The US Commodity Futures Trading Commission (CFTC) has published a report examining climate risk management in the US financial system. The report finds that “climate change poses a major risk to the stability of the US financial system and to its ability to sustain the American economy.”
The report suggests that financial markets do not accurately reflect the serious emerging risks posed by climate change. The authors call on US financial regulators to recognize these risks and “move urgently and decisively to measure, understand,” and mitigate them, but also recognize that some of the report’s recommendations require policy actions that extend beyond financial regulators’ purview. In addition to the CFTC and financial regulators, a consolidated set of recommendations drawn from across the report’s eight chapters also targets policymakers, municipal securities regulators, accounting standards regulators and standards development organizations, risk managers, and market participants.
Beginning with an introduction to finance in the face of climate change, the report emphasizes that financial markets will only be able to channel resources to activities that reduce greenhouse gas (GHG) emissions if an economy-wide price on carbon is in place at a level that reflects their true social costs. The absence of such a carbon pricing regime, the authors underscore, is “holding back capital from flowing to sustainable, low-carbon activities.” This lack of incentives to reduce GHG emissions as well as other barriers to sustainable investing can be addressed through, inter alia, government activities such as credit guarantees which attract private capital, “regulatory sandboxes,” and clarifying existing regulations on fiduciary duty to confirm and promote the use of environmental, social, and governance (ESG) factors in investment decision making.
The absence of a carbon pricing regime is holding back capital from flowing to sustainable, low-carbon activities.
Chapters 2 and 3 of the report describe physical and transition risks in the US context, reviewing implications for the US financial system. Whereas physical climate risks are associated with acute or chronic shocks and stresses posed by climate change itself on US infrastructure, assets or economic activity (e.g. from flooding, drought, etc), transition risks are those associated with the impacts of climate action and a transition to a low-carbon economy. This category of risk relates more to matters of policy, legal concerns, and concerns resulting from rapid technological change, which can result in stranded assets.
These risks are interrelated and not solely borne by the US, according to the CFTC. The report highlights that the US is not alone in confronting climate change challenges and the impacts of climate risk on the financial system. The authors emphasize that financial regulators and other actors around the world can ensure financial stability in the face of climate change, but that the US in recent years has been largely absent from international climate policy fora, and that there is a lack of political inertia. Without US participation and leadership, the report expects that “international efforts will surely fall short.”
Key recommendations beyond carbon pricing and ESG investing center on the need for leadership by US financial regulators, who, as chapter 4 of the report outlines, are faced with the intertwined challenges of safeguarding the financial system’s ability to support economic activity in the face of climate change whilst enabling the system to transition the US economy to one that is low-carbon and resilient. Overarching recommendations for these regulators relate to their five key functions:
- Identify and provide oversight of physical and transition risk at a systemic level;
- Ensure that financial institutions and market actors can monitor and manage climate risks;
- Ensure that financial institutions and market actors have the capacity to absorb climate-related impacts;
- Ensure that investors, customers and counterparties have adequate information to understand material climate risk; and
- Identify and address climate-related operational vulnerabilities in financial market utilities and critical service providers.
Additional report chapters focus on climate risk data and analysis (chapter 5), climate scenarios (chapter 6), climate risk disclosure (chapter 7), and financing a transition to net-zero emissions (chapter 8).
The report was adopted unanimously in a 34-0 vote by the CFTC’s Market Risk Advisory Committee’s (MRAC) Climate-Related Market Risk Subcommittee. The subcommittee is comprised of expert members representing industry, public interest groups and non-profit organizations, and academia. [Publication: Managing Climate Risk in the US Financial System] [CFTC Press Release]