Climate hawks in retreat?

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“Climate change” is soon to become taboo across the US federal government.  Donald Trump, the once and future president, believes global warming to be a “hoax”. Champions of Project 2025 – the right-wing blueprint for his second term – call for erasing climate change references “from absolutely everywhere”.

This bodes ill for the future of US climate-related financial regulation, an effort that’s been ailing for some time already.  Indeed, just last week Bloomberg reported that the Federal Reserve has rebuffed an effort by the Basel Committee on Banking Supervision to force banks to disclose climate risk information.  US regulators don’t need Trump to beat back the climate hawks, it seems.

And yet, I’m betting on US lenders getting more engaged with climate risk over the next few years, not less.

Now don’t get me wrong, I’m in favor of climate-related financial regulation – not because I’m worried that climate risks could bring down the banking system, but because I think regs can help accelerate the net-zero transition and scale up finance for climate adaptation.  

I’m also not going to pretend that US banks are going to self-regulate in furtherance of their voluntary climate commitments.  After all, the swell of climate alliances forged around COP26 all in one way or another were trying to get banks to voluntarily align their lending with climate-friendly practices – and it’s going about as well as you would expect.

However, I do think the US throttling back on climate policies while the European Union and China speed ahead heralds greater volatility in energy systems over the coming years.  I also reckon the skyrocketing exposure of US households and businesses to physical risks could push some lenders to take this threat more seriously.  Especially so if insurers and the federal government shoulder less of the burden of disaster recovery and reconstruction. 

Let’s take these two aspects of climate risk in turn. First, transition risk. I believe an anti-climate policy environment in the US is more likely to trigger the kind of “disorderly transition” hypothesized by central bankers.  If US climate policy freezes for four years (or more, depending on how seriously Republicans take the Constitution) and the country cedes a leadership role on driving clean energy, one can imagine energy markets fragmenting, with fossil fuel use expanding in some regions and declining rapidly in others. 

Internationally active US banks may have to pick their spots more carefully in such an environment, so as not to be surprised by abrupt shifts in energy regimes.  For example, a revival of the Russian gas trade to Europe may well occur if the US stops backing Ukraine, a partition takes place, and a tyrant’s “peace” is enforced.  That would presumably be bad for US lenders supporting the US-EU liquefied natural gas trade. Perhaps the European Union turns (even more) heavily to China to satisfy its appetite for cleantech goods and raw materials if it judges US trade relations to be unstable, with painful implications for US exporters.

American banks may also find themselves at a disadvantage to local competitors in this more disjointed world.  While Wall Street has the deepest pockets, I wonder if the protectionist attitude that defines “America First” leaves European, Asian, and African clients looking closer to home for banking services, fearful that an American entanglement could bite them in the behind if tariffs or sanctions start flying from the White House.  This may be a particular worry when it comes to energy-related investments, given their geopolitical significance.

These ‘what ifs?’ – far more tangible and immediate than those sketched out by central bankers’ climate scenarios – could make US lenders more sensitive to transition risk. I believe this prickliness will manifest as a new reluctance to do deals in certain jurisdictions and a reduction in exposures, rather than the kind of enhanced due diligence or extraordinary loan reserving traditional climate hawks have been advocating.

On the physical hazards side, I also believe a flight, not fight, mentality could become the default climate risk management position.  Yes, I share Tony’s view that natural catastrophes can actually turn out to benefit banks over the medium to long term.  His arguments, and the data they’re based on, are persuasive, and you should read them here and here.

However, I think a big reason that banks succeed in the aftermath of disasters (in the rich world, at least) is because huge amounts of public money – and insurance capital – traditionally rushes in to support homeowners and businesses to help them recover.  This “disaster put” effect puts the survivors and rebuilders on a sounder financial footing, making them better credit prospects for the banks.  Moreover, the promise of future public aid and insurance coverage for those areas ravaged by catastrophes likely encourages survivors to stay – and new people and businesses to give them the benefit of the doubt.

But what if in Trump’s America cities and states can’t depend on federal aid to finance the first wave of disaster recovery?  What if the so-called Department of Government Efficiency demolishes the Small Business Administration, a major source of low-cost finance for disaster-struck enterprises?  Well then, the “disaster put” becomes much less effective.  If insurers pull out of certain climate risk “hot zones”, there will be even less of a capital cushion for survivors to rely on.

True, perhaps new rich folk will swoop in to buy land at distressed prices and build elaborate, expensive properties – feeding the banks in the process.  Maybe they’ll be rich enough to self-insure, too.  Well, first of all there’s only so many rich people, and they are remarkably mobile.  Sure, they can purchase multiple properties, but I wonder whether they’ll start being more selective about where they buy their second (or third or fourth) home based on climate risk factors.  Maybe instead of buying houses on the hurricane-prone Florida coast and in the wildfire-prone California interior, they’ll choose one over the other.

Second of all, without the supporting infrastructure of public financing, insurance coverage, and physical disaster defenses common to large communities that have a healthy tax base, these rich people enclaves represent more direct exposure on the banks’ books.  How attractive is a bunch of highly-leveraged, uninsured properties without government-backed adaptation measures going to look to a risk manager, really?

Maybe I’m wrong.  Perhaps in the absence of federal support, individuals and businesses will take adaptive measures themselves to reduce their vulnerability to climate shocks.  But if these measures are deemed insufficient, I can’t see banks hanging around.  “Managed retreat” is a term used to describe communities relocation from high climate risk areas. I believe banks may beat a retreat of their own when faced with the weakening of the “disaster put”.

So, while climate hawks are likely to be banished from federal agencies under Trump 2.0, there’s a chance they may flourish on Wall Street.  These new birds of prey, however, will act very differently when confronted with Trump-induced transition risk and physical disasters than their regulatory brethren.  Instead of urging continued engagement with high-risk industries and geographies, I reckon many will simply get out of Dodge as soon as things get messy.

It’s a response that should keep banks robust.  What it does to the communities and businesses they leave behind, though, is unlikely to be pleasant.