar facilities.

Biden promises a prosperous transition from fossil fuels to renewables. So far, it has been a transition from abundant and affordable to scarce and unaffordable fossil fuels. Climate policy is also making America more reliant on OPEC for hydrocarbons and China for energy transition minerals.

Is there no one at the Fed, or in the administration, who sees the professional reputation risk in taking ownership of an economically ruinous, unlawful, and unsustainable agenda?