Regulatory Solutions to Climate Risk

Font Size:

Experts argue that the United States can do more to reduce the risk of climate change on financial markets.

Font Size:

In the final weeks of summer, severe weather wreaked havoc across the United States. Wildfires burned through the West Coast. A massive windstorm tore up the Midwest. Hurricanes flooded the Gulf Coast.

These kinds of disasters not only lead to massive disruptions and deaths, they also threaten to destabilize the U.S. financial system, according to a recent report commissioned by the Commodity Futures Trading Commission (CFTC). A CFTC subcommittee concluded that forestalling major economic destabilization from climate change will require “significant action” from the federal government.

The report highlights a range of possible climate-related scenarios that could occur all over the country, from excess flooding of the Mississippi River delaying agricultural shipments to increasingly frequent wildfires causing a decline in real estate prices in the West. Furthermore, as the COVID-19 pandemic has revealed, the U.S. health care system may not be ready to handle the major challenges that climate change will bring.

Although the CFTC report outlines a wide range of policies designed to combat climate change and secure U.S. financial markets, its authors present one key recommendation: Congress should adopt an economy-wide price on carbon to encourage industry members to reduce harmful gas emissions.

Under a “carbon pricing” scheme, the government attaches a price to greenhouse gas emissions. The costs can be imposed by collecting a “carbon tax” from the owners of emissions sources based on their total output. Another option is to cap potential pollution and provide entities with allowances equal to their emissions. Both methods encourage industry members to save money by reducing emissions.

The monetary value of carbon pricing would need to be linked to what the World Bank describes as “the external costs of carbon emissions.” These are the “costs that the public pays for in other ways,” such as crops that are damaged or properties that are destroyed due to climate change. Federal regulations do not currently attach an extra price to carbon emissions, the CFTC report notes, essentially treating the environmental costs of potentially harmful activities “as if they were ‘free.’” The authors directly link this failure to the growing risk of climate change.

If Congress maintains this course and does not enact carbon pricing, they warn, “financial markets will operate sub-optimally, and capital will continue to flow in the wrong direction.”

Passing legislation to establish a system of carbon pricing, however, “creates an economic incentive” to invest in the development of new technology to lower emissions.

Carbon pricing policies are gaining momentum in the United States and worldwide. Eleven U.S. states currently have an emissions trading system, and carbon taxes have been implemented in countries such as the United Kingdom, Canada, and Mexico. Even so, the Trump Administration has moved away from using carbon pricing as a guiding metric, and it seems the United States is still far from establishing a national climate policy. By calling for Congress to enact carbon pricing, one economist argues that the independent authors of the recent CFTC report advocate “a far stronger position than those taken by either the Republican or Democratic parties during the current election cycle.”

The CFTC subcommittee repeatedly stresses that carbon pricing needs to come from Congress, not regulators. That does not mean, however, that financial regulators are powerless to push back against the risks of climate change.

Federal and state agencies are already armed with an array of tools that could quickly be adapted to combat climate change. For example, just as the U.S. Federal Reserve routinely examines the capabilities of large banks, the CFTC report advises regulators to conduct climate risk stress tests for financial institutions using scenarios informed by the latest climate science.

In addition, the CFTC report contradicts at least one Trump Administration policy. Although the U.S. Department of Labor has proposed preventing environmentally conscious investing for retirement plans, the CFTC report recommends that regulators “confirm the appropriateness of making investment decisions using climate-related factors.”

The CFTC’s Climate-Related Market Risk Subcommittee is made up of business executives, academics, and environmental experts. Its report, released in September, “is the first wide-ranging federal government study focused on the specific impacts of climate change on Wall Street.” It remains unclear what, if any, government response will follow—the Trump Administration has reportedly disavowed the report, and President-Elect Joe Biden’s climate plan does not address carbon pricing.