Accelerating Decarbonization in the United States: Technology, Policy, and Societal Dimensions (2024)

11

Aligning the Financial Sector and Capital Markets with the Energy Transition

ABSTRACT

The financial sector directs the flow of capital and financial services to businesses and households throughout the United States and has been increasingly focused on the risks and opportunities associated with the net-zero transition. Historically, some communities have not had equal access to these services, an inequality that the energy transition must address. This chapter examines the financial sector’s unique role in decarbonization, distinct from policies that change the fundamental economics of greenhouse gas (GHG) emissions.

One key role is to ensure that all households are able to equitably benefit from energy transition through targeted financial support and tracking access to government subsidies. Many communities and households lack access to the credit and financing that would allow them to participate in government subsidies for clean energy investments ranging from electric vehicles to home equipment. Targeted programs can address these inequities.

A second key role relates to the data and information that allows investors and regulators to fully understand climate-related risks and opportunities in the financial sector. Improved and standardized data collection and disclosure encourages improved risk management, facilitates the pricing of climate risk into asset values, and directs capital flows in ways that are then sensitive to climate risks.

Last, financial regulators need to improve their monitoring and supervision of climate risks. Beyond data and information collection, this includes scenario analysis and stress testing to understand the vulnerability of key financial institutions and the sector as a whole.

INTRODUCTION

The financial sector includes a wide range of financial institutions and companies and financial regulators that together are responsible for the flow of capital and financial services to businesses and households in the United States, including both large

and relatively small public and private investors. This sector has become increasingly focused on climate change as both a risk and an opportunity for businesses and households that can have significant financial consequences. In recent years, discussion of capital flows associated with the nation’s energy transition has taken on issues of equity. There is a long history of inequity in the processes and outcomes of actors in the financial sector. Without intentional efforts, this inequity will likely carry over and worsen with an energy transition, as disadvantaged groups will both be limited in their access to energy transition opportunities as well as face a disproportionate share of the risks.

This chapter examines a number of questions relating to decarbonization and the financial sector:

• What did the committee’s first report recommend with regard to federal action needed to align the financial sector with decarbonization pathways?
• What changes have happened in the financial sector since the committee’s first report in February 2021, considering actions by the federal government, state governments, and the private sector?
• What changes are still needed in the financial sector during the 2020s to address both risks and opportunities and to help move the nation toward an equitable net-zero economy by midcentury?
• What barriers to change need to be addressed to accomplish such changes?
• What are the committee’s recommendations with respect to the financial sector?

As a starting point, however, the chapter’s introduction explains why the committee has included a discussion of this sector in its report. Clearly, the financial decisions of investors, companies, households, and governments to invest in either conventional, GHG-emitting capital and goods and services with high embedded GHG emissions (Scope 3 emissions), versus low- or zero-emitting alternatives, can either support or impede decarbonization. Other chapters discuss policies that fundamentally alter the economics of these choices toward low- and zero-emitting alternatives. This chapter considers the additional actions that may be necessary to ensure that financial flows follow the changing economics, avoid unnecessary risks, and harness opportunities, and do all of this with a keen eye to the equity of outcomes.

Because this chapter examines current and potential financial-sector reforms, the committee focuses on the following questions: What is the financial sector’s unique role in decarbonization, distinct from policies that change the fundamental economics of GHG emissions? What is the government’s role in support of corporate climate information and disclosure? What further government action or regulation should be pursued in the financial sector? What changes are needed to provide better access to capital for households, small businesses, and communities that, owing to historic and

structural inequalities, would otherwise not be full participants in the net-zero transition? The committee explores these questions within the framework created by prior committee recommendations, recent federal legislation and other activities, and gaps that need to be filled or barriers that need to be addressed going forward. Table 11-1, at the end of the chapter, summarizes all the recommendations that appear in this chapter regarding how the financial sector and capital markets can support decarbonization across the economy.

As noted, this chapter does not discuss government funding, financial incentives, and regulations that directly target the economics of conventional, GHG-emitting activities versus low- and zero-emission alternatives. Those policies focus on actions in a particular sector or system and are discussed in other chapters. This chapter also does not provide an assessment of the capital requirements for decarbonization, as this topic has been discussed in the committee’s first report.

FINANCIAL-SECTOR RECOMMENDATIONS FROM THE COMMITTEE’S FIRST REPORT

The committee’s first report recognized that “[f ]inancial markets play an essential role in the economy by pricing risk ‘to support informed, efficient capital-allocation decisions’” and recommended federal action in two areas: disclosure of financial risks associated with climate change, and creation of a national Green Bank (NASEM 2021, p. 202).

First, the committee pointed out that

The committee discussed the importance of private-sector actors as well as federal agencies taking climate risk into account in their own decisions. The committee recommended that Congress take several actions:

• Direct the Securities and Exchange Commission (SEC) to require public companies to formally disclose their risks from adverse impacts of climate change mitigation policies and climate change as part of their annual filings to the SEC.
• Direct the Federal Reserve System to identify climate-related financial risks, including by applying climate change policy and impact scenarios to financial stress tests.

• Direct federal agencies . . . to incorporate risks and costs from climate policies and climate change into the benefit-cost analyses required prior to the adoption of regulations or standards, or approval of public or private infrastructure investments.
• Require private firms to report their energy-related research and development investments by category (e.g., fossil, solar, wind) annually to the Department of Energy (DOE). (NASEM 2021, pp. 202–203)

Additionally, the committee recommended that the Commodity Futures Trading Commission (CFTC) “build on the recommendations of the report Managing Climate Risk in the U.S. Financial System . . . to ensure that climate risk is better reflected in the commission’s and other federal financial agencies’ oversight of commodities and derivative markets” (NASEM 2021, p. 203).

Second, the committee previously concluded that “the transition will be much more capital intensive than business-as-usual” and private “sources are unlikely to provide the needed capital, especially during the 2020s when the effort is new” (NASEM 2021, p. 206). The committee noted that the United States, unlike many of its economic competitor nations, does not currently have a “domestic independent development, investment, or Green Bank at the federal level,” although several such green banks exist at the subnational level (NASEM 2021, p. 207).

The committee recommended the establishment of a national Green Bank “to mobilize finance for low-carbon infrastructure and business in America,” with initial congressional funding of $30 billion and an additional $30 billion during this decade (NASEM 2021, pp. 206 and 208). The committee found that the Green Bank should be a non-governmental organization with that purpose and that it should use seed funding from the federal government to leverage private investment and support equitable outcomes (with emphasis added below):

Notably, the first report recommended that the United States adopt an economy-wide price on carbon in order to “unlock innovation in every corner of the energy economy, send appropriate signals to myriad public and private decision makers, and encourage a cost-effective route to net zero” (NASEM 2021, p. 12).

RECENT LEGISLATIVE, REGULATORY, OTHER POLICY, AND NON-GOVERNMENTAL ACTIONS RELATED TO THE FINANCIAL SECTOR

Since early 2021, the federal government has initiated action on the two topics where the committee recommended policy change: requirements for public companies to disclose climate risk and inclusion of climate risk into financial-sector risk assessments; and the seed funding for a new national Green Bank. Additionally, actors in the private sector have shown increased interest in corporate ESG accountability.

Federal Legislative Action

In Section 60103 of the Inflation Reduction Act of 2022 (IRA), Congress amended the Clean Air Act to authorize and appropriate federal funding for a new Greenhouse Gas Reduction Fund (GHG Reduction Fund). In effect, Congress has provided for the establishment of a national Green Bank, although fashioned to fit within the budget-reconciliation framework of the IRA.

The IRA appropriates $27 billion to the Environmental Protection Agency (EPA) for the GHG Reduction Fund and directs the agency to issue competitive grants to recipient entities so that they can use federal dollars to provide funding for and financing of the actions to reduce GHG emissions:

• $7 billion to states, municipalities, tribal governments, and other eligible recipients “for the purposes of providing grants, loans, or other forms of financial assistance, as well as technical assistance, to enable low-income and disadvantaged communities to deploy or benefit from zero-emission technologies, including distributed technologies on residential rooftops.”
• $11.97 billion to “eligible recipients”¹—certain nonprofit organizations—for the purposes of providing financial and technical assistance for direct and

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¹ In this section of the IRA, an “eligible recipient” is defined as “a nonprofit organization that—(A) is designed to provide capital, including by leveraging private capital, and other forms of financial assistance for the rapid deployment of low- and zero-emission products, technologies, and services; (B) does not take deposits other than deposits from repayments and other revenue received from financial assistance provided using grant funds under this section; (C) is funded by public or charitable contributions; and (D) invests in or finances projects alone or in conjunction with other investors” (IRA §60103).

• indirect² investment in “qualified projects”³ that reduce GHG emissions and that would otherwise lack access to financing.
• $8 billion to “eligible recipients” for the “purposes of providing financial assistance and technical assistance in low-income and disadvantaged communities” for direct and indirect investment in “qualified projects” that reduce GHG emissions and would otherwise lack access to financing.

As of the committee’s writing, EPA has taken a number of steps to implement this provision of the IRA. After issuing a request for information regarding the program guidance for the design and implementation of the awarding of funds for the GHG Fund, EPA received nearly 400 comments with disparate views about the approaches the agency should use to move the IRA funds into the financial sector (EPA 2022). On April 19, 2023, EPA announced that during the summer of 2023, the agency would hold three complementary grant competitions to distribute grant funding under the Greenhouse Gas Reduction Fund: a $14 billion National Clean Investment Fund competition to two to three national nonprofits to catalyze projects; a $6 billion Clean Communities Investment Accelerator competition to be awarded to two to seven “hub nonprofits” to provide access to financing for households and others in low-income and disadvantaged communities and to do so through networks of community lenders; and a $7 billion Solar for All competition for up to 60 grants to state, tribal, and local governments to support families’ access to affordable solar installations (EPA 2023c). As of mid-July 2023, EPA announced the schedule for applications for all three funds during the second half of 2023, with awards in 2024 (EPA 2023a,b).

Federal Executive Branch Action

A 2020 report from the CFTC’s Climate-Related Market Risk Subcommittee found that climate change posed complex and major risks to the U.S. financial system and urged regulators to act in a timely and decisive manner to measure, understand, and address the risks (Litterman 2020). Building on this report, the Financial Stability Oversight

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² “Indirect investment” relates to the provision of “funding and technical assistance to establish new or support existing public, quasi-public, not-for-profit, or nonprofit entities that provide financial assistance to qualified projects at the State, local, territorial, or Tribal level in the District of Columbia, including community- and low-income-focused lenders and capital providers” (IRA §60103).

³ A “qualified project” includes “any project, activity, or technology that—(A) reduces or avoids greenhouse gas emissions and other forms of air pollution in partnership with, and by leveraging investment from, the private sector; or (B) assists communities in the efforts of those communities to reduce or avoid greenhouse gas emissions and other forms of air pollution” (IRA §60103).

Council (FSOC)⁴ issued a 2021 report recommending that financial regulators identify and address climate risks, laying out an agenda that includes enhancing public disclosures, addressing methodological gaps and climate data needs, as well as improving interagency coordination (FSOC 2021). After concluding that existing disclosure requirements on climate-related risks for companies and financial entities do not result in consistent, comparable, and decision-useful disclosures, FSOC identified that enhanced disclosures would increase investors’ understanding of climate-related risks and allow these to be priced into markets.⁵ The FSOC report acknowledged parallel efforts by individual member agencies to make progress in this area, including actions by CFTC, SEC, the Federal Reserve Board, and the Federal Housing Finance Agency (FHFA).

After signaling its intention to do so during 2021, SEC issued proposed rules in March 2022 that would require publicly traded companies to include in their public disclosure statements “certain climate-related disclosures . . . including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements” (SEC 2022b,c).⁶ Furthermore, the proposed rule would require companies to disclose their GHG emissions, with the SEC’s intention that providing such “GHG emissions disclosures would provide investors with decision-useful information to assess a registrant’s

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⁴ FSOC is comprised of members from various federal agencies (i.e., the Department of the Treasury, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Consumer Finance Protection Board, SEC, CFTC, the Federal Deposit Insurance Corporation [FDIC], FHFA, and the National Credit Union Administration) along with an independent member with insurance expertise, the head the Office of Financial Research, the Federal Insurance Office, a state insurance commissioner, a state banking supervisor, and a state securities commissioner. FSOC has responsibilities that include monitoring the financial services marketplace to identify potential threats to U.S. financial stability and to make recommendations about aspects of regulation (or gaps in it) that could pose risks or vulnerabilities to U.S. financial stability.

⁵ Specific means identified for disclosures included agencies’ leveraging of the Task Force on Climate-Related Financial Disclosures’ existing framework (Litterman 2020), considering what constitutes appropriate information in a GHG disclosure, and coordinating disclosure data formats, comparability, and related elements of consistency.

⁶ “SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors,” press release, March 21, 2022, https://www.sec.gov/news/press-release/2022-46. “The proposed rule changes would require a registrant to disclose information about (1) the registrant’s governance of climate-related risks and relevant risk management processes; (2) how any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short-, medium-, or long-term; (3) how any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook; and (4) the impact of climate-related events (severe weather events and other natural conditions) and transition activities on the line items of a registrant’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements” (SEC 2022a).

exposure to, and management of, climate-related risks, and in particular transition risks” (SEC 2022c).⁷

Since SEC issued these proposed rules early in 2022, thousands of parties have filed comments that together constitute extensive legal, technical, and advocacy points—some in opposition, some in support, and many to modify SEC’s proposed rule in some way (SEC 2022b). Considerable uncertainty exists with regard to future action by SEC to adopt such rules and to the legal durability of such a rule, in light of the Supreme Court’s decision in West Virginia v. EPA. This decision limited EPA’s actions to areas where Congress has authorized the agency to make decisions of economic and political significance (Zucker et al. 2022).

SEC has also proposed new guidelines regarding what may constitute an ESG investment product, in addition to providing an approach to disclosures that would allow for easier comparisons of ESG funds (SEC 2022c). The proposed SEC rule would identify three types of ESG funds, with differing disclosure requirements: “integration funds,” which integrate ESG considerations along with other investment factors and would be required to describe how these elements are incorporated into investment decision making; “ESG-focused funds,” which would be required to provide detailed disclosures; and “impact funds” (a subset of the former category focusing on a particular impact), which would be required to disclose how progress toward this objective will be measured (SEC 2022a).

As of this report’s writing, there continues to be notable movement within elements of the federal government toward establishing means for supporting and enhancing climate-related considerations in the financial sector. This includes the development of proposals from the Federal Reserve, FDIC, and the Office of the Comptroller of the Currency for large financial institutions (with more than $100 billion in total consolidated assets) to identify and measure how climate-related risk affects them and to inform management of this exposure (Federal Reserve System 2022b). In January 2023, the Federal Reserve announced a pilot “Climate Scenario Analysis” exercise for the nation’s six largest banks, in order to “learn about large banking organizations’ climate risk-management practices and challenges and to enhance the ability of both large banking organizations and supervisors to identify, measure, monitor, and manage climate-related financial risks” (i.e., physical risks and transition risks on the banks’ loan portfolios)

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⁷ The proposed rules also would require a registrant to disclose information about its direct GHG “emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2). In addition, a registrant would be required to disclose GHG emissions from upstream and downstream activities in its value chain (Scope 3) if material or if the registrant has set a GHG emissions target or goal that includes Scope 3 emissions” (SEC 2022a).

(Federal Reserve System 2023b,c).⁸ In July 2023, CFTC held its second convening on voluntary markets and indicated that guidance was under development (Ellfeldt 2023).

Private-Sector Action

Although there has been interest among business-school researchers and activists in ESG efforts in the private sector for at least 20 years, the past 2 years have witnessed a number of reports by government and quasi-government agencies on climate financial risk, as well as an increasing (but still small) volume of academic research. A new academic journal, Journal of Climate Finance, for example, will publish its first issue in 2023 (Elsevier 2022).

ESG has begun to play an important role in climate investing.⁹ The impact of “socially responsible” investing began to demonstrate strength as early as the 1960s, most notably in the form of the anti-apartheid investment campaign in which many public and private institutions holding large financial assets pressed for disinvestment in South Africa because of its racial segregation policies and practices. That campaign has been credited with influencing that country’s decision to end apartheid as an official national policy in the early 1990s (Broyles 1998). Fifteen years ago, 16 national governments and financial institutions (including major public pension investment funds) representing $2 trillion in assets signed on to the United Nations’ then-new Principles of Responsible Investment (PRI) (UN 2006). Since then and up through 2021, thousands of other signatories with over $120 trillion in assets have aligned themselves with these principles (PRI 2021).

ESG principles align tightly with these PRI principles and tend to reflect investor attention to corporations’ attention to such factors as:

• Environment—for example, climate change, pollution, waste use, waste streams, and so on.

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⁸ Note that the Federal Reserve’s Chair Jerome Powell explained as recently as January 2023 that the Federal Reserve’s role in climate policy is extremely narrow—to ensure that financial institutions are appropriately managing their own climate-related risks (Newburger 2023).

⁹ In parallel with investor focus on ESG principles (and more specifically climate financial risk), firms themselves may consider such principles alongside traditional business models. Considerable research has explored the potential for ESG to increase firm value and performance. (See, for example, Henisz et al. 2019; Young and Reeves 2020.)

Because this chapter focuses on the financial sector, it does not address the actions of entrepreneurs, start-up companies, and other private-sector entities whose core business focuses on the development, manufacture, sales, and installation of products and services consistent with a net-zero economy. These companies have seen business opportunities in doing so and are not necessarily motivated by investors pursuing ESG strategies and outcomes. Furthermore, the chapter focuses more on the actions of investors in financial markets than on the actions of corporate managers.

• Socially responsible engagement with stakeholders—for example, workforce safety and voice; stances on things like child protection in labor standards and product safety in supply chains; preventing sexual misconduct.
• Governance—for example, diversity in board membership and corporate leadership; conduct in political contributions; prohibitions against bribes and corrupt practices; attentiveness to shareholder concerns.

For decades, some nonprofit organizations have organized the voice and impact of large institutional investors around ESG types of activities, not just calling for corporate boards’ attention to ESG but also urging corporations’ voluntary and, more recently, mandatory disclosure of climate risk in public financial statements (NYSE 2020).

Although there is organized opposition to the ESG movement (Gelles and Tabuchi 2022; Goldstein and Farrell 2022; Read 2022; Sorkin et al. 2022) stemming, at least in part, from political polarization around the concept, the broad expectation is that investors will continue to press companies to incorporate ESG principles, including climate risks and opportunities, into their strategies (Atkins 2020; Barclays 2022; Berlin 2022). This investor interest, combined with the adoption of federal financial incentives for decarbonization discussed throughout this committee’s report, is expected to help drive investments in the direction of a decarbonized economy. The actions of private-sector actors can assist and sometimes lead the policies adopted by state and federal governments.

More could be said about potential activism in this space, its direct and indirect mitigation consequences, and its interaction with efforts to strengthen mitigation policy. While valuable, the committee has instead chosen to focus on ensuring that financial flows can follow the changing economics of decarbonization, on addressing information and regulatory needs surrounding financial sector risks, and on providing equitable access to these flows and allocation of risk.

HOW FAR DO GOVERNMENT POLICY AND PRIVATE-SECTOR ACTIONS GET US?

The committee is not aware of modeling that captures the overall impacts of the changes in policies around financial disclosure and risk, private-sector actions affecting the alignment of ESG pressures, and the establishment of a national Green Bank

on decarbonization outcomes.¹⁰ Nor is the committee equipped with its own analytic tools to estimate the incremental impact of such activities on such outcomes.

That said, the committee views these policies and actions as supportive in moving financial markets toward better alignment with a lower-carbon energy system. To a large extent, financial sector actions create an enabling environment for an equitable decarbonization driven by other policies, technologies, and economics.

WHAT ISSUES AND BARRIERS TO IMPLEMENTATION NEED TO BE ADDRESSED?

Even with these recent efforts, there exist barriers to a strong alignment of financial markets with an accelerated and equitable decarbonization transition. The principal impediments are structural barriers that prevent many consumers from accessing the capital needed to buy and/or invest in low-carbon goods and services; persistent information gaps that enable decision makers to make better choices that take climate-related risks into account; and steps by financial-sector regulators to ensure adequate ongoing awareness of and ability to take action to address any adverse impacts of climate risks on financial stability.

Consumers’ Access to Capital

Federal tax credits¹¹ and other state/federal programs¹² create financial incentives for many households and businesses to purchase and install energy-efficient and low-carbon solar systems, electric vehicles, and other home products and services. However, many such households lack access to capital, have insufficient income, or

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¹⁰ For example, the REPEAT Project’s analysis of the impacts of the Infrastructure Investment and Jobs Act (IIJA) and IRA identifies the national Green Bank as an important element of the IRA that the project’s modeling was not able to capture (Jenkins et al. 2022).

¹¹ The IRA includes incentives for homeowners and other households to purchase appliances and equipment that use less energy or otherwise help to reduce GHG emissions: tax credits for the purchase of certain new electric vehicles produced in the United States and certain used plug-in hybrid vehicles; expanded residential tax credits for the purchase and installation of solar panels and associated battery storage systems; rebates on households’ purchases of energy-efficient appliances, electric equipment and building upgrades, with higher rebates for low-income households; tax credits for home improvements that reduce building energy use (Department of the Treasury 2022).

¹² The IIJA includes $3.5 billion in funding for weatherization assistance for low-income households and $0.55 billion for the Energy Efficiency and Conservation Block Grant Program to support, among other things, the financing of energy efficiency and other clean energy capital investments (BIL Summary 2021).

experience other situations (e.g., being renters rather than homeowners) that prevent them from taking advantage of such programs and policies.¹³

For example, 93.5 million people in the United States live in a census tract considered “disadvantaged” (CEQ 2022a,b) and 11 million households are both renters and extremely low-income (Aurand et al. 2022). A significant portion of U.S. households, especially those with low incomes, lack access to traditional forms of financing (Davidson 2018).¹⁴

Local lending institutions—like credit unions, Community Development Financial Institutions (CDFIs)—may exist in various parts of the nation and, as described by the Partnership on Mobility from Poverty, “attract and deliver much-needed financial services and investments in low-income and distressed communities,” but these tend to be both small and far from ubiquitous (Davidson 2018). CDFIs have the mission to promote “community development in markets comprised of economically distressed people and places. CDFIs are essentially a type of public-private partnership established to advance financial inclusion, the policy goal designed to increase the accessibility of traditionally underserved populations and markets to affordable financial services and products” (Getter 2022, p. 2).

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¹³ There have been efforts by federal financial regulators (e.g., Federal Reserve Board, CFPB, FHFA) and secondary finance markets (e.g., Fannie Mae, Freddie Mac) to consider the energy consumption of goods as part of these entities’ financial determinations and their oversight of the primary consumer financial providers (banks, mortgage underwriters, lenders, and other creditors). Examples are “green mortgages” for individual households and “green rewards” or similar guarantee, rate discounts, or other preferred financing terms for developers. (See, e.g., https://www.fhfa.gov/PolicyProgramsResearch/Programs/Pages/Fed-Adv-Committee-AES-Housing.aspx.) State and local governments have also explored financing approaches (such as Property Assessed Clean Energy programs, or regulatory requirements related to on-bill financing of energy efficiency measures or requirements that real estate transactions on buildings include disclosure of energy use. (See, e.g., https://www.energy.gov/scep/slsc/property-assessed-clean-energy-programs and https://database.aceee.org/state/building-energy-disclosure.)

¹⁴ As reported by the Atlanta Federal Reserve Bank, about “one in four U.S. households are either unbanked—having no relationship with a financial institution—or underbanked, meaning they have a bank account but go outside the traditional banking system for credit and other financial services. . . . [A]mong black and Hispanic households earning less than $40,000 a year (classified as low income [in 2018, when the Federal Reserve Board’s survey was conducted]), 20 percent lack access to a bank account, double the proportion among all low-income households. By contrast, only 1 percent of all families with annual incomes above $40,000 lack a bank account. More than a third of low-income adults have no credit card” (Davidson 2018).

CDFIs offer numerous product lines, the majority of which are consumer, residential real estate, and small business loans, with consumer finance being the primary or secondary line of business for 41 percent of CDFI respondents and small business finance being a primary or secondary line of business for 51 percent of respondents in a 2019 survey (Carpenter et al. 2021).

A recent report from the U.S. Partnership on Mobility from Poverty recommended an increase in U.S. public and private investment in CDFIs as a way to address households’ and communities’ access to financing resources (Elwood and Patel 2018). Notably, the IRA includes $27 billion in funding to entities that provide financial assistance for projects that reduce GHG emissions, of which at least $15 billion is targeted to projects in disadvantaged communities; CDFIs will likely participate in some fashion in such programs. (See the discussion of the national Green Bank and EPA’s GHG Reduction Fund, in the section “Federal Legislative Action” above.)

1. and the $8 billion to eligible nonprofit entities—where the Inflation Reduction Act specifically calls out low-income and disadvantaged communities as the beneficiaries of financing assistance, the additional $11.97 billion pot of funding to eligible nonprofit entities should also use at least 40 percent of that funding for projects that benefit low-income and disadvantaged communities.
2. Congress should increase funding for the Community Development Financial Institution (CDFI) Fund at the Department of the Treasury, and require reporting by CDFIs on their financial assistance related to GHG emissions reductions (with the provision of technical assistance to CDFIs for complying with this requirement).
3. Congress should conduct hearings and support research and convenings at key consumer finance institutions—including the Consumer Financial Protection Bureau, the Federal Reserve Bank, and the Federal Housing Finance Agency—to explore how they may expand private lenders’ reporting requirements regarding the energy consumption of the goods or services being financed (e.g., the mortgaged home or the auto loan) and, in turn, to incentivize finance for decarbonized alternatives and their availability to lower-income households.

While CDFIs provide one avenue to address inequities in the access to net-zero financial incentives, others also play critical roles:

• The Consumer Financial Protection Bureau has regulatory, educational, monitoring, and enforcement authorities to protect consumers in the financial marketplace (CFPB n.d.).
• FHFA has the responsibility to oversee and regulate the nation’s housing financial institutions particularly during current federal conservatorship of the government-sponsored enterprises (e.g., Fannie Mae and Freddie Mac), including through FHFA’s requirements that these institutions have a duty to serve key underserved markets (e.g., manufactured housing, affordable housing, rural housing) for low- and moderate-income households and that they assist in integrating building electrification into their green financing offerings (Fannie Mae 2022).
• The Federal Reserve Board’s role in regulating banks to ensure that they meet credit needs (including its oversight of the Community Reinvestment Act that encourages financial institutions to offer credit in all communities) could be used to identify strategies for financing inclusive energy transitions in affordable housing (Mills and Scott 2022).¹⁵

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¹⁵ Note that in October 2022, the Federal Reserve Bank of New York published a white paper with “consensus recommendations from housing and finance experts that were discussed during nine working

• The recently established Treasury Advisory Committee on Racial Equity is particularly focused on narrowing disparities faced by communities of color (Department of the Treasury n.d.).

The members of these and other groups could consider access to net-zero financial incentives and policies for decarbonization.

Distinct from addressing consumer access to capital directly and the equity of the access, it will also be important to monitor implementation of federal policies for adherence to equity principles. Major clean energy funding streams have been created by both the IRA and prior legislation, including funding to states, local governments, and nonprofits, through programs at Department of Housing and Urban Development (e.g., its Community Development Block Grant Program), DOE (e.g., its Energy Efficiency and Conservation Block Grant Program), EPA (e.g., its GHG Reduction Fund), and the Department of the Treasury (e.g., its CDFI Fund). To know whether equity is being addressed generally and with respect to the funding of energy efficiency and other decarbonization projects, these agencies will need to disclose appropriate indicators related to use of those funds in different communities.

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sessions hosted by the Federal Reserve Bank of New York, in partnership with the New York State Energy Research and Development Authority” and the Community Preservation Corporation. Although the “recommendations in the report should not be imputed as formal recommendations from the Federal Reserve Bank of New York or Federal Reserve System, NYSERDA, or other New York state or city agencies,” the report pointed to ways to help support the financing of decarbonization of buildings that serve low- and- moderate income households and neighborhoods, and included policy ideas (aimed at federal and state legislatures and other government entities) such as

• Giving tax incentives for early adopters to low-emissions heating and cooling systems;
• Providing tax relief to utility companies to induce them to reduce electricity rates to decarbonized buildings;
• Simplifying and aligning existing tax incentive programs to help owners finance retrofits to building systems;
• Recognizing the increased future value of carbon-neutral buildings in appraisals;
• Creating mortgage products that address decarbonization; and
• Charging lower interest rates for loans used to upgrade building systems to meet climate goals (Mills and Scott 2022).

Role of Information and Disclosure of Transition Risk

Information availability, asymmetries, and associated uncertainties all have significant impact on investor decisions about how to allocate capital and manage risk. Among institutional investors, 79 percent believe that climate-related risk is at least as important as financial risk (Ilhan et al. 2021). This climate-related risk includes financial consequences from both climate change impacts, particularly effects of droughts, wildfires, and floods on business operations, and decarbonization, including the consequences of a rapid elimination of fossil fuel use and GHG emissions through both regulation and external pressure. Investor concern about this latter transition risk motivates the need to consider and understand risk stemming from accelerating deep decarbonization. As noted by the International Panel on Climate Change

(IPCC, 15.6.2, AR6, WGIII) (Shukla et al. 2022) and TCFD (2017), such information can help increase climate financing.

A wide variety of firms are exposed to transition risk that accompanies the shift toward a decarbonized U.S. economy. Some companies are negatively exposed to risk (e.g., direct emissions impacts and business models) and some are positively exposed (e.g., renewables firms that stand to see increased demand with the energy transition) or both. The committee also notes the risk of firms over-investing in the transition, if policies fail to support the mitigation activities that firms provide and/or the economics of such activities fail to be profitable. This may not be a risk for the environment but remains a financial risk for investors. These issues motivate risk management by firms and investors—which requires information.

There is also a role for investors and companies that hope to benefit from the energy transition to push beyond immediate profits. The financial sector has an important role to play, as decarbonization requires a tremendous influx of new capital (as noted in the committee’s first report) to achieve net-zero goals alongside equity. With well-defined emission regulations and information, the financial sector is well equipped to channel the necessary resources. To date and although there has been progress in the past few years (TCFD 2022), both regulation and information have been lacking, which could slow the shift of capital flows from carbon-intensive investments to lower-carbon investments. With improved information, forward-looking investors and the expectation of future regulation can accelerate this shift (TCFD 2017).

In its 2021 Report on Climate-Related Financial Risk, FSOC identified numerous instances and sources of gaps in data and methodologies—both within member U.S. federal agencies and across them—that would otherwise be useful to these agencies in evaluating climate-related financial risks of regulated entities and financial markets. These data-related challenges include

Disclosing transition risk and climate-related information raises questions regarding how specific disclosures need to be and what information is—and can be—effectively provided. Standardizing and formalizing what disclosures look like raise important

issues, particularly because the relevant risks will be different for different types of firms. Some firms, for example, may be more likely to be candidates for rapid decarbonization based on the availability of low-carbon alternatives. Sometimes, the emissions intensity of a firm’s products may determine its transition risk; other times, it may be tied to the absolute emission level. Additionally, such things as validating carbon offsets and/or evaluating their permanence, accurately assessing Scope 3 emissions, and accounting for emissions leakage or international outsourcing of emissions (Dai et al. 2021) will be important to meaningful and rigorous disclosures, but all of these issues are difficult to standardize. Nonetheless, standardizing data and methods wherever possible will facilitate comparing the risk exposures of similar firms at the very least, and ideally across broader groupings of enterprises.

Hard data, such as total emissions or the carbon-intensity of products/processes, are more difficult to manipulate than soft data, and providing useful and usable data to inform policy and regulation will be important for avoiding distortions. Hard data are also an essential bedrock for carbon intensity–based performance standards, like the standard proposed in Recommendation 10-9. Standardizing future risk projections to the extent possible would be beneficial, as could standardizing the frequency of disclosure, which could allow for structures such as coupling executive compensation to hitting climate targets (akin to what is currently done with stock prices).

As the energy transition proceeds and the effects of climate change become more immediate, investors may demand compensation for holding climate risk, and look to hedge this risk by reducing exposure and increasing the required return. There is documented evidence of climate regulatory risks causally affecting bond credit ratings and yield spreads (Seltzer et al. 2022). Attention to the data and methods for reporting and tracking voluntary offset use bears particular mention. Offsets fund projects that reduce emissions in different ways—for example, by replacing carbon-based electricity through funding renewable energy projects or by removing and sequestering carbon through biological or engineering approaches. Government agencies cannot provide certainty where it does not fundamentally exist—for example, about the role of particular kinds of offsets in a future regulatory regime. However, firms should not need to jump through hoops to understand the qualities of offsets they are buying, nor should investors need to do the same regarding the offsets held by firms with whom they invest or provide credit.

Such careful accounting of offset quality would allow different kinds of offsets to be increasingly aligned with different scopes. To achieve net-zero emission, truly permanent offsets will need to be aligned with scope 1 emissions. In advance of that, other

types of offset requirements or actions might be aligned with scope 2 and 3 emission, but those will ultimately vanish as net-zero emissions are achieved. Clear disclosure of emission scope and offset qualities would facilitate such an alignment in advance of any policy decisions.

Financial-Sector Policies Beyond Disclosure

Beyond data collection and mandatory information disclosure, a number of other financial-sector policies have been discussed, proposed, or implemented. These include standardized scoring of climate-friendly activities, regulation of voluntary carbon markets, climate risk monitoring and supervision, capital requirements for banks related to carbon risk, and public ownership and management of fossil assets. The committee briefly discusses the first four topics below, while public ownership and management of fossil assets is discussed in Chapter 12. The first two policies discussed here—standardized scoring of climate-friendly activities and regulation of voluntary carbon markets—address the interest of financial-sector actors seeking to understand the climate change risks and opportunities associated with different economic activities or offsets. The other two discussed here—climate risk monitoring/supervision and capital requirements for banks—focus more on the overall performance of financial markets themselves.

Standardized Scoring of Climate-Friendly Activities

While mandatory information disclosure standardizes the information presented by firms subject to financial regulation, this policy does not attempt to digest that information into any kind of standard investment guidance. Investors themselves must decide how to value each piece of information.

The European Union has taken this a step further with its Taxonomy Regulation:¹⁶

Organizations’ economic activities are evaluated against six environmental objectives: climate mitigation, climate adaptation, water use and protection, waste (and the circular economy), pollution prevention and control, and biodiversity. Activities are broadly categorized as either eligible or ineligible contributors to these environmental objectives, and then must meet specific technical screening criteria in order to be considered “aligned” with them. In particular, the activity must (1) make a substantial contribution to one of the six objectives, and (2) do no harm to the others (with the technical screening criteria making this explicit). In 2022, firms need to report only the share of their economic activity that is “taxonomy-eligible” with increasing requirements for alignment reporting in 2023 and 2024 (Pettingale et al. 2022).

There is considerable debate about the EU taxonomy (Pacces 2021; Schütze et al. 2020; Zachmann 2022). At its core, the taxonomy is designed to facilitate financial flows toward environmentally sustainable activities, including climate mitigation. However, Zachmann points out that a green premium, which might be 20 basis points, is equivalent to a $1 carbon price—hardly likely to alter investments beyond existing economic incentives. Perhaps more importantly, a binary measure of sustainability may be overly simplistic and create considerable disagreement about assigned scores. While research has estimated how current financing breaks down into aligned and unaligned flows (Alessi et al. 2019), future work will be needed to assess the actual impact of the taxonomy on changing these flows.

Voluntary Carbon-Offset Market Regulation

As noted elsewhere in the committee’s report (e.g., Chapter 6 on the electric sector), many private-sector entities have made voluntary commitments to reduce their GHG emissions, often as an element of their ESG commitments. Many firms’ commitments include a net GHG emissions target, with the possibility, if not expectation, that the achievement of the goal will rely at least in part on use of carbon offsets. Sales of

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¹⁶ See https://ec.europa.eu/sustainable-finance-taxonomy/home. South Africa is also adopting a taxonomy, but reporting is not required (National Treasury of South Africa 2022). In the United States, CFTC (2020) suggested a standardized taxonomy for climate risks but not this type of “score” for economic activities.

voluntary offsets approached $2 billion in 2021 (Donofrio et al. 2022) and have been forecast to possibly reach $50 billion by 2030 (Blaufelder et al. 2021).

Voluntary carbon-offset markets have faced skepticism pertaining to the quality of the offsets they are offering. Summarized in a discussion paper from the International Organization of Securities Commissions, vulnerabilities for these markets include credit integrity concerns (including, but not limited to, double-counting, transparency and verification of carbon reduction calculations, and conflicts-of-interest), issues pertaining to market structure (such as issues of legal clarity, data availability, and standardization), as well as the need for responsible, legible communication (IOSCO 2022).

Some have advocated that the U.S. federal government should establish standards for GHG emission offsets used in the voluntary market. Currently, a number of third-party standards have emerged for rating offsets, and several have announced recent efforts to strengthen integrity (Integrity Council for the Voluntary Carbon Market 2022). Fredman and Phillips (2022) discuss the many problems that have arisen among third-party standards and argue that rather than leaving such standard setting to civil society, the federal government could step in to provide official standards. Fredman and Phillips argue that CFTC could and should provide guidance on offset quality and registries while also addressing fraud, brokerage businesses, and derivatives. Recent announcements by CFTC indicate that such guidance may be forthcoming (Ellfeldt 2023).

At the same time, participants in the voluntary market can choose to purchase government-certified offsets (or even allowances) rather than those certified exclusively for voluntary markets (Broekhoff et al. 2019). Government-certified offset standards already exist for multiple regulated emission trading programs, including California’s and the European Union’s. However, Badgley et al. (2022) discuss similar problems with government-certified offsets. Haya et al. (2020) discuss ways to mitigate the problems of additionality (i.e., ensuring that an offset represents a reduction in emissions that would otherwise not occur), baselines (e.g., for measuring the size of an offset), and perverse incentives (e.g., offset activities that end up directly or indirectly increasing GHG emissions) but conclude that the risk of over-crediting can be reduced but not eliminated.

Firms, investors, policy makers, and other stakeholders may hold different views about the value of precision in addressing such issues, especially in the context of voluntary as opposed to mandatory carbon markets. These views reflect, in essence, the balance between the risk of over-crediting emissions reductions versus the costs of reducing such risks.

Perhaps more to the point, it is not clear what role government regulation should play in the certification of offsets in voluntary markets. With the exception of cap-and-trade allowances from a binding jurisdictional cap, government certification does not alter the fundamental trade-off between cost and integrity associated with offset projects

that have been recognized for more than a decade (Hall 2007). Rather than attempting to arbitrate this debate, governments could pursue more modest steps by requiring standardized reporting and tracking of offset use, consistent with emerging disclosure requirements. Information that could be required by, say, the federal government might include the activity (or activities) leading to the creation of the offset (e.g., direct air capture, agricultural soils management, reforestation) and location, monitoring/reporting/verification methodologies and third-party certification, tracking and registry information, and cost or price paid.

Climate Risk Monitoring and Supervision

A different arena of potential policy and regulation is related to systemic risks to the financial system posed by both climate impacts and mitigation action. Such risk arises when large, interconnected banks or nonbank financial companies are, in turn, at risk of failing to provide needed services, including the clearing of payments, the provision of liquidity, and the availability of credit. The well-known example of this is the collapse of the market for mortgage-backed securities in 2008 that led to a broader financial crisis and, in turn, the Dodd-Frank Wall Street Reform and Consumer Protection Act, FSOC and other heightened efforts to monitor and supervise the financial sector. Smaller, regional risks are sometimes referred to as “sub-systemic” risks (CFTC 2020).

As noted above, FSOC issued a report in 2021 on climate-related risks to the financial sector. In addition to the findings and recommendations of that report related to collecting and disclosing climate-risk data and information, which were discussed previously in this chapter, FSOC also concluded that financial regulators should assess and mitigate climate-related risks to the stability of the nation’s financial institutions and markets.

Importantly, the focus of these recommendations was not the feedback of financial sector action to climate change mitigation. Stiroh (2022) explains this distinction in terms of single- and double-materiality, where single-materiality focuses on impacts of firm (e.g., a bank’s own) behavior—say, in reducing emissions in its portfolio—on the firm’s own risks. Double-materiality considers the impact of the firm’s (e.g., the bank’s) financial activities on climate change itself (e.g., resulting from its portfolio). For supervisory institutions in the United States, whose mandate is financial stability, the relevant focus is single-materiality.¹⁷

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¹⁷ In other countries, such as members of the European Union and the United Kingdom, financial authorities also have secondary mandates to support other government policies.

Many of the FSOC recommendations in this arena revolve around financial regulators’ use of scenario analysis and stress testing of financial institutions. In summer 2020, the Network for Greening the Financial System published a guide for such activities (NGFS 2020). This was followed in late 2020 and 2021 by pilots in France, Canada, and England, including a small number of banks (ACPR 2020; BOC 2022; BOE 2021). The European Central Bank completed analysis using existing data (Dunz et al. 2021). A key outcome of the pilot analyses has been the recognized need for development and standardization of methodologies for climate risk assessment and the availability of climate-related data (BOC 2022). In fall 2022, the Federal Reserve Board began a U.S.-based pilot scenario analysis exercise with six of the nation’s largest banks (Federal Reserve System 2022a).

Capital Requirements for Banks

A step beyond monitoring and supervision would be to consider changes in regulators’ determinations relating to capital requirements for banks. Banks hold capital to absorb unanticipated losses and allow them to continue to operate under conditions of stress. Regulators establish minimum capital requirements based on a bank’s loan portfolio to ensure that they can withstand adverse shocks with a high-level of confidence. Gelzinis (2021) suggests a number of changes to the regulatory capital regime in the face of climate risks. Meanwhile, supervisory institutions in different countries are considering the implications of climate risk for their regulatory capital requirements (Holscher et al. 2022).

However, as Holscher et al. (2022) point out, capital requirements are a tool to address unexpected losses; other tools (such as risk-based pricing, loan-loss provisions) make more sense if the problem is higher expected losses. It remains unclear whether climate risks are affected more by increased variability in losses or changes in the mean. Moreover, if the goal is really to facilitate the low-carbon transition, it will be important to consider the mandate of the supervisory institution, noted above.

The preceding discussions have focused on providing information to investors and encouraging federal agencies charged with supervising the financial sector to appropriately consider climate risks. All of these discussions exist within various agencies’ mandates to appropriately and equitably protect investors and society. This falls within ordinary prudential actions.

There have been efforts to limit these disclosure and supervisory activities by some sub-national governments. This would inevitably exacerbate climate risks to society through financial market channels and are not consistent with timely and efficient decarbonization efforts.

Table 11-1 summarizes all the recommendations in this chapter regarding how the financial sector and capital markets can support decarbonization across the economy.

SUMMARY OF RECOMMENDATIONS ON ALIGNING THE FINANCIAL SECTOR AND CAPITAL MARKETS WITH THE ENERGY TRANSITION

TABLE 11-1 Summary of Recommendations on Aligning the Financial Sector and Capital Markets with the Energy Transition

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