Economy and Society: The Federal Reserve and ESG

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG Developments This Week

In Washington, D.C.

Federal Reserve eyeing ESG-friendly stress-tests for banks

For most of the last year, the ESG-regulation debate has focused on two primary subjects: the Securities and Exchange Commission (SEC) and its desire to compel publicly traded companies to disclose environmental, social, and governance data along with traditional pecuniary disclosures; and the Department of Labor’s new proposed rule to overturn the Trump administration’s rule on investments by ERISA-governed retirement plans in ESG vehicles. Before this year is over, according to analysts, the Federal Reserve might potentially impose regulations on financial companies regarding ESG-related matters as well. Specifically, the Federal Reserve wants to make ESG dataand climate change exposure, in particularpart of the stress tests in which banks are required to participate. In October, for example, a senior contributor at Forbes noted the following:

“Fed Governor Lael Brainard, a pioneer in this area, offered some basic guidance on how the central bank is considering taking on efforts, strongly opposed by the financial industry, to take climate risks into account when assessing possible sources of volatility.

Brainard said the total cost of U.S. weather and climate disasters over the last five years is $630 billion, a record for such a period. This includes billions in damages to farms, homes and businesses, she said, with 2020 marking a sixth straight year seeing ten or more billion-dollar weather and climate events.

“We can already see the growing costs associated with the increasing frequency and severity of climate-related events,” she told a Boston Fed conference.

“Several foreign regulators have already undertaken climate scenario analysis, affording us the opportunity to learn from their experiences. It will be helpful to move ahead with the first generation of climate scenario analysis to identify risks and potential issues and to inform subsequent refinements to our models and data.”…

Brainard proposes using the existing bank stress test framework as a template for thinking about how to get started. Greater transparency on the part of banks as to their risks of not only direct risk to climate shocks but also potential pitfalls from the costs of energy transition will be key.”

In November, Reuters reported that Wall Street doesn’t expect these tests to be implemented immediately.

“A U.S. Treasury Department-led report warned last month that rising temperatures were an “emerging threat” to financial stability and said regulators should use scenario analyses to build robust predictive risk-management tools.

Despite being the most influential central bank in the world, the Fed has long lagged its peers in getting a grip on those risks.

Over the past year, however, the Fed has ramped up pressure on big banks to scan their portfolios for climate change risks and could be in a position to run a formal scenario analysis and release broad findings to the public in 2023, according to seven industry executives with direct knowledge of the discussions who declined to be named.

The previously unreported growing industry consensus shows how regulators are trying to move quickly to execute President Joe Biden’s agenda to incorporate climate risk into the financial regulatory system, with major ramifications for Wall Street banks like JPMorgan Chase & Co (JPM.N) Citigroup (C.N), Wells Fargo & Co (WFC.N), Bank of America Corp (BAC.N), Goldman Sachs Group (GS.N) and Morgan Stanley (MS.N)….

Reuters reported in May that Fed supervisors had begun privately pressing lenders for data and details on their efforts to assess the exposure of their loan books to climate change.

Those discussions are being driven by Kevin Stiroh, who began leading the Fed’s climate change supervisory work in February. They have intensified in recent months and started to focus on how a balance sheet scenario analysis might work, according to the executives.

“Broadly speaking, regulators are moving forward with all due speed on this,” said Sean Campbell, head of policy research at the Financial Services Forum, which represents big banks, adding a 2023 timeline “is about right.”

Fed officials have not previously indicated when they would expect to perform an analysis. In an interview with Reuters, Randal Quarles, the Fed’s outgoing vice chair for supervision, said that there was no official timeline, but he likewise told Reuters two years “sounds about right.””

One wildcard in the pending implementation of Federal Reserve’s new ESG-friendly stress-tests is hinted at in this last paragraph from Reuters, which quotes “Randal Quarles, the Fed’s outgoing vice chair for supervision.” According to a December 28 article in The Wall Street Journal, President Biden appears set to appoint Sarah Bloom Raskin to replace Quarles, a conservative, as the Fed’s top regulator. Raskin is an advocate of an ESG-related regulatory mission for the federal government (including, presumably, the Federal Reserve). The Journal noted:

“Ms. Raskin’s nomination could mollify progressive Democrats, some of whom opposed Mr. Biden’s decision in November to offer a second term to Fed Chairman Jerome Powell, a Republican first chosen for the top job by former President Donald Trump.

They have called for the Fed to take a tougher stance in regulating big banks and a bolder approach in addressing financial risks posed by climate change.

While serving as a Fed governor from 2010 to 2014, Ms. Raskin was deeply involved in behind-the-scenes work to write rules implementing the 2010 Dodd-Frank financial-regulatory overhaul.

Since leaving the government, Ms. Raskin has spoken out on the need for the Fed and other federal financial regulators to more proactively address growing threats from climate-related events such as natural disasters and wildfires.

“There is opportunity in pre-emptive, early and bold actions by federal economic policy makers looking to avoid catastrophe,” Ms. Raskin wrote in the foreword of a report last year from the Ceres Accelerator for Sustainable Markets, a climate advocacy group.

Sen. Elizabeth Warren (D., Mass.) has signaled to the White House she would support either Ms. Raskin or Richard Cordray, the Consumer Financial Protection Bureau’s first confirmed director, who also has been under consideration for the Fed’s banking-regulator post….

More recently, in a New York Times opinion article in May 2020, Ms. Raskin was critical of broad-based emergency-lending backstops enacted by the Treasury and Fed to assist businesses during the pandemic because she believed they should have taken steps to prevent lending to oil-and-gas concerns. “The decisions the Fed makes on our behalf should build toward a stronger economy with more jobs in innovative industries—not prop up and enrich dying ones,” she wrote.”

On Wall Street and in the private sector

Reuters: “How 2021 became the year of ESG investing” 

As one year draws to a close and another year begins, analysts have provided numerous looks at the Wall Street year that was and predictions about what the year ahead will hold. Many of those retrospectives and forecasts focused on ESG, which remained one of the fastest-growing investment strategies in the world in 2021.

On the upside for ESG, on December 23, Reuters reported the following:

“Investors concerned about climate change and social justice had a bumper year in 2021, successfully pushing companies and regulators to make changes amid record inflows to funds focused on environmental, social and corporate governance (ESG) issues.

Extreme weather becoming more frequent and events highlighting social justice issues, such as the death of George Floyd in Minneapolis police custody, contributed to ESG rising to the top of the agenda of investors, companies and policy makers.

A record $649 billion poured into ESG-focused funds worldwide through Nov. 30, up from the $542 billion and $285 billion that flowed into these funds in 2020 and 2019, respectively, the latest Refinitiv Lipper data shows. ESG funds now account for 10% of worldwide fund assets.

Stocks of companies rated highly for their sustainability efforts also notched gains. The MSCI World ESG Leaders’ index has risen 22% so far this year, compared with the MSCI World Index’s gain of 15%.

Investors flexed their muscle to challenge companies’ ESG credentials, culminating in a landmark board challenge against oil major Exxon Mobil Corp (XOM.N). Support for social and environmental proposals at the shareholder meetings of U.S. companies rose to 32% in 2021 from 27% in 2020 and from 21% in 2017, according to the Sustainable Investments Institute.

“It was a watershed year,” said Tim Smith, a director at investment management firm Boston Trust Walden….

[Additionally] In the United States, companies can sometimes avoid putting shareholder resolutions to a vote by asking the SEC for permission. Thomas Skulski, managing director at proxy solicitor Morrow Sodali, said the SEC strengthened the hand of ESG investors in November by narrowing the circumstances under which companies can skip votes. 

As a result, companies next year could face more challenges on operational issues, such as how they use consumer packaging or plastics, Skulski said.”

Financial Times: “ESG shares underperform oil and gas in 2021”

Meanwhile, however, ESG also suffered setback, perhaps the most important of which was noted just last week by The Financial Times:

“Oil and gas shares — knocked early in the pandemic and increasingly shunned by eco-conscious investors — have this year eclipsed the stock markets’ in-vogue environmental, social and governance-focused companies.

As of December 29, US giants Exxon and Chevron had added 48 per cent and 40 per cent respectively in 2021. The duo have helped power global energy equity funds past many of the hundreds of US and European sustainable funds as defined by Morningstar, a data provider.

The iShares MSCI global energy producers exchange-traded fund is up 37 per cent to December 29, outperforming the largest US ESG fund — the $31.8bn Parnassus Core Equity fund – which is up 28 per cent. The largest iShares ESG fund run by giant fund manager BlackRock has also trailed, up 30 per cent.

It marks a sharp change from 2020, with the more tepid performance leading to early signs that investor enthusiasm for ESG funds has cooled, as investor inflows into the fund class have slowed from their breakneck pace at the beginning of the year.

The Invesco Solar ETF and the iShares Global Clean Energy ETF are down more than a quarter this year. In contrast, these funds’ share prices tripled and doubled, respectively in 2020, when Exxon plummeted 41 per cent and Chevron fell 30 per cent.

Danish power group Orsted “was the darling” for ESG funds in 2020, Gauthier said. But Orsted and wind turbine maker Vestas have warned of challenging conditions in renewable energy after projects in Europe suffered low wind speeds and higher costs hit manufacturers.

Orsted and Vestas have dropped by around a third in 2021. Iberdrola, the Spanish utility that has also prioritised renewable electricity, is down around a tenth this year.

Meanwhile, despite volatility in the oil price following the emergence of the Omicron coronavirus variant last month, Brent crude and the US benchmark WTI are both up by more than a half in 2021.

Global oil demand is on track to surpass 2019 levels by March 2022 and is projected to continue its rise in 2023, according to JPMorgan. “We are seeing the first energy crisis of the decarbonisation era,” said Joyce Chang, chair of global research at JPMorgan.”