A recent report from the US Commodity Futures Trading Commission encourages financial regulators to consider the risks climate change poses to the US financial system and includes recommendations for addressing these risks.
The US Commodity Futures Trading Commission (CFTC) Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee released a report titled Managing Climate Risk in the US Financial System on September 9, 2020. The report’s overarching goal is to highlight the critical importance of US financial regulators recognizing that climate change poses risks to the US financial system and taking action to address these risks. The report encourages regulators to provide solutions, and concludes with 53 recommendations for moving forward to address the risks climate changes poses to the US financial system. Various market participants issued statements generally supporting the report and continued engagement with regulators.
Overview of Report
The report explains the climate-related physical and transition risks facing the US economy and financial system. Physical risks include physical climate change effects, such as effects on infrastructure, human health, agricultural productivity, current and expected economic activity, and asset valuations and firms, as well as on financial institutions, market functioning, and system stability. Transition risks, arising from uncertainties and substantive changes, include market, credit, legal, policy, technological, and reputational risks. The report explains how transition risks could lead to stranded assets or value.
From the perspective of financial regulators, the report reviews the challenge of climate risk, including uncertainty related to climate risk management and the potential for systemic shocks and liquidity disruptions, and regulators’ existing authorities with recommendations for actions to address risks outlined in the report.
The report also demonstrates the types of assets exposed to climate change (see below table), and provides guidance on how financial institutions can manage climate risk, including by using consistent, comparable, and reliable climate data and analytics.
Table 3.1: Categories of Assets Exposed to Climate Change Impacts
Financial assets directly tied to real property
- Commercial mortgage-backed securities (CMBS)
- Commercial real estate (CRE) bank loans
- Government-sponsored enterprise (GSE) Credit Risk Transfer securities
- Real Estate Investment Trusts (REITs)
- Residential mortgage-backed securities (RMBS)
- Residential mortgages
Financial assets tied to infrastructure
- Debt and equities of power and water utilities and communications companies
- Debt and equities of public and private transportation infrastructure
Financial assets tied to companies with businesses models or operations likely to be impacted by physical or transition risk
Equities and debt of firms in the following sectors:
- Airlines and the broader transportation sector
- Cement, steel, chemicals, plastics
- Energy, including coal, oil, and gas production
- Metals and mining
- Power generation
- Service and infrastructure providers to oil and gas
Financial assets tied to insurance coverage providers
- Insurance and reinsurance company debt and equities
- Insurance linked securities (ILS)
Financial assets tied to streams of government revenue
- Municipal bonds
- Sovereign bonds
The report uses climate scenarios that can help provide regulators and companies with useful insights to plan appropriately. The report also discusses ways the current disclosure regime can be strengthened to disclose climate risk. Finally, the report describes ways the financial system can facilitate capital flows “toward activities and technologies that promote the transition to a resilient, net-zero emissions economy, including new and existing instruments that integrate and help effectively manage climate risk.”
The report sets forth 53 recommendations to mitigate the risks to financial markets posed by climate change, with a focus on the types of actions the CFTC, Financial Stability Oversight Council, and other federal financial regulators should take. We summarize some key recommendations below.
Working with the Private Sector
- Working closely with financial institutions, regulators should undertake—as well as assist financial institutions to undertake on their own—pilot climate risk stress testing as is being undertaken in other jurisdictions and as recommended by the Central Banks and Supervisors Network for Greening the Financial System. This climate risk stress testing pilot program should include institutions such as agricultural, community banks, and non-systemically important regional banks (Recommendation 4.8). In this context, regulators should prescribe a consistent and common set of broad climate risk scenarios, guidelines, and assumptions and mandate assessment against these scenarios (Recommendation 6.6).
- Financial authorities should consider integrating climate risk into their balance sheet management and asset purchases, particularly relating to corporate and municipal debt (Recommendation 4.10).
- State insurance regulators should require insurers to assess how their underwriting activity and investment portfolios may be impacted by climate-related risks and, based on that assessment, require them to address and disclose these risks (Recommendation 4.12).
- Financial regulators, in coordination with the private sector, should support the development of US-appropriate standardized and consistent classification systems or taxonomies for physical and transition risks, exposure, sensitivity, vulnerability, adaptation, and resilience, spanning asset classes and sectors, in order to define core terms supporting the comparison of climate risk data and associated financial products and services. To develop this guidance, the United States should study the establishment of a Standards Developing Organization composed of public and private sector members (Recommendation 5.2).
- Material climate risks must be disclosed under existing law, and climate risk disclosure should cover material risks for various time horizons. To address investor concerns around ambiguity on when climate change rises to the threshold of materiality, financial regulators should clarify the definition of materiality for disclosing medium- and long-term climate risks, including through quantitative and qualitative factors, as appropriate (Recommendation 7.2).
- In light of global advancements in the last 10 years in understanding and disclosing climate risks, regulators should review and update the US Securities and Exchange Commission’s 2010 guidance on climate risk disclosure to achieve greater consistency in disclosure to help inform the market. Regulators should also consider rulemaking, where relevant, and ensure implementation of the guidance (Recommendation 7.5).
- Regulators should require listed companies to disclose Scope 1 and 2 emissions. As reliable transition risk metrics and consistent methodologies for Scope 3 emissions are developed, financial regulators should require their disclosure, to the extent they are material (Recommendation 7.6).
US Government Efforts
- The United States should establish a price on carbon. It must be fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement. This is the single most important step to manage climate risk and drive the appropriate allocation of capital (Recommendation 1).
- 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, including into their existing monitoring and oversight functions (Recommendation 4.1).
- The United States should consider integration of climate risk into fiscal policy, particularly for economic stimulus activities covering infrastructure, disaster relief, or other federal rebuilding. Current and ongoing fiscal policy decisions have implications for climate risk across the financial system (Recommendation 8.1).
- Financial regulators should establish climate finance labs or regulatory sandboxes to enhance the development of innovative climate risk tools as well as financial products and services that directly integrate climate risk into new or existing instruments (Recommendation 8.3).
- The United States and financial regulators should review relevant laws, regulations, and codes and provide any necessary clarity to confirm the appropriateness of making investment decisions using climate-related factors in retirement and pension plans covered by the Employee Retirement Income Security Act (ERISA), as well as non-ERISA managed situations where there is fiduciary duty. This should clarify that climate-related factors—as well as environmental, social, and governance factors that impact risk return more broadly—may be considered to the same extent as “traditional” financial factors, without creating additional burdens (Recommendation 8.4).
Commissioner Rostin Behnam, the sponsor of the CFTC’s Market Risk Advisory Committee, testified before the House Select Committee on the Climate Crisis on October 1, 2020. The hearing was held to discuss how the climate crisis aggravates economic harm and injustice and potential strategies for enhancing financial systems and access to capital to support economic recovery.
Commissioner Behnam discussed the Market Risk Advisory Committee’s work and the CFTC report, highlighting the importance of addressing climate risk and some of the report’s recommendations. While Commissioner Behnam appears to have gained momentum on climate risk issues, market participants should continue to engage with regulators and be a part of the process developing regulatory frameworks that attempt to mitigate against climate risk.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Kirstin E. Gibbs
Michael M. Philipp