Why the CFTC’s New Report on Climate Change and Financial Stability Matters

Over the past decade, financial regulators around the world have woken up to the growing risks that climate change poses for the financial system. At first, it seemed to financial authorities that climate change was an exclusive concern of environment and foreign ministries—an issue of diplomacy and energy policy, scarcely relevant to financial markets. Even the most forward-looking could see that climate change would touch finance, but the risks appeared too far in the future, or too abstract to deal with practically.

Then, countries began to adopt policies to cut emissions and price carbon. Some financial authorities began to take notice of the risk that companies and whole economic sectors — if they proved too slow to adapt to a transition to a net-zero-carbon economy — might find their assets and valuations plunging in value, disrupting financial markets. Then, as hurricanes, droughts, flooding, heat waves and wildfires destroyed livelihoods, property and supply-chains at an accelerating rate, the notion that climate change is a risk for the distant future collapsed. Financial supervisors began to consider what these extreme events could do to asset values over time and therefore to the stability of the financial system.

As a result, some regulators started to act. Central banks formed a group to advance the dialogue on the issue. UK and Dutch regulators began to experiment with ways to test if banks and insurance companies were ready for climate shocks. European authorities began pushing companies to disclose more of their climate-related risks.

The United States, however, has lagged in these efforts, despite being home to the world’s largest financial markets. With the publication of a major report this week by a group convened by U.S. financial regulators, it is time for that to change.

Broad Coalition and Key Timing

The Commodity Futures Trading Commission (CFTC) is one of several U.S. federal agencies regulating financial markets. The CFTC focuses on the market for complex financial products known as derivatives. In the late 1990s, CFTC Chair Brooksley Born famously warned about the risk of unregulated derivatives, a warning that proved prescient when these products fueled the 2008 financial crisis.

Last year, propelled by Commissioner Rostin Behnam, the CFTC convened a group of organizations to “identify and examine climate change-related financial and market risks.” While the group does not make policy, its recommendations should prove influential.

Two things are worth noting about the report, produced by a group of 34 institutions, including World Resources Institute. First, it incorporates a diverse range of perspectives, bringing together the views of major banks, asset owners and managers, academics, environmental NGOs, risk management and agribusiness companies, and two major oil and gas players. Consensus among such a diverse group was bound to be difficult, but the fact that the group unanimously voted to approve the report and refer it to the relevant CFTC officials suggests the politics are ripe for taking on this challenge.

Second, this report is not landing in a vacuum. It follows two major reports from legislators in the U.S. House of Representatives and the U.S. Senate calling for similar actions. It follows work from the Federal Reserve flagging risk to the financial system, as well as proposed legislation on climate-related stress testing and disclosure. And it comes at a time when the COVID-19 economic crisis is bound to weaken the financial system’s resilience to shocks, heightening the urgency of addressing the climate risk challenge.

Key Recommendations

The CFTC subcommittee’s report contains many recommendations, but a few are worth highlighting:

• Carbon price. Calling for a price on carbon is now commonplace, but the report makes it clear that (1) the price should be high enough to meet Paris Agreement temperature targets and (2) it should be fair, meaning the economic burden cannot fall on low-to-moderate income groups. The fact that such a diverse group embraced this recommendation is worth noting.
• Oversight of climate risk. After the 2008 crisis, Congress created the Financial Stability Oversight Council (FSOC), which is chaired by the Secretary of the Treasury. The Council is charged with monitoring emerging risks to the financial system and can recommend tighter regulation on institutions when it deems it prudent. The CFTC group calls on FSOC to integrate climate into its oversight functions and into its reporting to Congress. Importantly, it’s not just about oversight of “systemic” risk affecting the biggest and most interconnected firms. The report also calls for paying more attention to sub-systemic risk: the climate risk facing smaller financial institutions, which serve particular regions of the country and include community and agricultural banks.
• Climate stress testing. Stress tests simulate the impact of shocks of different magnitudes on balance sheets, helping regulators, banks and insurance companies better understand and manage financial risks. The CFTC group calls for introducing climate risk stress testing. As is already happening in other countries, the tests would be undertaken by regulators using a set of common scenarios. Financial institutions themselves would also be expected to run their own climate stress tests.
• Disclosure. Under current law, companies whose shares are listed in the stock market must disclose material risks, that is, those reasonably likely to affect the company’s financial condition. The critical question is under what conditions do climate risks —with their complexity and uncertain time horizons — meet the threshold of materiality. The report does not provide the answer, but it does recommend that regulators update decade-old disclosure guidance to make this clearer. They also call for mandatory disclosure by publicly-listed companies of Scope 1, 2, and eventually, Scope 3 emissions, to the extent they are material.
• Central bank asset purchases. To support financial markets during times of stress, the Federal Reserve can buy (and is currently buying) hundreds of billions of dollars of financial instruments, such as mortgage-backed securities and federal government debt. Recently, the Fed has also started buying other kinds of securities, including corporate debt. The CFTC report recommends that climate risk be incorporated into these asset purchase programs. Similar calls are being made in Europe regarding European Central Bank purchases.
• Promoting sustainable finance. The CFTC report rightly observed that the financial sector and regulators cannot just remain in a defensive crouch, avoiding climate risks. They must also be part of the solution. The report lists many examples of what can be done in this area. In particular, regulators should support the development of standards that enable investors to distinguish between truly “green” or “sustainable” financial products from those that merely exaggerate or misrepresent these qualities. Also, the report calls for reducing barriers to companies who want to offer ESG (environmental, social, and governance) friendly investment to their workers’ retirement plan options, a measure that could shift billions of dollars toward sustainable and climate-smart investments without trading off financial returns for retirees.
• U.S. leadership. With the largest financial system in the world, the United States cannot sit this one out. Instead, it should join the international conversation and become a full member of key international groups working on this issue, such as the Network of Central Banks and Supervisors for Greening the Financial System. It should also ensure that the G7 and G20 keep climate risk on top of mind and on their meeting agendas.

We hope that the CFTC group’s report will catch the attention and imagination of U.S. decision-makers, with the full understanding that the way forward will be hard. Climate risk is not one risk, but bundles of complex risks that interact with each other and with existing vulnerabilities in our financial system. Also, these risks are heading toward us at an accelerating pace. Yet, as the report concludes, U.S. regulators already have most of the authority they need under existing legislation to start addressing the challenge. What is needed now is the political will to do it.