The first time a U.S. regulatory body has identified climate change as a serious financial risk

The Subcommittee on Climate-Related Market Risk of the U.S. Commodity Futures Trading Commission (CFTC), a federal body regulating the U.S. derivatives markets, has produced Managing Climate Risk in the U.S. Financial System, a first-of-its-kind report from a U.S. financial regulator on the risks posed by climate change to financial markets. The Subcommittee sits under the Committee on Market Risk Advisory, which advises the CFTC and identifies “systemic issues that threaten the stability of the derivatives markets and other financial markets, and makes recommendations on how to improve market structure and mitigate risk.” (A helpful overview of derivatives can be found here).

The report was commissioned by the Committee on Market Risk Advisory to “initiate the critical process of moving toward a climate-resilient U.S. financial system” and to seek to come to a consensus on “complex issues that do not fit neatly into the current regulatory structure.” According to Robert Litterman, Chairman of the Subcommittee and a Founding Partner of Kepos Capital, “[t]his report reflects agreement around a set of fundamental principles beyond pricing carbon, such as the need for collaboration with international efforts to address climate-related financial market risk. Ultimately, these principles coalesce around the need for leadership by the financial regulators to guide an iterative process forward while leaving room for American financial innovation.”

The report and its recommendations to the CFTC were developed based on the insights of the members of the Climate-Related Market Risk Subcommittee. The Subcommittee comprises over 30 cross-sector representatives including, for example:

• Institutional investors, such as Kepos Capital, Morgan Stanley, Citigroup, Vanguard, JPMorgan Chase, Allianz and BNP Paribas;
• Public pension fund CalPERs;
• U.S. companies and trade associations that rely on commodity-trading, such as Cargill, Bunge, BP, ConocoPhillips and the Dairy Farmers of America; and
• Climate and financial risk experts from the Oxford University Sustainable Finance Programme, the Purdue University Climate Change Research Center, The Brookings Institution, and nonprofit organisations Ceres, Environmental Defense Fund, World Resources Institute and The Nature Conservancy.

Why this report is significant

While the findings and recommendations of the report have been identified by other global financial regulators and increasingly urged by institutional investors, the report is significant as it is the first from a U.S. regulatory body to push for an economy-wide carbon price and mandatory climate disclosures, among other recommendations. While acknowledging that not all of the CFTC’s members agree with all of the report’s findings, the Financial Times notes that through this report the CFTC “reached outside its turf to recommend changes in corporate disclosure, investments and central bank asset purchases, the domain of other federal agencies.” Leonardo Martinez-Diaz, Global Director of the Sustainable Finance Center at the non-profit World Resources Institute (and a member of the Subcommittee), points out that the U.S. has “lagged” behind its peers in efforts to address climate-related financial risks, “despite being home to the world’s largest financial markets.” Nonetheless, he underscores that “this report is not landing in a vacuum” coming after recent reports from U.S. legislators and the Federal Reserve highlighting the risks of climate change to markets. What is more, the report “comes at a time when the COVID-19 economic crisis is bound to weaken the financial system’s resilience to shocks, heightening the urgency of addressing the climate risk challenge.”

Key Takeaways

Below are some of the topline findings of the report:

• An economy-wide price on carbon is fundamental to addressing climate risk: “…[F]inancial markets will only be able to channel resources efficiently to activities that reduce greenhouse gas emissions if an economy-wide price on carbon is in place at a level that reflects the true social cost of those emissions.”
• Climate change is a significant economic risk: “Climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy. Climate change is already impacting or is anticipated to impact nearly every facet of the economy, including infrastructure, agriculture, residential and commercial property, as well as human health and labor productivity.”

Source: Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee, U.S. Commodity Futures Trading Commission, Managing Climate Risk in the U.S. Financial System (September 2020)

• Sub-systemic shocks are likely to harm small businesses, farms and households, especially those already underserved by the current financial system: “Regulators should also be concerned about the risk of climate-related ‘sub-systemic’ shocks,” defined as shocks “that affect financial markets or institutions in a particular sector, asset class, or region of the country, but without threatening the stability of the financial system as a whole.” Left unaddressed, sub-systemic shocks can “undermine the financial health of community banks, agricultural banks, or local insurance markets, leaving small businesses, farmers, and households without access to critical financial services. This is particularly damaging in areas that are already underserved by the financial system, which includes low-to-moderate income communities and historically marginalized communities.”
• Better data on climate-related financial risks is needed: “Insufficient data and analytical tools to measure and manage climate-related financial risks remain a critical constraint,” compounded by the lack of economy-wide standards and definitions for climate-related data. This lack of standardization is “hindering the ability of market participants and regulators to monitor and manage climate risk.”
• The existing climate-risk “disclosure regime” is not adequate: “The disclosure by corporations of information on material, climate-related financial risks is an essential building block to ensure that climate risks are measured and managed effectively,” and demand for this disclosure is growing. “However, the existing disclosure regime has not resulted in disclosures of a scope, breadth, and quality to be sufficiently useful to market participants and regulators.”
• International collaboration is needed to meaningfully address climate change as a financial risk: “While some early adopters have moved faster than others in recent years, regulators and market participants around the world are generally in the early stages of understanding and experimenting with how best to monitor and manage climate risk.” This means that “U.S. regulators are not alone in confronting climate change as a financial system risk” and that more international engagement with other countries could help to confront these challenges.

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Source: Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee, U.S. Commodity Futures Trading Commission, Managing Climate Risk in the U.S. Financial System (September 2020)

‍Key Recommendations

The report makes many recommendations for both policymakers and financial regulators. A few of the key recommendations highlighted by the report include:

• Establish an economy-wide price on carbon. The report underscores that “[t]his is the single most important step to manage climate risk and drive the appropriate allocation of capital.”
• Build climate-related risk into existing regulatory objectives
• Collaborate with the international community to build capacity and policy coherence
• Banks and other financial firms should take climate-related financial risk into account as a matter of sound corporate governance. This “includes embedding climate risk monitoring and management into the firms’ governance frameworks, including by means of clearly defined oversight responsibilities in the board of directors.”
• Likewise, insurers must also take climate risk into account.
• Standardize definitions and classifications for climate-related financial risks.
• Require companies to disclose material climate risks and greenhouse gas emissions as a matter of compliance, and build uniform frameworks that support them in defining, identifying and assessing these risks. “To address investor concerns around ambiguity on when climate change rises to the threshold of materiality, financial regulators should clarify the definition of materiality for disclosing medium- and long-term climate risks, including through quantitative and qualitative factors, as appropriate.” In addition, “[r]egulators should require listed companies to disclose Scope 1 and 2 emissions. As reliable transition risk metrics and consistent methodologies for Scope 3 emissions are developed, financial regulators should require their disclosure, to the extent they are material.”
• Continue to expand the bounds of fiduciary duty to include climate-related financial risks. Changes to relevant laws, regulations and codes “should clarify that climate-related factors—as well as ESG factors that impact risk-return more broadly—may be considered to the same extent as ‘traditional’ financial factors, without creating additional burdens.”

“Investors and financial markets are poised to deliver the low-carbon capital and infrastructure that our global economy requires to address climate risk. We know what we need to do and how to do it. We are impatiently waiting for the appropriate incentives and other policies to reduce emissions to be instituted through legislation. Only then will the awesome power of the financial system be able to address at scale this existential threat.”                        

Robert Litterman, Chairman, Climate-Related Market Risk Subcommittee, Managing Climate Risk in the U.S. Financial System (September 2020)

“A financial system that is better able to measure and manage these risks will be better positioned to absorb and recover from climate-related shocks, as well as to help investors and entrepreneurs seize opportunities that arise from the transition to net-zero emissions. That will be especially significant in the post-COVID period, when the weakened economy and financial system will be especially vulnerable to any additional disruption. Given the uncertain timing of physical and transition risks, it is imperative that this process begin now. As this report has mentioned repeatedly, policies essential to decisively address climate change lie beyond the purview of financial regulators. Those policies include, first and foremost, effective mechanisms to price carbon appropriately. Financial regulators and other market participants can insistently point to the need to ‘get incentives right,’ and they can warn about the consequences of failing to act. But, ultimately, these critical policies must come from Congress, coupled with an international framework that can facilitate synchronized reductions in greenhouse gas emissions across countries.”                        

Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee, U.S. Commodity Futures Trading Commission, Managing Climate Risk in the U.S. Financial System (September 2020)