U.S. regulator advisory committee recommends steps to address systemic financial risks from climate change

U.S. investors’ approach to climate change risks

Many asset owners and managers have urged regulators in the United States to address climate change as a systematic risk, even taking significant steps such as divesting from coal and accounting for climate risks in their investment policies.

In January this year, Larry Fink, the CEO of BlackRock, published an open letter in which he said that “climate risk is investment risk” and urged the financial sector to prepare for a “fundamental reshaping of finance” and a significant reallocation of capital as a result. More recently, a survey of U.S. financial advisors, high-net-worth individuals and institutional investors carried out by Federated Hermes found that environmental, social and governance (“ESG”) risk evaluation is becoming a key part of investment programs and that investors are becoming more sophisticated in their approach to ESG and sustainable investing.

Despite such appeals from certain investors, however, the U.S. government has been rolling back policies to control greenhouse gas emissions domestically and has largely been absent from international efforts to address sustainability risks. For example, earlier this year, the U.S. Department of Labor proposed a rule that could restrict certain pension administrators’ ability to select investments pursuant to non-financial objectives, including ESG objectives. More recently, Hester Peirce, a commissioner of the Securities and Exchange Commission (“SEC”), reiterated her support of the “tried and true” principles-based disclosure policy of the SEC–premised on materiality–in lieu of a more standardized disclosure framework around ESG. Commissioner Peirce’s position is favoured by the current majority of the five-member SEC.

However, on September 9, 2020, the Climate-Related Market Risk subcommittee of the U.S. Commodity Futures Trading Commission (“CFTC”) published a 165-page report “Managing Climate Risk in the U.S. Financial System,” (the “Report”) warning that “a world racked by frequent and devastating shocks from climate change cannot sustain the fundamental conditions supporting our financial system” and concluding that climate change poses systemic risks to the U.S. financial system. Further, the Report urges the United States to take responsibility as the second-largest emitter of greenhouse gases and to start actively engaging in the initiatives to manage climate-related financial and market risks. The recent announcement by China’s President pledging to make China carbon neutral by 2060 has raised the stakes considerably. While the Report was not officially adopted by the CFTC and it is not binding, it is noteworthy as an urgent call for clear regulatory action and coordination on recommended steps that may well be taken forward by a new U.S. administration depending on the results of the impending national election.

The Report

The Report includes a list of 53 comprehensive and far-reaching recommendations for understanding and managing climate risks. These recommendations were endorsed by the 34 members of the CFTC subcommittee representing banks, asset managers, academia and environmental groups. Because climate change is recognized as a complex, multi-faceted problem that no single agency or even single country can solve, the recommendations include guidance for lawmakers as well as various regulatory agencies. The recommendations embody an agreed direction for U.S. financial stakeholders in identifying, measuring and effectively managing emerging climate-related risks.

A few of these recommendations are worth highlighting from a corporate ESG perspective:

Carbon Pricing

According to the Report, at the heart of the climate change issue is the market’s inability to price in the negative externalities of greenhouse gas emission. The current market treats the environmental cost of greenhouse gas-emitting activities (such as burning fossil fuel and cutting down trees) as “free,” and thus the market has no incentive to curtail the emissions. To help the market derive an appropriate allocation of capital, the Report urges Congress to institute an economy-wide pricing scheme for carbon emissions that is “fair… and effective in reducing emissions consistent with the Paris Agreement.” The Report emphasizes getting the incentive right as the first and foremost step for decisively addressing climate change.

Oversight of Climate Risk

The Report notes that U.S. regulators have sufficient authority to start tackling climate risk immediately and calls upon various regulatory bodies to use their existing authority to monitor and manage climate risk. Specifically, the Dodd-Frank Act of 2010 provides regulators with broad authority and the tools to help ensure that financial institutions, broker-dealers, and other key market participants identify and manage climate risk effectively. Under the mandate of the Dodd-Frank Act, the regulatory bodies have a broad reach to oversee banks and other nonbank companies, commodities and derivatives markets, insurance companies and credit rating agencies, which are all vulnerable to systemic risks posed by climate change. To that end, the Report advises regulators to establish a clear framework with appropriate milestones for overseeing and managing environmental risks.

Disclosure

Notably, the Report includes proposed guidelines for a unified framework for climate risk disclosure. The proposed guidelines underscore the need for a regime that produces “decision useful” disclosures. While there are several disparate disclosure frameworks in the United States, the Report notes that information disclosed under each approach falls short of what capital market actors need in order to adequately integrate climate risks into their decision making.

The Report recommends that the SEC review and update its 2010 Guidance on climate risk disclosure to include experience gleaned in the past ten years. In addition, the Report suggests that U.S. regulators build on their global counterparts’ models and issue new rules for climate risk disclosures. The Report identifies several foreign disclosure regimes that the United States can adapt to its own context. Indeed, existing regimes on the other side of the Atlantic, such as the European Commission’s Guidelines on Reporting Climate-related Information, have been studied and tested and may provide a relatively clear roadmap to building a system-wide disclosure regime in the United States. The hope is that the United States will be able to devise a flexible approach that suits the needs of the financial institutions while balancing the need to address climate risks.

What next?

While the CFTC subcommittee’s recommendations are not binding, the key message in the Report is compelling: climate change will, over time, touch virtually every sector and region of the United States. A financial system that is better able to measure and manage the risks will be better positioned to absorb and recover from climate-related failures. The Report also points out that financial stability is not an end in itself—it is a means to protect the assets of millions of Americans and to ensure that the financial system continues to support their goals and aspirations.

Whether the Report will make a difference and prod action remains to be seen, but the hope is that, at a minimum, it will serve as a policy roadmap for reaching common ground in addressing climate change in the context of financial sustainability.

For further information on ESG issues in the United States, see our videocast: Snapshot of divergent UK/U.S. approaches to ESG and client briefing: The ESG landscape and opportunities on both sides of the Atlantic.