A groundbreaking policy report spearheaded by a commissioner of the Commodity Futures Trading Commission (CFTC) and published this month lays out the systemic risks climate change poses to the U.S. financial system. It is an acknowledgement that is symbolically important more than anything else, reviving calls for a tax on carbon, enhanced climate-risk disclosure requirements by publicly traded companies, and more.
“With this report in hand, policymakers, regulators, and stakeholders can begin the process of taking thoughtful and intentional steps toward building a climate-resilient financial system that prepares our country for the decades to come,” CFTC Commissioner Rostin Behnam said in announcing the report.
Behnam jumpstarted the initiative in June 2019 at a meeting of the CFTC’s Market Risk Advisory Committee, which had convened to examine financial risks related to climate change. The meeting ultimately laid the groundwork to establish the Climate-Related Market Risk Subcommittee, a 34-member multi-stakeholder group of representatives from the business and investor community, public-policy sector, and academia.
“I think this report … really pushes the ball forward, so that when we do take action, we have something to look at. We have a report that shines light on the issues, the risks, and what needs to get done.”
CFTC Commissioner Rostin Behnam
The result was a nearly 200-page report, “Managing Climate Risk in the U.S. Financial System,” published Sept. 9, that the subcommittee voted unanimously 34-0 to adopt. It calls on U.S. financial regulators to “recognize that climate change poses serious emerging risks to the U.S. financial system, and they should move urgently and decisively to measure, understand, and address these risks.”
Bringing further urgency to the issue, the report noted, the coronavirus pandemic will likely prolong “fiscal deterioration, stressed business balance sheets, and depleted household wealth. In this context of heightened financial fragility, managing climate-related risk becomes even more important and urgent.”
In its simplest form, the report describes two types of risks associated with climate change: physical and transition risk. Physical risks are things like impact on infrastructure, human health, and agricultural productivity, as well as the impact on economic activity, asset valuations, and firms. Transition risks, on the other hand, “are associated with the uncertain financial impacts that could result from a transition to a net-zero emissions economy,” like suddenly stranded assets in the fossil fuel industry or shifts in climate policy, technology, or consumer preferences.
The report describes with great care both the specific physical and transitional risks, as well as the extensive scale of the challenges. It also provides 53 concrete recommendations to mitigate those risks.
The first of those recommendations, which calls for a price on carbon in the United States, provides the context for the rest of the report. “Financial 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,” the report states. Any price on carbon “must be fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement. This is the single most important step to manage climate risk and drive the appropriate allocation of capital.”
Standardized disclosure framework
Another key recommendation calls for more “sophisticated and robust climate risk disclosure in financial filings,” which would put the onus on publicly traded companies to improve the quality of their climate risk disclosures. “Financial filings should include disclosure of any material financial risks from climate change in a consistent but non-boilerplate manner, as well as a qualitative description of how firms assess and monitor for potential changes in climate risks that may become material,” the report states.
Here, it pressed the Securities and Exchange Commission to play a role by reviewing and updating its 2010 guidance on climate risk disclosure. “What this report helps to do is move climate risk information from a nice-to-have to a must-have,” Mindy Lubber, CEO of sustainability nonprofit group Ceres, said on a Sept. 14 Webinar. “It confirms that climate risk is a material financial risk—like currency risk and trade risk and inflation risk and other risks—and it ought to be dealt with the same seriousness.”
The report recommended the SEC incorporate guidance on what information companies should provide to enable financial regulators to assess climate-related systemic risks. It also recommended establishing rules that build off existing industry-specific climate disclosure standards—such as those developed by the Task Force on Climate-related Financial Disclosures, the Sustainability Accounting Standards Board, and others.
U.S. companies themselves should be encouraged “to partner with these standard-setting bodies to further develop, standardize, implement, and validate these metrics over time,” the report states. Currently, the quality of climate disclosure “largely remains inadequate,” mainly “because materiality under U.S. law is often interpreted as limiting required disclosure to short- and medium-term risks, and firms may have assumed that climate risks are relevant only over longer time horizons.”
“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,” the report recommends.
There are, however, issues that still need to be ironed out. “We believe that with respect to certain recommendations, such as those around disclosure, there are challenges that require further study and examination by relevant authorities responsible for the development and implementation of any additional regulatory guidance or requirements within their regulatory scope,” a joint statement from Citigroup, JPMorgan Chase, and Morgan Stanley states.
Climate risk management
In the financial services industry, effective climate risk management needs to be integrated into existing risk management processes, “including defining the risk categories impacted by climate risk—credit, market, strategic, insurance, liability, underwriting, operational, and reputation,” the report states.
It further describes what steps a financial institution can take to apply a climate risk analysis to support and strengthen climate risk management, including:
- Categorizing climate risk—for example, through a heat map exercise;
- Quantifying climate-related risk;
- Conducting scenario analyses to analyze climate risk; and
- Monitoring and managing climate risk.
“Depending on the nature of their business, financial institutions could shift the allocation of capital in their portfolio from higher climate risk companies to lower climate risk companies, adjust their underwriting and investing exposures to different sectors or geographies, adjust the tenor or other structural aspects of their loans or reduce insurance underwriting exposure to higher climate risk companies,” the report recommends.
“The main area that the report is silent on is how to foster an open dialogue between the regulatory community and risk practitioners,” says Jo Paisley, co-president of the Global Association of Risk Professionals Risk Institute. “Financial institutions, central banks, and governments can work collaboratively to ensure the financial system’s resilience in the face of climate change.”
“This is not a regulator problem. This is not a private-sector problem. This is a global problem. We have to do it together. We have to do it thoughtfully. We have to recognize the risks that are out there, and we have to take one step at a time. That’s the only way it’s going to get done. We need everyone’s hands on deck here to push the conversation forward.”
CFTC Commissioner Rostin Behnam
The Climate Financial Risk Forum, co-chaired by the U.K. Financial Conduct Authority and the Prudential Regulation Authority, provides a model for such engagement, Paisley says. “This forum brings together senior representatives from across the financial sector, including banks, insurers, and asset managers. The aim of the forum is to build capacity and share best practices across financial regulators and industry that can advance the sector’s responses to the financial risks from climate change.”
Another key part of the report calls for the “availability of consistent, comparable, and reliable climate risk data and analysis to advance the effective measurement and management of climate risk.” Paisley says, “In our dealings with both the practitioner and regulatory communities, this is a common refrain.”
As comprehensive as the report is, the real work comes in the actual implementation of it. Tackling climate change lies beyond the purview of financial regulators. Ultimately, the most critical policies—like taxing carbon—rests with Congress, whose dismal efforts embarrassingly trail legislators in other countries.
From a financial regulatory perspective, Commissioner Behnam said on the Webinar with Ceres not to expect any rules being implemented in the next month. It starts with building blocks, he said, “in building an argument, in building momentum, in building a process toward solutions and toward regulatory responses.”
“Unfortunately, the basic building blocks weren’t there, until now,” Behnam added. “I think this report … really pushes the ball forward, so that when we do take action, we have something to look at. We have a report that shines light on the issues, the risks, and what needs to get done.”
What’s truly needed now is more dialogue between the public and private sector. “This is not a regulator problem. This is not a private-sector problem. This is a global problem,” Behnam said. “We have to do it together. We have to do it thoughtfully. We have to recognize the risks that are out there, and we have to take one step at a time. That’s the only way it’s going to get done. We need everyone’s hands on deck here to push the conversation forward.”
Editor’s note: An original version of this story incorrectly attributed the “Managing Climate Risk in the U.S. Financial System” report to the CFTC. The report is approved by the subcommittee on Climate-Related Market Risk of the Market Risk Advisory Committee. It does not carry an agency seal. The views, analyses, and conclusions expressed in the report reflect the work of the subcommittee and do not necessarily reflect the views of the MRAC, the CFTC or its staff, or the U.S. government.
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