In September 2020, the Climate-Related Market Risk Subcommittee (the Subcommittee) of the Market Risk Advisory Committee (the MRAC) of the U.S. Commodity Futures Trading Commission (CFTC) published a report, “Managing Climate Risk in the U.S. Financial System” (the Report).1 The Report reflects on the potential economic costs of climate change and sets out recommendations directed toward regulators and market participants throughout the U.S. financial system. The report first describes risks to the stability of the financial system posed by climate change. It then sets forth certain findings of the Subcommittee with respect to those risks. The report concludes with specific recommendations to the CFTC itself, other state and federal regulators, and even Congress for managing and mitigating those risks.
The Report is ambitious. It provides an extensive description of the work of other regulatory bodies, academics, and industry groups with respect to the possible economic costs associated with climate change. The list of references at the Report’s end may provide a valuable resource.
One need not read past the first paragraph of the Report to understand the task the Subcommittee gave itself:
Climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy. The Subcommittee found that climate change is already impacting or is anticipated to impact nearly every facet of the economy, including infrastructure, agriculture, residential and commercial property, as well as human health and labor productivity. Over time, if significant action is not taken to check rising global average temperatures, climate change impacts could impair the productive capacity of the economy and undermine its ability to generate employment, income, and opportunity. Even under optimistic emissions reduction scenarios, the United States, along with countries around the world, will have to continue to cope with some measure of climate change-related impacts, in the Subcommittee’s view.
Who wrote the report?
The CFTC is an independent federal agency that regulates the U.S. markets for commodity derivatives, including futures and options markets. The CFTC also has antifraud and antimanipulation jurisdiction over transactions in “commodities” and broader regulatory jurisdiction over transactions in commodity derivatives. The definition of “commodities” is broad, encompassing all goods, articles, services, rights, and interests in which futures contracts are currently or in the future dealt. Aside from onions and motion picture box office receipts, which have been specifically excluded from the definition of “commodity” under the Commodity Exchange Act for interesting but presently irrelevant reasons, almost everything conceivable is a “commodity.”2 Though the CFTC is a relatively small agency, the markets overseen by the CFTC are vast.
The MRAC is a discretionary advisory committee established under the Federal Advisory Committee Act. The MRAC’s mandate includes advising the CFTC on systemic risk issues, including issues that threaten the stability of CFTC-regulated markets and — highly relevant to the Report — “other financial markets.” The Subcommittee was formed at the urging of CFTC Commissioner Rostin Behnam and is chaired by Robert Litterman, a founding partner of Kepos Capital. The Subcommittee’s membership consists of 34 representatives from banking, asset management, insurance, a credit rating company, agricultural and energy companies, data providers, environmental groups, and academia. The Subcommittee approved the 165-page Report unanimously.
What are the findings of the Report?
The Subcommittee describes the Report’s “fundamental finding” as follows: “[F]inancial markets will only be able to channel resources efficiently to activities that reduce greenhouse gas emissions if an economy-wide price on carbon is in place at a level that reflects the true social cost of those emissions.” Its first recommendation (see below) relates to this finding. Another central finding is that climate change “could pose systemic risks to the U.S. financial system.”
The Report makes a number of other findings, including that legislation already is in place in the United States granting regulators the authority and the tools to start addressing financial climate-related risk but that these authorities and tools are not currently being fully utilized. The Report also finds deficiencies in corporate disclosure of climate-related risks and finds that the commodity derivatives markts, over which the CFTC has regulatory authority, could play a role in reducing the exposure of market participants to climate-related risks.
The Subcommittee directs its recommendations both internally and at other regulatory bodies, Congress, and financial market participants. Because the Subcommittee’s role is purely advisory, it lacks any rulemaking authority that would mandate or prohibit any action by market participants. However, a number of the recommendations in the Report are directed toward or may be relevant to nongovernment actors. For example, Chapter 6 discusses the use of climate-related scenario analyses by both government and nongovernment actors.
The Report describes the “critical role” financial market participants play in addressing climate-related risk. It encourages innovations in transparent risk management, including improved scenario planning and the development of better methodologies for market participants to measure and report climate-related risk.
Because the Report may inform the views of the CFTC itself or other regulatory bodies, and those regulatory bodies may adopt regulations that are binding on market participants, the Report may foreshadow regulatory responses to climate change over the coming years and decades. The Report has also drawn the attention of Congress, and CFTC Commissioner Behnam recently testified before the House Select Committee on the Climate Crisis regarding the Report’s findings and recommendations.3
The Subcommittee’s recommendations include these:
- The United States should establish a price on carbon that is fair, economywide, and effective.
- All relevant federal financial regulatory agencies should incorporate climate-related risks into their mandates and develop a strategy for integrating these risks in their work.
- Financial supervisors should require financial firms to address climate-related financial risks through their existing risk management frameworks in a way appropriately governed by corporate management.
- The Federal Insurance Office, in collaboration with state insurance regulators, should assess the insurance sector’s systemic vulnerability to climate-related effects and evaluate the adequacy of state insurance regulators’ oversight of climate-related risks.
- Financial supervisors should require financial firms to address climate-related financial risks through their existing risk management frameworks, including by embedding climate risk monitoring and management into the firms’ governance frameworks.
- Federal regulators should ensure that risk management standards governing the operations related to the payment, clearing, and settlement activities of financial market utilities, including central clearing counterparties (CCPs), incorporate measures to monitor and manage physical climate risks.
- Transparency and consistency in corporate disclosure is paramount. All financial regulators should consider the following principles for effective disclosure when developing rules on climate risk disclosure, implementing existing rules or guidance, or seeking public comment on actions such regulators should take:
- Disclosures should represent relevant information.
- Disclosures should be specific and complete.
- Disclosures should be clear, balanced, and understandable.
- Disclosures should be consistent over time.
- Disclosures should be comparable among companies within a sector, industry, or portfolio.
- Disclosures should be reliable, verifiable, and objective.
- Disclosures should be based on current consensus science (and updated as the science evolves) and the best available projections regarding climate change effects.
- Disclosures should be provided on a timely basis.
Regulators should take actions consistent with the goals set under the Paris Agreement on climate change.
A global price for carbon
The Report does not approach climate change from the perspective of imposing regulatory mandates that require or forbid market participants from taking particular actions. Instead, the Report calls for a policy framework that incentivizes the fair and effective reduction of emissions via market forces. The development of a price for carbon is one of the Report’s few areas where the Subcommittee recognizes the limitations of the existing authority granted to regulators and calls for legislative action.
Toward a net-zero emissions economy
Woven throughout the Report is an underlying assumption that the world must transition to a “net-zero emissions economy.” The Report proposes the need to go beyond net zero and begin pulling greenhouse gasses out of the atmosphere.
The Report describes the Subcommittee’s analysis of the potential health effects of climate change, the financial effects of those health effects, and the broader financial effects of climate change as disproportionately burdening low-wage workers and historically marginalized populations and potentially exacerbating existing economic inequality. The Report also proposes that mitigating climate change may reduce economic inequality.
The Subcommittee states that it recognizes that financial institutions are both at risk from climate change and are a source of innovation to mitigate climate risk. Further, it states that the incentives to pursue climate risk mitigation include fiduciary duties to beneficiaries and clients and the credit risk to customers and clients from the impact of climate risk on sectors, geographies, and asset classes. While the entire Report is relevant to financial institutions, one highlight is Table 3.1, which endeavors to sort the financial assets most likely to be affected by climate change into five categories:
- real property (e.g., real estate investment trusts, mortgages, mortgage-backed securities)
- infrastructure (e.g., securities of utilities, communication companies, transportation companies)
- companies whose business is affected by climate-related risks (e.g., securities of companies in a broad range of industries, including agriculture, energy, and tourism)
- coverage providers (namely insurers and reinsurers) (e.g., insurance-linked securities, securities of insurance companies)
- government revenue (e.g., municipal and sovereign bonds)
Recommendations to the CFTC
Although the Report’s recommendations are extensive, the CFTC may pay close attention to the recommendations specifically directed at the CFTC itself.4 The Report makes four recommendations to the CFTC:
- Research. The CFTC should undertake research into how climate-related risks are affecting and could affect markets and market participants under the CFTC’s oversight. This would include derivatives clearing organizations (DCOs), futures commission merchants (FCMs), traders, and investment funds. The research should cover how the CFTC’s role may need to adapt in light of climate change and identify gaps in the CFTC’s regulatory and supervisory framework.
- Regulatory gap analysis. Drawing on this research, the CFTC should review the adequacy of its rules to monitor and manage climate-related risks. The Report identifies several areas in which the CFTC should review its rules: capital and margin requirements for FCMs and swap dealers, initial margin and default fund rules, risk management rules, and DCO capital requirements. The Report also specifically mentions that the CFTC should review whether its rules for noncleared over-the-counter derivatives (e.g., swaps) are appropriate for monitoring and managing climate-related risks. These rules largely consist of the CFTC’s regulations implementing Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The ink on those regulations is barely dry, yet the Report calls on the CFTC to re-evaluate the rules in light of climate change risk.
- Increase DCO stress testing. The Report calls on the CFTC to expand its own DCO stress testing to cover operational continuity and organizational resilience with respect to operations and facilities exposed to physical climate-related risks (e.g., damage to physical infrastructure caused by natural disasters). The Report also calls on other regulators that have supervisory responsibility for CCPs to address the supervision of physical climate-related risk affecting those CCPs.
- Consider expanding certain rules and reporting. The Report asks the CFTC to consider expanding its risk management and quarterly risk exposure reporting rules to cover material climate-related risks, as a better understanding emerges of risk-transmission pathways and where material climate risks lie.
- SIFMU resilience review. The Report calls on the CFTC to review the extent to which financial market infrastructure, including systemically important financial market utilities (SIFMUs) for which the CFTC is not the primary regulator, is resilient against losses that could arise through the physical effects of climate change. This recommendation is notable because it appears to call for the CFTC to review the resiliency of SIFMUs that are not primarily supervised by the CFTC. There are currently eight SIFMUs. The CFTC has primary jurisdiction over only two of them.
1 See https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf.
2 One might say that everything but the kitchen sink is a “commodity,” but that is incorrect, because the kitchen sink also is a commodity.
3 See Testimony of Commissioner Rostin Behnam before the House Select Committee on the Climate Crisis, Oct. 1, 2020, available at https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam16.
4 See Recommendations 4.11 and 4.16.
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