Managing Climate Risk in the U.S. Financial System

Arecent US Commodity Futures Trading Commission report calls for new climate risk requirements and decisive measures by U.S. regulators to address the serious risks that global warming poses to the financial system. This is the first time that a US-wide financial regulator has reported about climate risks and could set the scene for other federal regulators to follow suit given the report states that financial markets could face “unprecedented disruption” due to physical and transition risks. It follows similar concerns expressed by central banks and regulators in other parts of the world.

Incentives to Reduce Greenhouse Gas Emissions

The report recommended an economy-wide price on carbon be established to reduce net greenhouse gas emissions. This was part of a focus on policies and incentives that could maintain the soundness of the financial system, facilitate capital flow toward net-zero emission activities and sustainable investments, and result in accurate pricing of climate risks.

“It’s a fundamental flaw in the financial system that the incentives go the wrong direction,” said Bob Litterman, chairman of the Climate-Related Market Risk Subcommittee. He contends there is a lack of appropriate incentives to reduce GHG emissions. By putting a price on emissions, there can be an economic incentive to allocate capital toward developing new, lower-emitting technologies.

“That is the number one recommendation of the report,” says Litterman. “In terms of these scenarios and stress tests [of the impacts of climate change] and understanding what the physical impacts and reporting on that might be, investors need to direct capital toward the net-zero economy.”

Systemic Impacts Require Regulatory Action

According to the report, “U.S. financial regulators must recognize that climate change poses serious emerging risks to the U.S. financial system and should move urgently and decisively to measure, understand, and address these risks.” The financial community, it notes, “should not simply be reactive—it should provide solutions.”

“There are new and emerging risks that absolutely have to be addressed,” Litterman said. They [financial regulators] need to start to build up the capacities to understand the risks to financial markets from climate change and to address the need for data and transparency about those risks,” he said. However, the report also notes that U.S. financial regulators already have wide-ranging and flexible authorities that could be used to start addressing climate-related risk now. So financial institutions have been put on notice that regulatory scrutiny may start to increase.

The report also sets out the extent to which climate financial risk is expected to be incorporated into the standard components of risk management — identification, measurement, management, monitoring and reporting. Risk management solutions outlined in the report include recommendations that firms embed climate risk monitoring and management into governance frameworks along with clearly defined board oversight responsibilities, standardized requirements on climate risk disclosure, and climate risk stress-testing.

The pandemic is actively demonstrating the interconnections between the different aspects of the financial system and peoples’ health and livelihood. The report was published into a world dealing with COVID-19, which is stressing companies’ balance sheets, straining government budgets and depleting household wealth, all of which undermine the resilience of the financial system to future shocks. The report raises the concern that the impacts of climate change may increase while the world is still dealing with the aftermath of COVID-19, which may further exacerbate financial system vulnerabilities and erode the wealth and capital of financial market participants.

Note: The CFTC report, entitled “Managing Climate Risk in the U.S. Financial System,” is part of GARP’s Continuing Professional Development (CPD) program.