A watershed CFTC report highlights the dangers of climate change to the US economy, and provides a broad risk-mitigation roadmap.

By Jean-Philippe Brisson, Paul A. Davies, Nicola Higgs, Yvette D. Valdez, R. Andrew Westgate, Kristina S. Wyatt, and Deric Behar

On September 9, 2020, the US Commodity Futures Trading Commission’s (CFTC’s) Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee (MRAC) published Managing Climate Risk in the U.S. Financial System (the Report) — a first-of-its-kind publication from a US regulator focusing on the systemic threat that climate change poses to the stability of the US financial system.

The Report is the product of the collaborative effort of the CFTC and a diverse advisory panel of 34 market participants across industries and sectors, including investors; non-governmental organizations; investment banks; academic organizations; and insurance, agriculture, and oil and gas companies.

The Report calls on legislators and market regulators to overcome what it describes as “political inertia” and to take urgent and decisive action commensurate with the risks. To that end, the Report presents a broad range of concrete recommendations, designed to either directly or indirectly mitigate the risks that climate change poses to the US financial markets and long-term economic growth.

The Dangers of Climate Change

The Report emphasizes that climate risk affects a broad range of sectors, geographies, and asset classes. The impacts may be felt simultaneously across multiple sectors and asset classes throughout the United States (systemic shocks), or they may affect discrete sectors, asset classes, or geographic regions within the United States (sub-systemic shocks). They may emerge within both short- and long-term time horizons. Emerging climate risks such as global warming and extreme weather events are able to destabilize markets, not only by inflicting economically significant physical damage, but also by precipitating disorderly fluctuations in asset prices. Furthermore, the COVID-19 pandemic has strained household, municipal, federal, and corporate treasuries, making the threat of cascading economic shock even more ominous.

An Unprecedented Clarion Call

The Report provides 53 recommendations to legislators and regulators designed to facilitate the transition to a more resilient and sustainable economy. Some of the key recommendations are to:

  • Establish an economy-wide price on carbon to reduce net greenhouse gas emissions
  • Incorporate attention to climate risks into existing regulatory frameworks, research, and operations
  • Create appropriate market incentives to facilitate capital flow and accurate pricing of climate-related risks
  • Mandate that firms embed climate risk monitoring and management into governance frameworks along with clearly defined oversight responsibilities
  • Strengthen and standardize requirements for public companies on climate risk disclosure
  • Implement climate risk stress-testing for financial institutions
  • Require credit rating agencies to disclose the extent to which their ratings take into account climate risk
  • Foster the development of reliable data and analytical tools to measure and manage climate-related financial risks
  • Allow for the development of new derivatives contracts to enable hedging of climate-related risks, and encourage the incorporation of sustainability elements into existing derivatives contracts
  • Permit environmental, social, and governance (ESG) considerations in retirement and pension fund management
  • Establish climate finance labs or regulatory sandboxes to promote innovation in the creation of climate risk tools and financial products and services that integrate climate risk mitigation
  • Collaborate with international counterparts to address climate risks

A Global Perspective

While the Report notes that “the United States remains, at best, a reluctant participant in these efforts [to address climate risk in the financial system], and in some cases, it is absent,” the issue has been a top priority for other global regulators for some time. The Report represents an important addition to the work of other regulators’ initiatives, such as those in: Hong Kong (HKMA White Paper on Green and Sustainable Banking, June 2020); Singapore (MAS Guidelines on Financial Risk Management, June 2020); the UK (Bank of England Supervisory Statement (SS3/19) on banks’ and insurers’ approaches to managing the financial risks from climate change, April 2019, and the Climate Financial Risk Forum (CFRF), a guide for insurers, banks, and asset managers on how to approach climate-related financial risk, June 2020); as well as a broad regulatory framework developed under the European Commission’s Sustainable Finance Action Plan.

Planning Ahead and Taking Action

According to a statement by CFTC Commissioner Rostin Behnam, who initiated the CFTC’s effort to examine climate-related impacts on the financial system, the Report is intended to provide policymakers, regulators, and stakeholders with the necessary tools to “begin the process of taking thoughtful and intentional steps toward building a climate-resilient financial system.”

Transitioning the economy to climate-risk resilience poses its own set of risks, and the Report acknowledges that regulators and legislators must approach climate risk in a way that is not destabilizing to the economy.

The Report comes at a vital moment for the US and global economies, as unpredictable climate fluctuations and extreme weather events exact heavy financial tolls around the globe. The stark warnings in the Report and urgent call to action by one of the premier regulatory agencies in the US should help to galvanize lawmakers to protect the US economy and its participants from climate risks.

Latham & Watkins will continue to monitor developments in this area.

The AFME White Paper on Managing the Transition to Sustainable Finance, authored by Latham lawyers, serves as a resource for financial institutions seeking counsel on managing the transition to sustainable finance. The paper highlights 15 principles together with practical considerations for achieving them. Each of the principles is linked to the relevant ESG voluntary standards and mandatory rules for each type of firm, so as to help financial institutions embed them within ESG implementation plans.