The Trump administration’s financial regulators are trying to get back to the basics of sound policy and sound economics. This fall, the Federal Deposit Insurance Corporation, the Federal Reserve Board and the Office of the Comptroller of the Currency issued a news release withdrawing the interagency Principles for Climate-Related Financial Risk Management for Large Financial Institutions.
According to Michelle Bowman, the vice chair for supervision of the Federal Reserve’s Board of Governors, the guidelines are being rolled back because their effect was “to create confusion about supervisory expectations and increase compliance cost and burden without a commensurate improvement to the safety and soundness of financial institutions or to the financial stability of the United States.”
The rollback of the principles is a welcome change and a win for regulatory reform.
When instituted in 2023, the interagency principles sought to change the behavior of large financial institutions by treating climate change as a serious threat to their financial interests. The principles took the form of a “three-way pact” between the FDIC, the Fed Board and the OCC, requiring large financial institutions — those with more than $100 billion in assets — to adhere to a series of guidelines dictating how alleged climate change risks should be managed.
In addition to listing protocols for mitigating risks from extreme weather, the principles instituted standards for organizational transitions to renewable energy.
“Transition risk” is the risk that a transition to a low-carbon economy is said to pose for a firm. Under the principles, carbon-intensive firms were considered risky, and banks were expected to charge higher interest rates when lending to them.
Although the principles were part of agency guidance and therefore non-binding and technically voluntary, the guidance effectively imposed environmental policy on financial institutions.
This attempt to achieve environmental policy goals through financial means was problematic for several reasons. The most fundamental of these is that regulators should not act as central planners, which leads to distortions in markets and harms the economy. Government action encouraging environmental, social, and governance (ESG) investments does not improve economic outcomes. Instead, it distorts price signals and market incentives.
Under a system of economic freedom, the market directs funds toward projects with high returns and away from projects with low returns, thereby ensuring efficient allocation of scarce resources. Ideologically driven investments are based more on dubious notions about “climate risks,” not hard economics.
“Over the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, an average 6.3 percent return compared with an 8.9 percent return,” Terrence Keeley, the chief investment officer of 1PointSix LLC, explained in 2022.
Distorting traditional principles of financial regulation to promote boutique, progressive notions about the effects of carbon emissions does not increase profits—nor, in fact, reduce the risk companies face.
Proponents of ESG investing argue that these policies promote the public interest. However, even putting aside the dubious scientific and economic theories on which they are based, these calculations do not account for the increased costs, decreased profits and reduction of efficiency ESG mandates produce. Regardless of their good intentions, regulators who distort market incentives hamstring the efficient allocation of capital.
In her statement supporting the rejection of climate guidance, Bowman notes that the principles created a compliance nightmare for financial firms. The guidance states that banks are “likely to be affected” by climate change-related risks and directs them to conduct scenario analysis and plan for possible events in the distant future. The principles required banks to “develop strategies, deploy resources and build capacity to identify, measure, monitor and control for climate-related financial risks,” but omitted any concrete endpoint for data collection.
Subsequently, predicting events in the distant future forced banks to rely heavily on speculation and assumptions. Even worse, these policies distracted financial institutions from their central role in assessing and protecting their clients from legitimate financial risks.
The track record of the Principles for Climate-Related Financial Risk Management for Large Financial Institutions demonstrates the consequences of using financial mechanisms to advance environmental policy. Such efforts to orchestrate economic outcomes invariably lead to economic inefficiency, oversteps of agency authority, and muddled regulatory mandates.
In his 1776 work “The Wealth of Nations,” Adam Smith writes that attempts to “trade for the public good” rarely produce benefits for society. Instead, regulators should encourage financial institutions to focus on their core duties to consumers.
Rejecting ESG investing guidance is a positive step, and policymakers should seek to encourage further deregulatory efforts.