The Federal Reserve is floating ideas for how to assess climate risk in the financial system, including a “scenario analysis” to gauge the risks to individual firms and the financial system as a whole.

At a climate summit Thursday, Fed Governor Lael Brainard said that the central bank is in conversations with other regulatory agencies at home and central banks abroad about the best framework for integrating climate risks.

“These are not easy problems, and they will not have easy solutions,” Brainard said.

But Brainard said a “scenario analysis” may be an effective way of addressing the “high uncertainty inherent in estimating climate risks.”

Under such an analysis, the Fed would examine the ability of individual firms and the financial system at large to handle different hypothetical shocks, similar to the regulatory stress tests that assess the ability of banks to absorb financial stress.

The analysis would check for two types of risk: physical damage from the climate events themselves, but also “transition” risk that could come from a disorderly shift to a low-carbon economy, for example.

“There is unlikely to be a single ‘right’ approach to a challenge as complex as the financial impact of climate change,” Brainard said.

Climate tests

Brainard clarified that a scenario analysis would be distinct from its traditional stress tests, which have been a major pillar of the Fed’s bank supervisory framework after the 2008 financial crisis. One difference: the climate test would look at the long-run impact on a range of financial markets, whereas the stress tests are focused on firm-specific capital levels over the short-run.

The Fed governor also suggested the use of “new tools” like mandatory disclosures and more standardized data reporting.

Brainard said that as the central bank’s newly-formed Supervision Climate Committee (SCC) works through the creation of these tools, it will be mindful of the differences between firms.

“We do want, as we do in all of our supervisory work, to make sure that the approach is very much tailored to the size and complexity of the institution,” Brainard said. She added that the SCC is engaging with banks and industry groups through the process.

Over the last couple of years, the Federal Reserve System has ramped up its focus on climate risks. After hosting its first conference focused on climate change in 2019, the Fed last year formally added climate to its list of risks to the financial system.

“Low probability, high-severity events do happen and we need to be prepared for them,” Brainard said Thursday.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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