October 29, 2020
TO: The Chief Executive Officers or the Equivalents of New York State Regulated Financial Institutions
RE: Climate Change and Financial Risks
We live in an increasingly complex world in which crises proliferate and magnify risks to our financial system. Together we are correctly focused on public health, the economy, and racial justice. A fourth crisis, climate change, poses significant financial risks as well. Climate change is increasing the frequency and intensity of extreme weather events and is projected to have profound effects on the U.S. economy and financial system, which we must address. Since taking the helm of the New York State Department of Financial Services (“DFS”) last year, I have spoken frequently about climate change and the impact on the safety and soundness of the individual financial institutions and the broader financial stability implications for the financial industry.
As a signal of the importance of this issue, last year, DFS joined the Network of Central Banks and Supervisors for Greening the Financial System (“NGFS”), which is a group of central bankers and supervisors committed to managing financial risks from climate change globally. Additionally, DFS has hired its first Director of Sustainability and Climate Initiatives, Dr. Yue (Nina) Chen, to engage with various stakeholders, including regulators and the industry, and to develop expert guidance in this critical area.
As the global public health pandemic of COVID-19 has made clear, preparation is key to addressing systemic risks. By the time a crisis occurs, it is simply too late.
This letter is intended to provide some background information on climate risks, outline DFS’s expectations for New York regulated banking organizations, New York licensed branches, agencies of foreign banking organizations, New York regulated mortgage bankers and mortgage servicers, as well as New York regulated limited purpose trust companies (collectively, the “Regulated Organizations”), and to commence a dialogue as to how DFS can best support our Regulated Organizations' efforts to manage the financial risks from climate change.
DFS is also providing this letter and information to New York regulated non-depositories (other than New York regulated mortgage bankers, mortgage servicers, and limited purpose trust companies), including New York regulated money transmitters, licensed lenders, sales finance companies, premium finance agencies, and virtual currency companies (collectively, the “Regulated Non-Depositories”), outlining DFS’s expectations for the Regulated Non-Depositories, and starting discussions to assist their work in managing the financial risks from climate change.
DFS supervises and regulates the activities of approximately 1,500 banking and other financial institutions with assets totaling more than $2.6 trillion, ranging from global institutions to family-owned small businesses, and nearly 1,800 insurance companies with assets of more than $4.7 trillion.
A) The Severity of Climate Change
Climate change is accelerating, and the cost of climate-related natural disasters is increasing
The ten hottest years ever recorded have all occurred since 1998, with 2020 likely to be among the hottest. In May 2020, the concentration of carbon dioxide in the atmosphere increased to the highest level ever recorded in human history. This year’s record-breaking wildfire season on the West Coast is yet another reminder of the devastating consequences of climate change. The aggregate cost of billion-dollar natural disasters in the U.S. more than quadrupled from the 1980s to the 2010s. For every one degree Celsius increase, the combined value of market and nonmarket damages across the U.S. economy is about 1.2% of gross domestic product. Globally, “the damages from climate change amount to almost 3% of GDP by 2060.”
B) Risks of Climate Change and Impact on Regulated Organizations
Climate risks are often grouped into two categories: physical and transition risks.
- Physical risks of climate change and impact on Regulated Organizations
Physical risks exist when damage to property or assets is caused by an increase in the frequency and severity of weather events and long-term shifts in climate patterns, such as sustained higher temperatures that may cause sea level rise, heat waves, or droughts. Chronic climate change has been shown to increase the severity and frequency of storm surges and hurricanes. It is estimated that single- and multi-family residential homes in New York City with $334 billion of reconstruction value are at high risk of storm surges. BlackRock has estimated that 80% of the commercial properties damaged during Hurricanes Harvey and Irma lay outside official Federal Emergency Management Agency (“FEMA”) flood zone maps. “This indicates they could have had insufficient flood insurance.” What’s more, while FEMA classifies 8.7 million properties as having substantial risk, a new study shows that in the U.S. “nearly 70% more, or 14.6 million properties with the same level of risk” when the current climate data are used. With sea level rise and changing precipitation patterns, “the number of properties with substantial risk is expected to grow to 16.2 million by the year 2050” in the U.S.
Physical risks can cause destruction of properties and assets, business disruption, supply chain disruption, increase in costs to recover from disasters, reduction in revenue, and migration. In turn, these can lead to lower household wealth and lower corporate profitability, translating into financial risk and losses for Regulated Organizations.
Mortgage loans, commercial real estate loans, agricultural loans, and derivatives portfolios are a few examples of the types of assets that can be at risk due to weather events. Economically vulnerable communities, often minorities and communities of color, are particularly threatened with respect to physical devastation. In hard-hit communities, climate change is expected to undermine economic output, reduce already limited household income and wealth, and diminish access to capital. Regulated Organizations, in turn, could see an increase in default rates, reduced lending activity, devalued assets, and losses.
The flood risk could impact regional and community banks in particular. According to a report by the U.S. Commodity Futures Trading Commission’s Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee, “Regional and community banks … are more vulnerable to regionally concentrated physical risk, including to sudden extreme events.” “These banks’ property loans tend to be more geographically concentrated than the loans of larger banks. In addition, CRE [commercial real estate] loans constitute a much larger share—nearly a third—of the loan books of small banks.” 
Limited purpose trust companies and trust divisions within banking organizations are typically tasked with the administration, management, and transfer of assets, including investment management and wealth preservation. In particular, when limited purpose trust companies act as a custodian or an asset manager for a customer, there is frequent re-balancing and re-evaluation of risk, coupled with active monitoring of investments’ performance and suitability, including debt securities, equities, and derivatives. Certain real estate asset-backed securities are common in wealth management securities portfolios that are managed by limited purpose trust companies or trust divisions of banking organizations and could be at risk of losing value due to weather events.
Also, research has shown that municipal bond markets may have begun pricing sea level rise exposure, especially on the East Coast. This can result in lower valuation for such bonds. Based on the data from Federal Reserve Board’s Financial Accounts of the U.S., U.S. banking organizations are significant holders of municipal bonds.
Adverse physical impacts of a weather event in one community may not necessarily be contained in that community, and losses at one financial institution may not be confined to that institution and may ricochet across the financial system, as correlated risks from these events could have an effect that may reach beyond an individual organization to the broader financial system and the economy.
Finally, the Coronavirus pandemic has demonstrated the lack of financial security across households and small businesses, a challenge that could be even greater if a climate event causes damage to property and interruption in commerce and economic activity.
- Transition risks of climate change and impact and opportunity for Regulated Organizations
Transition risks arise from the potential for loss resulting from a shift toward a lower-carbon economy, driven by policy, regulations, low-carbon technology advancement, consumer sentiment, and liability risks, impacting the value of certain assets. This transition can lead to stranded assets—assets that “turn out to be worth less than expected as a result of changes associated with the energy transition”—in the fossil-fuel industry and carbon-intensive infrastructure, transportation and others. It can also result in costs to reinvest in and replace infrastructure. Given the large size of the fossil fuel industry and carbon intensive industries such as mining and chemical, these cumulative losses and costs could send broad, intersecting and amplifying financial ripples to financial institutions with exposures to these industries. Depending on how the companies in these industries respond to global emissions reductions, the value of these companies' stranded assets currently ranges between $250 billion and $1.2 trillion.
Companies active in the oil, gas and energy sectors are frequent issuers of bonds and stocks, and these securities typically comprise a significant percentage of the total capital allocation of a wealth management’s investment portfolio managed by limited purpose trust companies and trust divisions of banking organizations. Transition risks could have a significant negative impact on the valuation of these portfolios.
A recent report and analysis by Ceres, a sustainability nonprofit organization, indicated that “the current view of transition risk in the banking sector is incomplete, focusing only on banks’ direct loans to the fossil-fuel sector. A full assessment must take into account a bank’s financing of industries that rely heavily on fossil fuels as inputs as well — including agriculture, manufacturing, construction, transportation and the financial sector itself.”
At the same time, an immense amount of new investment is needed to transform the energy system, infrastructure, transportation and other sectors to reach the Paris Agreement goal of keeping the global average temperature rise well below 2 degrees Celsius above pre-industrial levels, which is what is needed to keep the Earth habitable for humans. Regulated Organizations can contribute positively to this transition and grow their business at the same time. One estimate puts the need for additional investments into low-carbon energy and energy efficiency compared to the current level, at $300 billion per year every year between now and 2030.
C) Risks of Climate Change and Impact on Regulated Non-Depositories
Besides direct risk from property damage and business disruption from natural disasters or extreme weather events, climate change could negatively impact the balance sheets of Regulated Non-Depositories through adverse impact on the businesses of their customers, including their loss of income, as well as any devalued investments due to physical or transition risks.
With respect to Non-Depositories engaged in virtual currency business activities, some studies have estimated that the environmental impact of cryptocurrency mining is substantial, though it is relatively small compared to sectors such as transportation. For example, while the exact energy consumption for mining bitcoins depends on the exact locations of the mining activities, which are difficult to identify,  it is reported that the bitcoin network’s consumption of energy on an annual basis represents a carbon footprint equivalent to that of New Zealand, and is equivalent to Venezuela’s electricity usage. Virtual currency firms should consider increasing transparency of the location and equipment used in bitcoin mining to help alleviate these concerns. It is also reported that the energy cost for mining virtual currencies is sizable compared to the value of the virtual currencies. These estimates, of course, do not take into account the electricity needed to power the storage, trading, and tracking of virtual currency necessary to keep the industry operating. Institutional investors are increasingly focused on the need for an urgent action on climate change and the move toward embedding social, environmental, and governance factors into their investment decisions. They are of the view that sustainability and climate-integrated portfolios can provide better risk-adjusted returns for investors. Virtual currency firms with high carbon footprints could face a loss of investment and trading opportunities, which could have a negative impact on their financial results. There is data to suggest that some crypto miners are making advancements towards utilizing alternative and sustainable methods for energy production to mitigate this risk.
D) Risk Management
Financial risks from climate change are unprecedented. “[B]ecause of the radical uncertainty associated with a physical, social and economic phenomenon that is constantly changing and involves complex dynamics and chain reactions,” the Bank for International Settlement has warned that climate change carries “green swan” risks: “potentially extremely financially disruptive events that could be behind the next systemic financial crisis.”
Climate change can impact Regulated Organizations’ assets, investments, operations, business strategies, revenues and losses. Regulated Organizations are not only exposed to the physical and transition risks of climate change, but they also may be actively exacerbating those risks by continuing to provide substantial financing to activities that intensify climate change. Furthermore, physical and transition risks will likely introduce new strategic risks as Regulated Organizations seek to pursue new business strategies and opportunities to address climate-related financial risks and as their credit and market exposures evolve.
Without a doubt, climate change is a source of financial risk and a risk-management question with direct impact on the safety and soundness of our Regulated Organizations. As such, it falls squarely on DFS and other financial regulators to ensure that Regulated Organizations have appropriate risk-management frameworks in place and are resilient to these risks.
However, the traditional tools for identifying, monitoring, and managing risks will need to be adapted to the distinctive characteristics of climate change, as climate change affects all aspects of our economy and can be correlated in a non-linear manner.
E) Global Climate-Related Supervision
International regulators have been incorporating climate considerations into macro- and micro-prudential supervision for several years. For example, NGFS has issued a “Guide for Supervisors Integrating climate-related and environmental risks into prudential supervision.” The European Central Bank has issued a “Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure.”
While the U.S. is behind our European counterparts in terms of climate-related supervision, we have learned from their experience, and can take advantage of the supervisory tools that they have developed and will continue collaborating with them in this area going forward.
F) DFS Expectations
- DFS expects that all Regulated Organizations:
- start integrating the financial risks from climate change into their governance frameworks, risk management processes, and business strategies. For example, Regulated Organizations should designate a board member, a committee of the board (or an equivalent function), as well as a senior management function, as accountable for the organization’s assessment and management of the financial risks from climate change. This should include an enterprise-wide risk assessment to evaluate climate change and its impacts on risk factors, such as credit risk, market risk, liquidity risk, operational risk, reputational risk, and strategy risk; and
- start developing their approach to climate-related financial risk disclosure and consider engaging with the Task Force for Climate-related Financial Disclosures framework and other established initiatives when doing so.
- DFS expects that all Regulated Non-Depositories:
conduct a risk assessment of the physical and transition risks of climate change, whether directly impacting them, or indirectly due to the disruptive consequences of climate change in the communities they serve and on their customers, such as business disruptions, out-migrations, loss of income and higher default rates, supply chain disruptions, and changes in investor and consumer sentiments, and start developing strategic plans, including an outline of such risks, the impact on their balance sheets, and steps to be taken to mitigate such risks.
DFS understands this entails complex and challenging issues, including the transmission channels of climate-related risks, building data, developing climate-related scenarios and methodologies, and developing expertise. DFS also recognizes that climate change affects each Regulated Organization and Regulated Non-Depository in different ways and to different degrees depending on size, complexity, geographic distribution, business lines, investment strategies, and other factors, and appreciates that Regulated Organizations and Regulated Non-Depositories do not have the same level of resources to manage these risks and are at different points in the process of incorporating these risks into their governance, strategy, and risk management. Therefore, in this process, each organization should take a proportionate approach that reflects its exposure to the financial risks from climate change and the nature, scale, and complexity of its business.
DFS is developing a strategy for integrating climate-related risks into its supervisory mandate and will engage with your organizations and work and coordinate with our U.S. and international counterparts to develop effective supervisory practices, as well as guidance and best practices in order to mitigate the financial risks from climate change.
Several New York Regulated Organizations and Regulated Non-Depositories have already taken important steps to address climate-related risks, such as considering how natural disasters might affect their operations, reducing greenhouse gas emissions from their operations and financing renewable energy projects. Some have conducted internal stress tests on climate. Others have actively participated in international networks in assessing and disclosing the greenhouse gas emissions associated with their loans and investments. While DFS commends these initiatives, it is critical that all Regulated Organizations and Regulated Non-Depositories be prepared to prudently manage physical and transition risks from climate change.
There are many publicly available resources on climate-related financial risks. For example:
- The Climate Financial Risk Forum (“CFRF”) convened by the Bank of England Prudential Regulation Authority and Financial Conduct Authority published a CFRF guide written by industry for industry to help firms approach and address climate-related financial risks.
- The United Nations Environment Programme Finance Initiative (“UNEP FI”) Task Force for Climate-related Financial Disclosures Banking Programme published “Charting a New Climate: State-of-the-art tools and data for banks to assess credit risks and opportunities from physical climate change impacts” which was developed by engaging thirty-nine global financial institutions on six continents.
- The United Nations Principles for Responsible Investment, which includes American banks as its signatories, has published resources such as An introduction to responsible investment: climate change for asset owners.
We commend those who have already made significant progress and we will support others as they embark on this journey. The challenge ahead is great, but we know from experience that together we can meet it. Mitigating the financial risks from climate change is a critical component of creating a stronger industry and a healthier and safer world for ourselves, our families, and future generations. There is no more time to wait. Let’s get to work.
Please direct any questions or suggestions regarding this circular letter to Dr. Yue (Nina) Chen, Director of Sustainability and Climate Initiatives, at [email protected].
Linda A. Lacewell, Superintendent
New York State Department of Financial Services
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