U.S. Financial System Sizes Up Climate Risks | Article

The House Select Committee on the Climate Crisis held a hearing, Creating a Climate Resilient America: Strengthening the U.S. Financial System and Expanding Economic Opportunity, to hear testimony on a landmark report issued by the Commodity Futures Trading Commission (CFTC), Managing Climate Risk in the U.S. Financial System. At the October 1 hearing, CFTC Commissioner Rostin Behnam explained that while the report finds that climate change poses serious and systemic risks to the country’s financial system, those risks can be mitigated with the proper policy tools, including climate risk disclosures and carbon pricing.

For more discussion on physical and transitional risk, check out the presentation by Leo Martinez-Diaz, of the World Resources Institute, during EESI’s November 2019 briefing, Delay and Pay or Plan and Prosper: Practical Solutions to Adapt to the Effects of Climate Change.

The CFTC report covers both “physical” and “transition” risks from climate change. Physical risks are the large losses on investments from natural disasters or other changes to earth systems caused by climate change, such as changes in rainfall patterns depressing agricultural yields. Transition risks are risks of losses to balance sheets caused by green energy transition policies—for example, a drop in fossil fuel industry profits caused by regulations restricting the construction of new fossil fuel power plants.

According to the report, significant physical and transitional risks can ripple through the whole financial system because large losses for one investor (such as a big bank like JPMorgan Chase) lead to losses for its creditors and investors (such as a pension fund like CalSTRS). These risks would impact large providers of essential financial products like pensions, mortgages, and home insurance, causing disturbances on the scale of the 2008 financial crisis. Major economic disruptions from climate change would be exacerbated by the hesitancy of risk-averse financial institutions to offer services like credit or insurance. Commissioner Behnam summarized the urgency of the threat in his opening remarks, “A world wracked by frequent and devastating shocks from climate change cannot sustain the fundamental conditions supporting our financial system.”

The 34 members of the CFTC's climate risk subcommittee share Behnam’s sense of urgency. The members, including a wide range of leaders in the energy and agricultural industries, academia, banking and insurance, and environmental NGOs, approved the report unanimously.

Despite these warnings, the report also found that devastating outcomes are far from inevitable. Behnam stated that financial markets are effective at responding to a given set of incentives, but, in the case of climate risk, more can be done to make the incentives clear. The report recommends requiring companies to disclose their exposure to both physical and transitional risks. With this information, investors would be better prepared to protect themselves against losses.

Behnam stated that climate risk disclosures should be “mandatory, clear, and understandable,” using information that is “fair, objective, and common.” Flexibility will also be needed, as more knowledge is developed on this topic. Mandatory disclosures would be overseen by federal regulators and financial authorities like the Securities and Exchange Commission (SEC) and Federal Reserve. Importantly, these bodies already have the authority to enforce new climate disclosures under existing statute, meaning that enforcement will not require any new legislation from Congress.

Behnam further emphasized the need for broad-based collaboration and flexibility in assessing climate risk. He discussed the importance of public-private partnerships in creating disclosure standards and pointed to the private sector’s growing support for initiatives like the Task Force on Climate-related Financial Disclosures, a private-sector coalition that promotes and develops standards for voluntary disclosure. The Commissioner also advocated for international collaboration to advance knowledge of climate risks and promote consistency across the international financial system. Major central banks like the Bank of England and European Central Bank have already started conducting assessments of climate risk and “stress-testing” their local financial systems.

In addition to mandatory climate risk disclosure, Behnam also discussed the importance of enacting a carbon price. According to the report, $110 trillion in global investments will be required to limit warming to less than 2 degrees Celsius by 2050, with $4.5 trillion over the next 10-20 years required to decarbonize the U.S. energy sector alone. Financial markets can be a powerful tool for rapidly allocating large quantities of capital, but will only do so in response to incentive structures. If the price of carbon emissions is raised in accordance with the “social cost” of those emissions, financial markets will be better able to direct capital towards greener investments and accelerate the energy transition.

In a webinar with Resources for the Future following the hearing, Behnam acknowledged that a global energy transition could create its own risks and instabilities in the financial system, but emphasized that the larger goal of the transition is far more important than these setbacks.

“We should not let these roadblocks and these temporary steps back take us away from the larger goal. We have to move forward. If we pause or move backwards in the transition, it’s only going to cause a feedback loop of climate crises.”

Author: Joseph Glandorf