Climate Change Is a Systemic Financial Risk

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Corporate counsel should heed regulators’ warnings that climate change is a risk to the financial industry.

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The U.S. Commodity Futures Trading Commission (CFTC) issued a report last month on the impact of climate change that landed like a thunderbolt.

The bipartisan report, adopted by a subcommittee of the Commission’s Market Risk Advisory Committee, declared climate change to be a major financial risk to the U.S. economy and recommended a package of actions financial regulators should take to address this risk, including putting a price on carbon.

It is one thing for a sustainability organization like the one I work for to issue such a report. For a subcommittee of a major U.S. financial regulator to do so is another thing altogether. The report’s issuance is even more extraordinary when you consider the wide range of perspectives expressed by the subcommittee’s members—including representatives from major banks, institutional investors, power sector companies, and environmental groups.

The report is testament to both the urgent need for regulatory action and an emerging universal understanding of climate risks.

The devastating impacts of climate change have come into plain view. Only now are Americans living on the West Coast finally able to step outside again after a devastating season of climate-exacerbated wildfires. The Southeast is picking up the pieces from a record-setting series of climate-worsened hurricanes. The Midwest has endured pummeling hail storms. So far this year, climate-related disasters have caused $16 billion in damages.

And it is not just the physical impacts of climate that are coming to bear. The economic risks associated with a disjointed and disorderly shift away from fossils fuels is playing out as well. With the pandemic accelerating the high-carbon industry’s long-foreseen decline, oil and gas companies around the world wrote down nearly $90 billion worth of assets during the first quarter of 2020 alone. A new report from Ceres found that the risks of shifting to a lower carbon economy could cost the U.S. banking sector hundreds of billions of dollars. Climate change-based litigation is on the rise as well.

In this context, the CFTC’s release of its advisory subcommittee’s report signifies an inflection point. It is no longer just advocates, investors, or lawmakers calling for changes to financial regulation that better mitigate climate risk—it is increasingly the regulators themselves making these pleas.

With a U.S. presidential election upon us and a potential for a new Administration and new regulatory appointments, climate regulation of the financial sector could come faster than anticipated.

Here are a few key truths that corporate legal counsels should know about the CFTC subcommittee’s report on climate risk and potential regulatory changes that could be looming:

  • Systemic risk means that climate risk is everyone’s concern. The CFTC report explicitly identifies climate change as a potential systemic risk, meaning that it is a risk that threatens the very stability of financial markets. This framing, although new in the U.S. financial regulatory landscape, is already commonplace globally. Global central banks recognize the destabilizing impacts of the climate crisis on an economy already weakened by the ongoing pandemic. Corporate counsel must consider what this designation means for the businesses they advise. When risk is systemic, it is everyone’s problem. There may not be the potential to diversify against a risk that hits the whole system.
  • Global regulators have woken up, and U.S. regulators are awakening. In addition to recognizing the systemic threats of the climate crisis, global regulators are starting to act to address its impacts. Central banks in the United Kingdom, Japan, and Australia, among others, have announced stress testing for climate change. Other countries, including France and New Zealand, are mandating climate change disclosures. In the United States, regulatory developments could head in that direction quickly, too. Democrats in both the U.S. Senate and U.S. House of Representatives released major climate risk reports this summer that affirmed that climate change poses a systemic risk to markets, recommending a series of regulatory actions to address it. U.S. lawmakers have proposed new legislation on disclosure and financial supervision. Reacting to these trends, a number of U.S. regulators—including regional banks of the Federal Reserve and the Federal Housing Finance Agency—are beginning to conduct research conferences on climate change. Although federal financial regulators in the United States have not yet taken formal policy action on climate change, corporate counsel should note that the signs seem to indicate that they are weighing their options.
  • State regulators are leading the way, with a focus on insurance. Federal financial regulators may be muted on climate change, but their state-level counterparts are starting to take decisive action. A major insurance and banking regulator—the New York Department of Financial Services—recently sent a letter to all New York-based insurers, directing them to integrate considerations of climate risk into their governance frameworks, risk management processes, and business strategies. California Insurance Commissioner Ricardo Lara created the first-ever database of green insurance products for his constituents. Washington state Insurance Commissioner Mike Kreidler hosted an entire summit focused on the financial impact of climate change.
  • Climate risk disclosure will lay the foundation for new regulatory policies. While regulators are exploring ways to embed climate change into the prudential supervision process, climate change disclosure continues to be seen as a foundational step. Senator Elizabeth Warren (D-Mass.) recently wrote to U.S. Securities and Exchange Commission (SEC) Chair Jay Clayton, urging the agency to mandate climate risk disclosure. SEC Commissioner Allison Herren Lee recently penned a strong op-ed in the New York Times, making the case for her agency to take up the mantle on climate change and push for stronger climate risk disclosure. Corporate counsel should look for ways to make sure that their companies are taking proactive steps to enhance their disclosures.
  • Investors are looking for regulators to play a role in addressing climate risk. More investors are coming to understand the ways that climate risk is affecting their portfolios. This summer, investors with nearly $1 trillion in assets under management sent a letter to the heads of U.S. financial agencies, including the Federal Reserve and the SEC, urging them to address climate change as a systemic financial risk and to heed the recommendations of a recent report from the Ceres Accelerator for Sustainable Capital Markets. When the U.S. Department of Labor moved to restrict investors’ ability to screen investments for climate risk and other environmental, social, and governance issues, they faced ferocious investor pushback.

Change is coming down the pike. It would behoove corporate managers and directors to begin to engage with this changing regulatory landscape. Corporate counsels can prepare their companies by taking steps now to plan for a regulatory environment that accurately reflects the systemic risk of climate change. Investors, lawmakers, and even regulators themselves are pushing for these changes. Even federal regulatory agencies are starting to sound the alarm bells.

Companies should act accordingly so that they can plan for and contribute to this new regulatory reality. It seems to be coming whether we are ready or not.

Veena Ramani

Veena Ramani is the senior program director of Capital Market Systems at Ceres.