MANAGING CLIMATE RISK IN
THE U.S. FINANCIAL SYSTEM
Report of the Climate-Related Market Risk Subcommittee,
Market Risk Advisory Committee of the
U.S. Commodity Futures Trading Commission
Commissioner Rostin Behnam, Sponsor
Bob Litterman, Chairman
Library of Congress Control Number: 2020915930
ISBN: 978-0-578-74841-2
This report is approved by the Subcommittee on Climate-Related Market Risk of the Market Risk Advisory
Committee (MRAC). The views, analyses, and conclusions expressed herein reect the work of the
Subcommittee on Climate-Related Market Risk of the MRAC, and do not necessarily reect the views of
the MRAC, the Commodity Futures Trading Commission or its staff, or the U.S. Government. Reference
to any products, services, websites, organizations, or enterprises, or the use of any organization, trade,
rm, or corporation name is for informational purposes only and does not constitute endorsement,
recommendation, or favoring by the U.S. Government.
To view individual subcommittee members’ concurring statements, if any, please see cftc.gov.
MANAGING CLIMATE RISK IN
THE U.S. FINANCIAL SYSTEM
Report of the Climate-Related Market Risk Subcommittee,
Market Risk Advisory Committee of the
U.S. Commodity Futures Trading Commission
Commissioner Rostin Behnam, Sponsor
David Gillers, Chief of Staff, Office of Commissioner Behnam
Bob Litterman, Chairman
Leonardo Martinez-Diaz, Editor
Jesse M. Keenan, Editor
Stephen Moch, Associate Editor
Executive Summary ....................................................i
List of Tables and Figures ...............................................xi
List of Acronyms and Abbreviations ......................................xiii
Foreword ..........................................................xvii
Chapter 1: Introduction to Finance in the Face of Climate Change ................1
Chapter 2: Physical and Transition Risks in the Context of the United States .......11
Chapter 3: Implications of Climate Change for the U.S. Financial System. . . . . . . . . . 25
Chapter 4: Existing Authorities and Recommendations for Financial Regulators .....41
Chapter 5: A Closer Look at Climate Risk Management and Data ...............55
Chapter 6: A Closer Look at Climate Scenarios .............................73
Chapter 7: A Closer Look at Climate Risk Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . 87
Chapter 8: A Closer Look at Financing the Net-Zero Transition ................103
Conclusion ........................................................119
List of Recommendations .............................................123
References ........................................................137
Appendix .........................................................159
Members of the Climate-Related Market Risk Subcommittee. . . . . . . . . . . . . . . . . . 163
Table of Contents
Climate change poses a major risk to the stability of the U.S. nancial system and to
its ability to sustain the American economy. 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 signicant 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.
This reality poses complex risks for the U.S. nancial system. Risks include disorderly
price adjustments in various asset classes, with possible spillovers into different parts of
the nancial system, as well as potential disruption of the proper functioning of nancial
markets. In addition, the process of combating climate change itself—which demands a
large-scale transition to a net-zero emissions economy—will pose risks to the nancial
system if markets and market participants prove unable to adapt to rapid changes in policy,
technology, and consumer preferences. Financial system stress, in turn, may further
exacerbate disruptions in economic activity, for example, by limiting the availability of credit
or reducing access to certain nancial products, such as hedging instruments and insurance.
A major concern for regulators is what we don’t know. While understanding about particular
kinds of climate risk is advancing quickly, understanding about how different types of climate
risk could interact remains in an incipient stage. Physical and transition risks may well
unfold in parallel, compounding the challenge. Climate risks may also exacerbate nancial
system vulnerabilities that have little to do with climate change, such as historically high
levels of corporate leverage. This is particularly concerning in the short- and medium-term,
as the COVID 19 pandemic is likely to leave behind stressed balance sheets, strained
government budgets, and depleted household wealth, which, taken together, undermine
the resilience of the nancial system to future shocks.
i
EXECUTIVE SUMMARY
Executive Summary
The central message of this report is that U.S. nancial regulators must recognize
that climate change poses serious emerging risks to the U.S. nancial system, and
they should move urgently and decisively to measure, understand, and address these
risks. Achieving this goal calls for strengthening regulators’ capabilities, expertise, and
data and tools to better monitor, analyze, and quantify climate risks. It calls for working
closely with the private sector to ensure that nancial institutions and market participants
do the same. And it calls for policy and regulatory choices that are exible, open-ended,
and adaptable to new information about climate change and its risks, based on close and
iterative dialogue with the private sector.
At the same time, the nancial community should not simply be reactive—it should
provide solutions. Regulators should recognize that the nancial system can itself be a
catalyst for investments that accelerate economic resilience and the transition to a net-zero
emissions economy. Financial innovations, in the form of new nancial products, services,
and technologies, can help the U.S. economy better manage climate risk and help channel
more capital into technologies essential for the transition.
Findings of the Report
This report begins with a fundamental nding—nancial markets will only be able to
channel resources efciently to activities that reduce greenhouse gas emissions if an
economy-wide price on carbon is in place at a level that reects the true social cost of
those emissions. Addressing climate change will require policy frameworks that incentivize
the fair and effective reduction of greenhouse gas emissions. In the absence of such a price,
nancial markets will operate suboptimally, and capital will continue to ow in the wrong
direction, rather than toward accelerating the transition to a net-zero emissions economy.
At the same time, policymakers must be sensitive to the distributional impacts of carbon
pricing and other policies and ensure that the burden does not fall on low-to-moderate
income households and on historically marginalized communities. This report recognizes
that pricing carbon is beyond the remit of nancial regulators; it is the job of Congress.
A central nding of this report is that climate change could pose systemic risks to the
U.S. nancial system. Climate change is expected to affect multiple sectors, geographies,
and assets in the United States, sometimes simultaneously and within a relatively short
timeframe. As mentioned earlier, transition and physical risks—as well as climate and
non-climate-related risks—could interact with each other, amplifying shocks and stresses.
This raises the prospect of spillovers that could disrupt multiple parts of the nancial system
simultaneously. In addition, systemic shocks are more likely in an environment in which
nancial assets do not fully reect climate-related physical and transition risks. A sudden
revision of market perceptions about climate risk could lead to a disorderly repricing of
assets, which could in turn have cascading effects on portfolios and balance sheets and
therefore systemic implications for nancial stability.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
ii
At the same time, this report nds that regulators should also be concerned about the
risk of climate-related “sub-systemic” shocks. Sub-systemic shocks are dened in this
report as those that affect nancial markets or institutions in a particular sector, asset
class, or region of the country, but without threatening the stability of the nancial system
as a whole. This is especially relevant for the United States, given the country’s size and
its nancial system, which includes thousands of nancial institutions, many regulated at
the state level. Sub-systemic shocks related to climate change can undermine the nancial
health of community banks, agricultural banks, or local insurance markets, leaving small
businesses, farmers, and households without access to critical nancial services. This is
particularly damaging in areas that are already underserved by the nancial system, which
includes low-to-moderate income communities and historically marginalized communities.
The report nds that, in general, existing legislation already provides U.S. nancial
regulators with wide-ranging and exible authorities that could be used to start addressing
nancial climate-related risk now. This is true across four areas—oversight of systemic
nancial risk, risk management of particular markets and nancial institutions, disclosure
and investor protection, and the safeguarding of nancial sector utilities. Presently, however,
these authorities and tools are not being fully utilized to effectively monitor and manage
climate risk. Further rulemaking, and in some cases legislation, may be necessary to ensure
a coordinated national response.
While some early adopters have moved faster than others in recent years, regulators
and market participants around the world are generally in the early stages of under-
standing and experimenting with how best to monitor and manage climate risk. Given
the considerable complexities and data challenges involved, this report points to the need
for regulators and market participants to adopt pragmatic approaches that stress continual
monitoring, experimentation, learning, and global coordination. Regulatory approaches in
this area are evolving and should remain open to renement, especially as understanding
of climate risk continues to advance and new data and tools become available.
Insufcient data and analytical tools to measure and manage climate-related nancial
risks remain a critical constraint. To undertake climate risk analysis that can inform
decision-making across the nancial system, regulators and nancial institutions need
reliable, consistent, and comparable data and projections for climate risks, exposure,
sensitivity, vulnerability, and adaptation and resilience. Demand will likely grow for public
and open access to climate data, including for primary data collected by the government.
Public data will enable market participants to, among other things, compare publicly
available disclosure information and sustainability-benchmarked nancial products. At
the same time, proprietary data and analytical products can introduce innovations that
improve climate risk management. A key challenge will be how best to balance the need
for transparency through public data on one hand, with the need to foster private innovation
through proprietary data, on the other.
iii
EXECUTIVE SUMMARY
The lack of common denitions and standards for climate-related data and nancial
products is hindering the ability of market participants and regulators to monitor and
manage climate risk. While progress has been made in this area thanks to voluntary
disclosure frameworks and work by foreign regulators, the lack of standards, and differences
among standards, remains a barrier to effective climate risk management. The problem is
compounded by a lack of international coordination on data and methodology standards.
A common set of denitions for climate risk data, including modeling and calculation
methodologies, is important for developing the consistent, comparable, and reliable data
required for effective risk management. Also, taxonomies or classication systems can
help foster greater transparency and comparability in markets for nancial products labeled
as “green” or “sustainable.”
Climate-related scenario analysis can be a useful tool to enable regulators and market
participants to understand and manage climate-related risks. Scenarios illustrate the
complex connections and dependencies across technologies, policies, geographies, societal
behaviors, and economic outcomes as the world shifts toward a net-zero emissions future.
Scenario analysis can help organizations integrate climate risks and opportunities into a
broader risk management framework, as well as understand the potential short-term impact
of specic triggering events. Scenario analysis is gaining traction in several contexts, both
domestically and internationally, and regulators are increasingly using scenario analysis to
foster greater risk awareness among nancial market actors.
Yet, the limitations of scenario analysis should be recognized. While useful, climate
scenarios and the models that analyze them have important limitations. Scenarios are
sensitive to key assumptions and parameters, most have been developed for purposes
other than nancial risk analysis, and they cannot fully capture all the potential effects of
climate- and policy-driven outcomes. Scenario analysis should have a valuable place in the risk
management toolkit, but it should be used with full awareness of what it can and cannot do.
The disclosure by corporations of information on material, climate-related nancial risks
is an essential building block to ensure that climate risks are measured and managed
effectively. Disclosure of such information enables nancial regulators and market participants
to better understand climate change impacts on nancial markets and institutions. Issuers
of securities can use disclosure to communicate risk and opportunity information to capital
providers, investors, derivatives customers and counterparties, markets, and regulators.
Issuers of securities can also use disclosures to learn from peers about climate-related
strategy and best practices in risk management. Investors can use climate-related disclosures
to assess risks to rms, margins, cash ows, and valuations, allowing markets to price risk
more accurately and facilitating the risk-informed allocation of capital.
Demand for disclosure of information on material, climate-relevant nancial risks
continues to grow, and reporting initiatives have led to important advances. Investors
and nancial market actors have long called for
decision useful
climate risk disclosures,
and in 2019, more than 630 investors managing more than $37 trillion signed the
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
iv
Global Investor Statement to Governments on Climate Change
, which called on governments
to improve climate-related nancial reporting. Disclosure frameworks have been developed
to enhance the quality and comparability of corporate disclosures, most notably, the Task
Force on Climate-related Financial Disclosures (TCFD). Also, in 2010, the U.S. Securities
and Exchange Commission (SEC) published
Commission Guidance Regarding Disclosure
Related to Climate Change
, which provides public companies with interpretive guidance
on existing SEC disclosure requirements as they apply to climate change.
However, the existing disclosure regime has not resulted in disclosures of a scope,
breadth, and quality to be sufciently useful to market participants and regulators. While
disclosure rates are trending in a positive direction, an update published by the TCFD found
that surveyed companies only provided, on average, 3.6 of the 11 total TCFD recommended
disclosures. Large companies are increasingly disclosing some climate-related information, but
signicant variations remain in the information disclosed by each company, making it difcult
for investors and others to understand exposure and manage climate risks. In addition, the
2010 SEC
Guidance
has not resulted in high-quality disclosure across U.S. publicly listed
rms; it could be updated in light of global advancements in the past 10 years.
In addition to the absence of an economy-wide carbon pricing regime in the United
States, other barriers are holding back capital from owing to sustainable, low-carbon
activities. One involves the misperception among mainstream investors that sustainable
or ESG (environmental, social, and governance) investments necessarily involve trading
off nancial returns relative to traditional investment strategies. Another is that the market
for products widely considered to be “green” or “sustainable” remains small relative to
the needs of institutional investors. In addition, lack of trust in the market over concerns of
potential “greenwashing” (misleading claims about the extent to which a nancial product
or service is truly climate-friendly or environmentally sustainable) may be holding back the
market. And policy uncertainty also remains a barrier, including in areas such as regulation
affecting the nancial products that U.S. companies may offer their employees through
their employer-provided retirement plans.
These barriers can be addressed through a variety of initiatives. For example, a wide range
of government efforts—through credit guarantees and other means of attracting private capital
by reducing the risks of low-carbon investments—catalyze capital ows toward innovation
and deployment of net-zero emissions technologies. A new, unied federal umbrella could
help coordinate and expand these government programs and leverage institutional capital
to maximize impact and align the various federal programs. Climate nance labs, regulatory
sandboxes, and other regulatory initiatives can also drive innovation by improving dialogue
and learning for both regulators and market innovators, as well as via business accelerators,
grants, and competitions providing awards in specic areas of need. In addition, clarifying
existing regulations on duciary duty, including for example, those concerning retirement
and pension plans, to conrm the appropriateness of making investment decisions using
climate-related factors—and more broadly, ESG factors that impact risk-return—can help
unlock the ow of capital to sustainable activities and investments.
v
EXECUTIVE SUMMARY
Derivatives markets can be part of the solution. Renements or modications could be
made to existing instruments to reduce derivatives market participants’ risk exposure. For
example, commodity derivatives exchanges could address climate and sustainability issues
by incorporating sustainability elements into existing contracts and by developing new
derivatives contracts to hedge climate-related risks. New products may include weather,
ESG, and renewable generation and electricity derivatives. However, development of new
derivatives will require that the relevant climate-related data is transparent, reliable, and
trusted by market participants. This also applies to a wide range of asset classes that can
direct capital to climate-related opportunities and help manage climate risk.
U.S. regulators are not alone in confronting climate change as a nancial system risk;
international engagement by the United States could be signicantly more robust. Financial
regulators and other actors have launched important initiatives to tackle the challenge.
The United States already participates in the Basel Committee on Banking Supervision’s
climate task force, the International Organization of Securities Commissions (IOSCO)
sustainable nance network, and relevant committees within the Financial Stability Board
(FSB) to study climate-related nancial risks. However, at the federal level the United
States is not yet a member of the Central Banks and Supervisors Network for Greening
the Financial System (NGFS), the Coalition of Finance Ministers for Climate Action, or
the Sustainable Insurance Forum (SIF). The Group of Seven (G7) and Group of Twenty
(G20), in which the United States plays a central role, could also address this challenge
and promote international cooperation, but only if the United States is supportive.
Key Recommendations
The full list of the report’s recommendations can be found at the end of relevant chapters
and compiled in an annex at the end of this report. Below, we highlight some of the most
important.
We recommend that:
●
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 nancial 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 Financial Stability Oversight Council (FSOC)—of which the Commodity Futures
Trading Commission (CFTC) is a voting member—as part of its mandate to monitor
and identify emerging threats to nancial stability, should incorporate climate-related
nancial risks into its existing oversight function, including its annual reports and other
reporting to Congress. (Recommendation 4.2)
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
vi
●
Research arms of federal nancial regulators should undertake research on the nancial
implications of climate-related risks. This research program should cover the potential
for and implications of climate-related “sub-systemic” shocks to nancial markets and
institutions in particular sectors and regions of the United States, including, for example,
agricultural and community banks and nancial institutions serving low-to-moderate
income or marginalized communities. (Recommendation 4.3)
●
U.S. regulators should join, as full members, international groups convened to address
climate risks, including the Central Banks and Supervisors Network for Greening the
Financial System (NGFS), the Coalition of Finance Ministers for Climate Action, and
the Sustainable Insurance Forum (SIF). The United States should also engage actively
to ensure that climate risk is on the agenda of G7 and G20 meetings and bodies,
including the FSB and related committees and working groups. (Recommendation 4.6)
●
Financial supervisors should require bank and nonbank nancial rms to address
climate-related nancial risks through their existing risk management frameworks in a
way that is appropriately governed by corporate management. That includes embedding
climate risk monitoring and management into the rms’ governance frameworks,
including by means of clearly dened oversight responsibilities in the board of directors.
(Recommendation 4.7)
●
Working closely with nancial institutions, regulators should undertake—as well as
assist nancial institutions to undertake on their own—pilot climate risk stress testing
as is being undertaken in other jurisdictions and as recommended by the NGFS. 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)
●
The CFTC should undertake a program of research aimed at understanding how
climate-related risks are impacting and could impact markets and market participants
under CFTC oversight, including central counterparties, futures commission merchants,
and speculative traders and funds; the research program should also cover how the
CFTC’s capabilities and supervisory role may need to adapt to fulll its mandate in light
of climate change and identify relevant gaps in the CFTC’s regulatory and supervisory
framework. (Recommendation 4.11)
vii
EXECUTIVE SUMMARY
●
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 avail-
ability of consistent, comparable, and reliable climate risk data and analysis to advance
the effective measurement and management of climate risk. (Recommendation 5.1)
●
Financial regulators, in coordination with the private sector, should support the devel-
opment of U.S.-appropriate standardized and consistent classication systems or
taxonomies for physical and transition risks, exposure, sensitivity, vulnerability, adapta-
tion, and resilience, spanning asset classes and sectors, in order to dene core terms
supporting the comparison of climate risk data and associated nancial products and
services. To develop this guidance, the United States should study the establishment
of a Standards Developing Organization (SDO) 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, nancial
regulators should clarify the denition 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 past 10 years in understanding and disclosing
climate risks, regulators should review and update the SEC’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, nancial regulators should require their disclosure, to the extent they
are material. (Recommendation 7.6)
●
The United States should consider integration of climate risk into scal policy, partic-
ularly for economic stimulus activities covering infrastructure, disaster relief, or other
federal rebuilding. Current and ongoing scal policy decisions have implications for
climate risk across the nancial system. (Recommendation 8.1)
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
viii
●
The United States should consolidate and expand government efforts, including loan
authorities and co-investment programs, that are focused on addressing market failures
by catalyzing private sector climate-related investment. This effort could centralize
existing clean energy and climate resilience loan authorities and co-investment programs
into a coordinated federal umbrella. (Recommendation 8.2)
●
Financial regulators should establish climate nance labs or regulatory sandboxes to
enhance the development of innovative climate risk tools as well as nancial products
and services that directly integrate climate risk into new or existing instruments.
(Recommendation 8.3)
●
The United States and nancial regulators should review relevant laws, regulations
and codes and provide any necessary clarity to conrm 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 duciary duty. This should clarify
that climate-related factors—as well as ESG factors that impact risk-return more
broadly—may be considered to the same extent as “traditional” nancial factors,
without creating additional burdens. (Recommendation 8.4)
●
The CFTC should coordinate with other regulators to support the development of a
robust ecosystem of climate-related risk management products. (Recommendation 8.5)
ix
EXECUTIVE SUMMARY
Figures
Figure 2.1: Relationship Between Physical and Transition Risks
Figure 2.2: U.S. Billion-Dollar Disaster Events 1980–2020 (CPI-Adjusted)
Figure 2.3: High-level Framework for the Scenario Analysis of Physical and Transition Risks
Figure 3.1: Spatial Concentration of Gross Domestic Product
Figure 3.2: Commercial Real Estate Mortgages as a Percent (%) of Total Loans, by Bank
Size Measured in Assets
Figure 3.3: Regional Exposure to Commercial Real Estate Lending
Figure 3.4: Regional Exposure to Agricultural Lending
Figure 3.5: Municipal Bond Holdings, by Type of Holder
Figure 6.1: Relationships Between Transition Scenarios and Climate Risks
Figure 6.2: Representative Structure for Scenario Models
Tables
Table 3.1: Categories of Assets Exposed to Climate Change Impacts
Table 7.1: Sample of Leading Voluntary Frameworks
Table 7.2: Principles for Effective Disclosures
Appendix Table 1: Sample of Multi-Sector Efforts to Increase Climate Data Availability
xi
LIST OF TABLES AND FIGURES
List of Tables and Figures
AASB Auditing and Assurance Standards Board
ALM asset liability management
AMS American Meteorological Society
Amtrak National Railroad Passenger Corporation
ASCE American Society of Civil Engineers
ARPA-E Advanced Research Projects
Agency-Energy
AUASB Australian Accounting Standards Board
BES Biennial Exploratory Scenario, Bank
of England
BII BlackRock Investment Institute
BIS Bank of International Settlements
CA100 Climate Action 100+
CalPERS California Public Employees’ Retirement
System
CalSTRS The California State Teachers’ Retirement
System
CCAR Comprehensive Capital Analysis and
Review
CCS carbon capture and storage
CCUS carbon capture, utilization, and storage
CDI California Department of Insurance
CDO Climate Data Online
CDP formerly, the Climate Disclosure Project
CDS credit default swap
CDSB Carbon Disclosure Standards Board
CFTC Commodity Futures Trading Commission
CMBS commercial mortgage-backed securities
CME Chicago Mercantile Exchange
CO
2
carbon dioxide
COSO Committee of Sponsoring Organizations
of the Treadway Commission
COVID-19 Severe Acute Respiratory Syndrome
Coronavirus 2
CRD Corporate Reporting Dialogue
CRE commercial real estate
CSA Canadian Securities Administrators
DCM designated contract markets
DCO designated clearing organizations
DFA The 2010 Dodd-Frank Wall Street
Reform and Consumer Protection Act
DNB De Nederlandsche Bank
DOE U.S. Department of Energy
DOL U.S. Department of Labor
DOT U.S. Department of Transportation
xiii
LIST OF ACRONYMS AND ABBREVIATIONS
List of Acronyms and Abbreviations
DTCC Depository Trust and Clearing
Corporation
EC European Commission
ECB European Central Bank
EIA U.S. Energy Information Agency
EMMA Electronic Municipal Market Access
EPA U.S. Environmental Protection Agency
ERISA The Employee Retirement Income
Security Act of 1974
ERM enterprise risk management
ESG environmental, social and governance
ETF exchange-traded fund
ETS Emissions Trading System
EU European Union
EU ETS European Union Emission Trading System
FAM Food and Agriculture Microdata
Catalogue
Fannie Mae Federal National Mortgage Association
FAO Food and Agricultural Organization of
the United Nations
FASAB Federal Accounting Standards
Advisory Board
FASB Financial Accounting Standards Board
FCM futures commission merchants
FDIC Federal Deposit Insurance Corporation
FEMA Federal Emergency Management Agency
FINRA Financial Industry Regulatory Authority
Fintech nancial technology
FIO Federal Insurance Ofce, U.S.
Department of the Treasury
FLIGHT
F
acility
L
evel
I
nformation on
G
reen
H
ouse
G
ases
T
ool
FMU Financial Market Utilities
Freddie Mac Federal Home Loan Mortgage
Corporation
FSB Financial Stability Board
FSDA Future of Sustainable Data Alliance
FSOC Financial Stability Oversight Council
G7 Group of Seven
G20 Group of Twenty
GAO U.S. Government Accountability Ofce
GDP Gross Domestic Product
GEM Global Energy Monitor
GFOA Government Finance Ofcers Association
GHG Greenhouse Gases
GHGRP Greenhouse Gas Reporting Program
GSE Government Sponsored Enterprises
GRESB Global Real Estate Sustainability
Benchmark
GRI Global Reporting Initiative
HMC Harvard Management Company, Inc.
HSFO high-sulfur fuel oil
IAFP Investor Agenda Founding Partners
IAIS International Association of Insurance
Supervisors
IEA International Energy Agency
IFRS International Financial Reporting
Standards
IIRC International Integrated Reporting Council
ILS insurance linked securities
IMF International Monetary Fund
IOSCO International Organization of Securities
Commissions
IPCC Intergovernmental Panel on Climate
Change
IR Integrated Reporting
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
xiv
IRENA International Renewable Energy Agency
ISDA International Swaps and Derivatives
Association
ISO International Organization of
Standardization
IWG Interagency Working Group on the
Social Cost of Greenhouse Gases
LMBA London Bullion Market Association
LMI low-to-moderate income
LPO Loan Programs Ofce
LSFO low-sulfur fuel oil
MBA Mortgage Bankers Association
MD&A Management’s Discussion and Analysis
MSP major swap participants
MSRB Municipal Securities Rulemaking Board
NAIC National Association of Insurance
Commissioners
NASEM National Academies of Sciences,
Engineering, and Medicine
NCA 4th National Climate Assessment
NCD non-centrally cleared derivatives
NFIP National Flood Insurance Program
NFMA National Federation of Municipal Analysts
NGFS Central Banks and Supervisors Network
for Greening the Financial System
NOAA National Oceanic and Atmospheric
Administration
NYGB New York Green Bank
OFR Ofce of Financial Research,
U.S. Department of the Treasury
ORSA Own Risk Solvency Assessments
OTC over-the-counter derivatives or swaps
P-ROCC Physical Risks of Climate Change
PG&E Pacic Gas & Electric Company
PRA Prudential Regulatory Authority
(United Kingdom)
PRI Principles for Responsible Investment
RCP Representative Concentration Pathways
REIT Real Estate Investment Trust
RFS Renewable Fuel Standards
RGGI Regional Greenhouse Gas Initiative
RMBS residential mortgage-backed securities
RPS Renewable Portfolio Standard
SASB Sustainability Accounting Standards
Board
SCC social cost of carbon
SDG Sustainable Development Goals
SDO Standards Developing Organization
SEC U.S. Securities and Exchange
Commission
SEF swap execution facilities
SIF Sustainable Insurance Forum
TCFD Task Force on Climate-related Financial
Disclosures
TEG technical expert group
UNEP FI United Nations Environment Programme
Finance Initiative
UNFCCC United Nations Framework Convention
on Climate Change
USCRT U.S. Climate Resilience Toolkit
USDA U.S. Department of Agriculture
USGCRP U.S. Global Change Research Program
VaR Value at risk
WBCSD World Business Council for Sustainable
Development
WCI Western Climate Initiative
xv
LIST OF ACRONYMS AND ABBREVIATIONS
Bob Litterman, Chairman,
Climate-Related Market Risk Subcommittee
As this report is being nalized, the United States is in the midst of a worldwide pandemic,
with deaths already exceeding 180,000 from COVID-19, and an associated economic
collapse. Of course, there are many differences between the global pandemic, a sudden
health crisis that is expected to have impacts of perhaps a few years, and climate change—a
global threat that will play out over decades with potentially permanent consequences.
But both are similar in one crucial dimension: Science clearly indicates that the cost of
delay in responding to the risk can be devastating. A recent study suggests that, in the
case of the virus, delaying social distancing by one week in the United States doubled the
number of deaths (Pei, et al., 2020). Similarly, every year of delay in the policy response
to climate change will lead to a higher mean global temperature increase and to greater
probability of irreversible and catastrophic damages. I hope this obvious parallel will help
move forward the inevitable global policy response, which in the case of climate change
is the creation of incentives to reduce emissions.
The members of the Commodity Futures Trading Commission’s Climate-Related Market Risk
Subcommittee and I recognize that the nancial community must prepare for climate-related
risk management challenges. The smooth functioning of the nancial markets is crucial
to economic prosperity generally, and in particular to facilitating the ow of capital toward
mitigating and adapting to climate change. We appreciate Commissioner Rostin Behnam’s
leadership and timely decision to convene this subcommittee and to request this report
to guide the management of climate risk in the U.S. nancial system. We also appreciate
and thank the Market Risk Advisory Committee (MRAC) and the CFTC for their support.
The MRAC’s work to examine systemic issues that threaten the stability of the derivatives
markets and other nancial markets is critical. We hope our recommendations can play
an important role in guiding the management of climate risk in the U.S. nancial system.
xvii
FOREWORD
Foreword
This assignment as chairman of the subcommittee has entailed working with an incredibly
talented and dedicated group of climate risk management and nancial professionals.
In convening the subcommittee, Commissioner Behnam asked many of the most important
institutions that participate in the commodity and nancial markets to pick a representative
who would not only convey their interests, but who could also bring the expertise of the
entire organization. These institutions included major banks, an insurance company, energy
and agricultural market participants, investors, asset owners, universities, think tanks and
non-governmental organizations. This report represents the collective wisdom of this group
of professionals and their institutions.
My own background was well suited to lead this effort. I spent a 23-year career in risk
management and investing roles at Goldman Sachs. I am well known in the nancial
community as the co-developer, along with Fischer Black, of the Black-Litterman global
asset allocation model, which we created 30 years ago and which is still widely used in the
investment industry to build portfolios that optimally balance risk and return. As a result of
these experiences, I have a deep respect for the critical role that the nancial markets have
in facilitating the efcient allocation of capital in our market economy, and the importance
of appropriate regulation, oversight, and risk management.
I have a broad background including economics, nance, and risk management, but also
a long-term interest in biology, climate change, natural capital, and sustainable nance.
As an undergraduate I majored in human biology at Stanford University. My rst job was
as a general assignment reporter for the San Diego Union. After a year, though, I decided
to get a Ph.D. in economics, which I received from the University of Minnesota in 1979.
I taught economics at the Massachusetts Institute of Technology for two years, followed
by ve years at the Federal Reserve Bank of Minneapolis working as a staff economist
focused on economic forecasting. In 1986 I moved to Goldman Sachs and began a career
on Wall Street as one of the early nancial engineers. I started in xed income research
building nancial models, followed by a promotion to partner in 1994 when I became the
head of rm-wide risk management. In 1998, I moved to the asset management division
and headed the quantitative group. In 2009, I left Goldman and helped to create Kepos
Capital, a New York based investment management rm where I am currently a partner
and chairman of the risk committee.
My focus on climate risk began when I left Goldman Sachs. Like many others, I was
concerned that society is not adequately addressing the risks created by climate change.
The root cause of climate change is the increase in greenhouse gas (GHG) emissions
from humans. As an economist and risk professional, it has long been obvious to me that
the risks created by climate change must be addressed by the creation of appropriate
incentives to reduce carbon emissions. There is uncertainty about the precise policy levers
and tools that will be used to mitigate climate risk, and the innovations that will be required
to do so. However, at this moment, what is very clear is that the risks created from climate
change are increasing rapidly, economic incentives are misdirected, and immediate action
across the global nancial system is required.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
xviii
The Heart of the Matter
A fundamental aw in the economic system lies at the heart of the climate change problem—
the lack of appropriate incentives to reduce GHG emissions. No discussion of climate-
related nancial risk management can begin without focusing on this market failure. Financial
markets do an amazing job of allocating capital in the direction of the incentives that they
are given. Appropriate incentives arise in these markets primarily from the prices that
balance supply and demand for capital, but that is not always the case.
When negative externalities exist, as is the case with the risks and costs imposed by GHG
emissions, there is a role for government to ensure that those externalities are reected in
prices. Unfortunately, that is not happening; emissions remain mispriced and capital is owing
in the wrong direction. In fact, on average, global public policies strongly subsidize carbon
emissions from fossil fuel consumption—the International Monetary Fund (IMF) estimated
$5.2 trillion (6.5 percent of gross domestic product) in 2017 alone (Coady, et al., 2019). Given
the lack of appropriate incentives to reduce emissions, the inevitable responses in economic
behavior are directly responsible for the current rapidly accelerating increase in climate risk.
The primary obstacle is political inertia. While there is an ongoing debate about the right price
for emissions, what we do know is that inaction creates a large and growing liability. It is
very possible that each ton of carbon dioxide put into the atmosphere today will have to be
removed and sequestered at some future date to stabilize the world’s climate, an expensive
process that is not currently feasible and thus a substantial liability that this generation is
creating for future generations. If we knew today what it would cost to pull carbon dioxide out
of the atmosphere at industrial scale in the not too distant future, the present value of that
cost would give us a good sense of an upper bound on where we should price carbon today.
But, because the future is very uncertain, society today should err on the side of caution.
In the context of pricing climate risk, that implies imposing a higher price than what models
used to calculate the social cost of carbon currently suggest. Prudent risk management
calls for immediately implementing carbon pricing globally to quickly reduce GHG emissions
and to try to get the planet to net-zero emissions as soon as possible while ensuring that
the costs are shared equitably across society and that the distributional impacts are not
regressive. Of course, policy should respond to new information over time, and it is very
likely that circumstances will require that we need to go beyond net-zero and pull green-
house gases out of the atmosphere.
Managing Climate Risk
How should nancial markets and regulators respond in the face of this enormous market
failure? Nearly everyone in the nancial markets understands several fundamental principles
of risk management. The rst is that you must think about worst case scenarios. Of course,
only rarely is there a well-dened “worst case.” In the nancial community, we generally use
xix
FOREWORD
the expression “extreme, but plausible” to communicate a common-sense understanding
of this type of risk scenario. In this report, we explore a variety of risks, including those
that are extreme but plausible, which challenge the stability of the U.S. nancial system.
Second, it is well understood that the purpose of risk management is to recognize risks
and to warn when they are not being priced appropriately. Markets are in equilibrium when
assets reect not only the expected outcome, but when investors are paid an appropriate
premium for the risks that they take. In the case of climate risk, neither the expected
impacts—nor the potential for extremely bad outcomes—is being priced appropriately.
Third, time is of the essence. Given enough time, virtually any problem can be addressed.
But in risk management, time is a scarce resource. When time runs out, risk can turn into
catastrophe. With climate change, we do not know precisely when the planet’s climatic
system will be pushed past catastrophic tipping points, beyond which nancial (and other)
consequences would become non-linear. Indeed, some scientists argue that there are
thresholds which are very close or may have already been crossed. This uncertainty about
thresholds is a powerful reason not to delay.
Finally, in nancial markets we often distinguish between risk and uncertainty. Risk generally
refers to a model-based statistical measure of a probabilistic distribution, such as volatility
or Value-At-Risk (VaR). But we recognize that the real world does not behave according
to a model. Our models give us measures of risk, but what we manage in the nancial
markets is the broader concept of uncertainty, the full potential of bad outcomes when
our models are wrong. Similarly, with respect to climate change, the consequences are
highly uncertain. After all, this is the rst time we have performed this planetary experiment.
This uncertainty means that in managing climate risk we must err on the side of caution if
we are to maintain the relative stability and proper functioning of our market economies.
Unlike most nancial risks, climate risk has unique characteristics, such as the extended
time horizon over which damages are expected to occur, which make it more difcult to
measure and manage. For the nancial risk management of climate change to succeed,
we need to be able to understand how physical climate impacts and the transition to a
sustainable economy will affect the valuations of nancial instruments. To understand this,
regulators, investors, and nancial institutions require meaningful data related to risk, as
well as analytic tools that can interpret that data.
About This Report
Commissioner Behnam asked me to lead a group of expert market participants to initiate the
critical process of moving toward a climate-resilient U.S. nancial system. The commissioner
asked for a consensus document, and a process that facilitated meaningful conversations
among relevant parties on complex issues that do not t neatly into the current regulatory
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
xx
structure. I think we accomplished that task, and we found plenty to agree on. Our toughest
challenge was to keep the report to a manageable length.
What did we agree on? Let’s start with the need for appropriate incentives. We all see
that appropriate incentives are fundamental to the efcient allocation of capital. They are
urgent, they are missing, and need to be addressed. Financial markets today are not pricing
climate risk. The nancial markets cannot do that on their own. Until this fundamental aw
is xed, capital will ow in the wrong direction. That is the context for, but not the focus,
of this report.
This report reects agreement around a set of fundamental principles beyond pricing carbon,
such as the need for collaboration with international efforts to address climate-related
nancial market risk. Ultimately, these principles coalesce around the need for leadership
by the nancial regulators to guide an iterative process forward while leaving room for
American nancial innovation. It also reects a consensus about immediate next steps,
such as the need to quickly improve the quality of the data, analytics, and understanding
of the many dimensions of climate risk. We have also pointed out approaches to scenario
analysis, stress testing, and standardization of denitions that will help move us forward
on what will no doubt be a complex, iterative path toward the development of meaningful
disclosure of material climate risk information—a goal toward which we all agree we must
move more quickly.
Although we have not resolved all of the many difcult issues that need to be addressed,
we hope that we have succeeded in developing a pragmatic platform for managing the
risks and opportunities of climate change. This report makes recommendations to the
CFTC but, recognizing that no one regulator can address climate risk in isolation, we also
address this report to the wider nancial community and Congress.
Investors and nancial markets are poised to deliver the low-carbon capital and infrastructure
that our global economy requires to address climate risk. We know what we need to do and
how to do it. We are impatiently waiting for the appropriate incentives and other policies to
reduce emissions to be instituted through legislation. Only then will the awesome power
of the nancial system be able to address at scale this existential threat.
Why am I so passionate about climate risk? The answer is easy. Like others, I see what
is already happening—entire regions burned by increasing wildres, larger storms, more
frequent oods, ecosystems under mounting stress, major health impacts, and climate
refugees. In addition, I worry about the future my four grandchildren will likely experience
in the coming decades, along with the rest of their generation. Our decisions today will
have a major impact on the quality of their lives. Those of us who see the danger, recognize
the required path forward, and understand the urgency of taking action must muster the
courage and clarity of vision to do what is required now to get us on that path.
xxi
FOREWORD
While this report will be presented to the U.S. Commodity Futures Trading Commission
(CFTC), its conclusions and recommendations will also be relevant to other federal and
state nancial regulators, federal and state lawmakers, leaders in nance and business,
and the general public. Its objective is to analyze the existing and emerging risks that
climate change poses to the soundness and stability of the U.S. nancial system, and
offer recommendations. The report considers the risk of climate change impacts, such as
sea-level rise, extreme weather events, and rising temperatures, for economic activity and
nancial markets. It also takes into account the risks posed to the U.S. nancial system
by shifts in policy, technology, and consumer preferences—shifts that will be necessary
to stabilize concentrations of greenhouse gases (GHGs) and reduce the risk of the most
damaging impacts of climate change.
Importantly, since climate change will remain a matter of growing legislative interest, the
report should help inform policy debates in the U.S. Congress and state legislatures. Finally,
the report’s recommendations should be of interest to the American people, who would
ultimately benet if our country can better manage one of the most signicant threats it faces.
Over the past decade, nancial regulators, business leaders, and legislators around the
world have recognized the urgency of the challenge and embraced the need to better
manage climate-related nancial and market risks. Many countries have adopted legisla-
tion, guidance, and other initiatives to advance this goal. In addition, myriad international
initiatives, working groups, task forces, coalitions, and other efforts have emerged to
facilitate collaborative solutions and accelerate learning and information exchange. The
United States has been involved in, and has even led, some of these international efforts;
but it is noticeably absent in others. As the world’s largest economy and second-largest
emitter of GHGs, the United States must engage in—and lead—these initiatives. They
are in the best interest of the nation, particularly since neither climate change nor nancial
crises respect national boundaries.
1
CHAPTER 1: INTRODUCTION TO FINANCE IN THE FACE OF CLIMATE CHANGE
Introduction to Finance in
the Face of Climate Change
Chapter 1
At the same time, managing climate-related nancial risks requires close attention to the
unique circumstances of the United States. They include the idiosyncrasies of our complex
system of nancial regulation, as well as existing and proposed legislation. It also must
take into account the central role that the private sector plays in our nancial system, and
the importance of consultation and collaboration between the private and public sectors
in the design of new policies.
Finally, it is worth noting two interrelated challenges. One is safeguarding the soundness
and stability of the nancial system in the face of climate change. The main goal here is
to responsibly manage climate risk to protect the system’s ability to serve the American
public, support economic activity and entrepreneurship, and safeguard the assets of millions
of savers, retirees, institutions, and businesses. The second challenge involves helping
the nancial system facilitate the transition to a low-carbon, climate-resilient economy.
Central to this challenge is identifying ways nancial markets and institutions can channel
signicantly more capital toward sustainable investments and net-zero-emission activities,
including low-carbon and renewable energy, energy efciency, other net-zero or low-carbon
technologies for transportation, industry and agriculture, and resilience against climate
impacts. “Net-zero” refers to activities or investments that seek a net neutral balance
between GHG emissions produced and removed from the atmosphere.
This report focuses primarily on nancial stability in the face of climate change. However,
the report devotes a chapter to sustainable investment, recognizing its role in climate risk
management and that, ultimately, a stable and well-functioning nancial system is incompat-
ible with unmitigated climate change. A world racked by frequent and devastating shocks
from climate change cannot sustain the fundamental conditions supporting our nancial
system. Promoting the transition to a net-zero emissions economy and safeguarding
nancial stability are consistent, mutually reinforcing objectives.
The State of Play
As a starting point, this report acknowledges the U.S. government’s ofcial position on the
scientic consensus on the causes, occurrence, and impacts of climate change. Departments
and agencies of the U.S. government, as mandated by the Global Change Research
Act of 1990 and operating through U.S. Global Change Research Program (USGCRP),
must record and report on the scientic consensus on the causes and impacts of climate
change. The most recent, ofcially promulgated report to Congress is known as the Fourth
National Climate Assessment (NCA). As reected in the NCA, the consensus of the U.S.
government is that it is “extremely likely that human activities, especially emissions of
greenhouse gases, are the dominant cause of the observed warming since the mid-20th
century” (Wuebbles, et al., 2017, p. 1).
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
2
Limiting GHG concentrations to a level consistent with a warming of well below 2 degrees
Celsius above pre-industrial levels—the core objective of the Paris Agreement on climate
change—is therefore essential to achieve a reasonable probability of avoiding irreversible,
catastrophic impacts. The best current science suggests that, to reach that goal, global
emissions must peak during the current decade and then decline rapidly, reaching net-zero by
mid-century. Limiting warming to 1.5 degrees Celsius would yield very signicant additional
benets in the form of avoided damage to human populations as well as ecosystems
(IPCC, 2018).
But, despite efforts by many countries, progress remains insufcient. Current policies put
the world on a path toward a future well in excess of 2 degrees Celsius. Despite a short-
term reduction in carbon dioxide (CO
2
), largely attributed to a transition away from coal, the
United States is not on track to meet either its 2020 or 2025 goals under the Paris Accord
(UNFCC, 2015; EIA, 2020; EPA, 2020). While the COVID-19 pandemic and its attendant
economic contraction will almost certainly signicantly reduce emissions globally in 2020
and possibly beyond, those reductions are expected to be temporary in the absence of
structural change. In any case, economic collapse is not a viable strategy for stabilizing
the world’s climate.
The United States’ involvement is crucial in global efforts to combat climate change because
of its size and economic weight. It is currently second only to China in emitting GHG.
Cumulatively, the United States has put more GHGs into the atmosphere than any other
country (including the European Union as a whole). It has contributed roughly one-quarter of
all CO
2
emitted since the beginning of the Industrial Revolution (Ritchie and Roser, 2017).
At the same time, the United States also remains the world’s largest and most dynamic
economy, as well as one of the largest producers and consumers of fossil fuels and energy
generally. The scope and scale of U.S. industrial activity, long-term assets, and large population
signicantly expose the United States to climate change impacts (USGCRP, 2018).
While climate change is a global phenomenon, with the United States accounting for
roughly one-sixth of annual global GHG emissions, U.S. leadership, historically, has been
indispensable to global cooperation on climate change. For example, the United States
played a key role in negotiating the United Nations Framework Convention on Climate
Change, signed by President George H. W. Bush in 1992 and ratied by the U. S. Senate
the same year. The United States also played an important role in negotiating the 1997
Kyoto Protocol, while its subsequent failure to ratify the agreement undermined its effec-
tiveness. Ultimately, the United States was a driving force in the design and international
adoption of the 2015 Paris Agreement, which has been ratied by 189 countries. That
agreement is designed to achieve broad global participation, with all countries accepting
responsibility to reduce emissions while balancing national autonomy with a clear expec-
tation of continually increasing ambition. It also promotes transparency about countries’
commitments and how well they are meeting those commitments.
3
CHAPTER 1: INTRODUCTION TO FINANCE IN THE FACE OF CLIMATE CHANGE
While the United States has formally indicated its intention to withdraw from the Paris
Agreement in November 2020, other countries are moving ahead. Most notably, the
European Union has pledged to reduce emissions by 40 percent below 1990 levels by 2030
and is now moving forward with policies to increase that reduction target to 55 percent.
Yet, no country or bloc can meet the global challenge by itself. Renewed U.S. engagement
in international climate efforts, and its embrace of policies aimed at decarbonizing the
economy, will be necessary to achieve signicant, coordinated reductions in global emissions.
The Centrality of Carbon Pricing
The British economist, Lord Nicholas Stern, in his inuential
Review of the Economics of
Climate Change
, famously called climate change “the greatest and widest-ranging market
failure the world has ever seen” (Stern, 2007). From an economic perspective, greenhouse
gas pollution is a powerful example of a negative externality. Emissions of CO
2
and other
GHGs impose signicant damages on society at large in the form of future climate impacts,
but at least in the absence of government policy, these damages remain “external” to the
calculus of individual economic agents (Stern). In effect, the environmental costs of burning
fossil fuels, cutting down tropical forests, and other emitting activities have been treated
as if they were “free
.
”
Without an effective price on carbon, nancial markets lack the most efcient incentive
mechanism to price climate risks. Therefore, all manner of nancial instruments—stocks,
bonds, futures, bank loans—do not incorporate those risks in their price. Risk that is not
quantied is difcult to manage effectively. Instead, it can build up and eventually cause a
disorderly adjustment of prices.
The global damage from an additional metric ton of CO
2
is uncertain but is captured in the
concept of the “social cost of carbon” (SCC). The U.S. government’s central estimate for
the 2020 SCC, calculated in 2016, amounts to $52 per metric ton of CO
2
in current dollars
(IWG, 2016). However, some scholars have argued that a more comprehensive consider-
ation of damages or risk aversion would likely lead to a signicantly higher SCC (Revesz
et al., 2014; Daniel et al., 2019). Recent empirical evidence also nds that some measures
of climate damages are much higher than previously understood (Hsiang et al., 2017).
The economist’s standard policy prescription in such cases is to correct the “missing price,”
by either imposing a tax equal to the marginal social cost of pollution or by establishing an
emissions trading system (ETS) that creates a market for emissions reductions (subject
to a cap on total pollution across covered facilities) and thus a market price for pollution.
Putting a price on GHG emissions, creates an economic incentive to allocate capital
toward the development of new, lower-emitting technologies, promoting dynamic efciency.
In many ways, the two types of carbon pricing policies are broadly equivalent in practice.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
4
Some jurisdictions have adopted carbon taxes or emissions trading systems. Eleven
U.S. states and two Canadian provinces currently have an ETS. States in the Northeast
established the Regional Greenhouse Gas Initiative (RGGI) in 2008. With the addition of
Virginia in 2021, it will cover emissions from power generation in 11 states, capturing about
18 percent of total emissions in the region. Launched in 2013, the California Cap-and-Trade
Program represents the broadest carbon pricing system in the world, covering 80 percent
of the state’s GHG emissions. The California program is directly linked to the Quebec
system under the umbrella of the Western Climate Initiative (WCI), the rst international
mechanism linking different sub-national entities. As with RGGI, there are derivatives
markets for California carbon allowances, including futures contracts.
The European Union Emission Trading System (EU ETS) remains the largest ETS worldwide,
accounting for almost 90 percent of global emission trading volume. The EU ETS is
supported by a large secondary market, in which allowances are traded bilaterally or on
an exchange-cleared basis. In its next phase (2021 to 2030), the EU ETS will align its
goals to the goals of the 2015 Paris agreement. Meanwhile, China is expected to launch
a national ETS in 2020 that will initially cover the power sector before expanding to cover
seven other industrial sectors by 2025. It has the potential to become the world’s largest.
Finally, carbon taxes are in place in jurisdictions, including Canada, Chile, Colombia, Mexico,
South Africa, Sweden, and the United Kingdom.
Yet, despite these efforts, carbon remains underpriced worldwide. Today, various carbon
pricing policies operate in 78 countries, states, provinces, and cities. Together, these
initiatives cover about 22 percent of global GHG emissions. However, prices in many
jurisdictions remain low, with half of the emissions covered by carbon pricing initiatives priced
at $10 per metric ton or less (World Bank, 2020). In 2017, the High-Level Commission on
Carbon Prices concluded that a carbon price in 2020 in the range of $40 to $80/t
CO
2
and
rising to $50 to $100/t
CO
2
by 2030 would be consistent with meeting the temperature target
in the Paris Agreement (High-Level Commission on Carbon Prices, 2017). In the absence
of effective, broadly applied carbon pricing, nancial markets will continue to struggle to
motivate economic agents to act in ways compatible with long-term temperature targets.
Various coalitions of governments, non-governmental organizations, and companies in
different sectors have issued myriad statements in recent years afrming the importance
of carbon pricing. Notable examples include: (i) the Carbon Pricing Statement signed by
73 countries and more than 1,000 companies and investors in 2014; (ii) the 2019 Global
Investor Statement to Governments on Climate Change signed by 613 investors with
more than $37 trillion in assets; (iii) the Guiding Principles announced by the CEO Climate
Dialogue made up of 21 companies and four non-governmental organizations (NGOs)
in 2019; (iv) the
Economists’ Statement on Carbon Dividends
signed in 2019 by more
than 3,500 economists including all four former chairs of the Federal Reserve, 27 Nobel
laureates, and 15 former chairs of the Council of Economic Advisers; and, (v) the Vatican
Dialogues Participant Statement on Carbon Pricing signed by the CEOs of 10 major oil
companies along with major asset managers and others in 2019.
5
CHAPTER 1: INTRODUCTION TO FINANCE IN THE FACE OF CLIMATE CHANGE
These and other similar statements commonly cite principles for carbon pricing policy that
include, (i)
fairness
, with respect to both the incidence of a carbon pricing policy (in other
words, how the impacts are distributed among different income groups, as well as how
revenue is allocated); (ii)
scope
, in particular whether the carbon pricing policy covers specic
sectors or the entire economy; and, (iii)
effectiveness
in achieving emissions reductions
and thus limiting warming—a function of the initial price level and how fast it rises, as well
as whether the policy establishes an enforceable and stringent limit on emissions.
This report recognizes that all climate policy frameworks should be sensitive to the inequitable
burdens of climate change, particularly current and future market failures impacting low-
and moderate-income households and historically marginalized communities. To this end,
this report highlights the extent to which business-as-usual represents signicant risks
for not only American nancial institutions, but also for American households. However,
where there are risks, there are also opportunities for broader advancement in achieving
equitable and sustainable prosperity.
U.S. and Global Action on Climate in the Financial Sector
Despite the absence so far of effective carbon pricing globally and in many key jurisdictions,
nancial regulators and market participants increasingly recognize the need to measure and
manage climate risks. Central banks have been especially prominent in calling for efforts to
advance that goal. The Central Banks and Supervisors Network for Greening the Financial
System (NGFS), chartered in 2017, is a group of central banks and supervisors, “willing, on
a voluntary basis, to share best practices and contribute to the development of environment
and climate risk management in the nancial sector and to mobilize mainstream nance
to support the transition to a sustainable economy” (NGFS, 2019). As of June 2020, the
group had 66 members and 13 observers, including members from most of the largest
global economies and from the New York State Department of Financial Services—but no
U.S. federal government entity (NGFS, 2020).
The views of central bankers are illustrative of growing concern about climate risk among
nancial regulators. U.S. Federal Reserve Board Governor Lael Brainard gave remarks
titled
Why Climate Change Matters for Monetary Policy and Financial Stability
, stating,
“Congress has assigned the Federal Reserve specic responsibilities in monetary policy,
nancial stability, nancial regulation and supervision, community and consumer affairs,
and payments. Climate risks may touch each of these” (Brainard, 2019). In 2018, Benoit
Cœuré, then a member of the Executive Board of the European Central Bank (ECB), noted
that climate change may warrant monetary policy action, if climate change impacts are so
persistent that central banks can no longer “look through” climate change as a short-term
shock (Cœuré, 2018). Guy Debelle, deputy governor of the Reserve Bank of Australia,
echoed that statement in 2019, saying that central banks should view climate change as
a “trend change” with an ongoing rather than temporary impact (Debelle, 2019).
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
6
Central banks are increasingly researching climate risk, including parts of the Federal
Reserve System. The Federal Reserve Bank of San Francisco organized a conference in
November 2019 on “The Economics of Climate Change.” The Bank of England, the Bank
of Canada and the ECB are all researching how climate change could affect macroeconomic
forecasting, systemic risks, and monetary policymaking (Wilkins, 2019; Carney, 2019;
Lagarde, 2020). The Basel Committee on Banking Supervision published a survey of its global
membership of nancial regulators in April 2020. Twenty-four of 27 responding members
and observers have conducted research on climate-related nancial risks (BIS, 2020).
Central banks and other nancial regulators from major economies are focusing on greater
disclosure of climate-related risks and opportunities by corporations. In 2015, the Group of
Twenty (G20) asked the Financial Stability Board (FSB), composed of nancial regulators from
the world’s largest economies, to consider climate risk. In response, the FSB established
the industry-led Task Force on Climate-related Financial Disclosures (TCFD). The FSB
initially focused on disclosure because, as noted in the its 2015 response to G20 leaders,
“[a]ppropriate disclosure is a prerequisite for both the private sector and authorities to
understand and measure the potential effects on the nancial sector of climate change,
as markets evolve and as the wider economy transitions towards a low-carbon economy”
(FSB, 2015, p. 2). The TCFD called for voluntary climate-related nancial disclosures that are
“consistent, comparable, reliable, clear, and efcient, and provide decision-useful information
to lenders, insurers, and investors” (TCFD, 2020a). It also issued recommendations for
implementing disclosures. As of February 2020, more than 1,000 companies and other
organizations, including private sector organizations with a collective market capitalization
of $12 trillion and nancial rms responsible for $138.8 trillion of assets, have declared
support for the recommendations (TCFD, 2020b).
Insurance regulators are also thinking about the management of climate risk. The Sustainable
Insurance Forum (SIF), a network of 31 insurance supervisors and regulators from around
the world, was created in 2016 to work on sustainability challenges. Membership includes
the U.S. National Association of Insurance Commissioners, the California Department of
Insurance, the New York Department of Financial Services, and the Washington State
Ofce of the Insurance Commissioner (SIF, 2020). Its goals are to strengthen insurance
supervisors’ and regulators’ understanding of, and responses to, both sustainability and
climate-related challenges and opportunities for the insurance business. The SIF has
focused on developing and sharing supervisory best practices to address risks posed by
climate change to the insurance sector as a whole and to individual insurance rms as
underwriters and investors (SIF/IAIS, 2018; SIF/IAIS, 2020).
Investors—through a variety of formal and informal bodies—also are increasingly focused
on climate-related risks. For example, Climate Action 100+ is a group of 450 investors
with more than $40 trillion in assets. The group has encouraged “systemically important
emitters” to reduce their GHG emissions, as well as to increase board oversight and
disclosure (CA100, 2019). The Net-Zero Asset Owner Alliance, established in 2019, is
7
CHAPTER 1: INTRODUCTION TO FINANCE IN THE FACE OF CLIMATE CHANGE
a group of major institutional investors, managing nearly $4.7 trillion in assets, who have
committed to shifting their investment portfolios to net-zero GHG emissions by 2050.
Another example is the United Nations Principles for Responsible Investment (PRI) initiative,
which requires strategy- and governance-focused climate risk reporting for all of its more
than 3,000 signatories, which manage more than $100 trillion in assets (PRI, 2020).
The leaders of some large asset owners and managers have made signicant statements
about the need to take climate risk seriously. The $1 trillion Norwegian government pension
fund, the world’s largest sovereign wealth fund, has adopted a detailed set of climate-related
expectations for all portfolio companies, covering strategy, risk management, disclosure, and
policy (Norges Bank, 2019). The fund has also divested its holdings in certain coal-mining
and coal-burning power companies. The California State Teachers’ Retirement System
(CalSTRS), one of the largest U.S. public pension funds, divested from U.S. thermal coal
companies in 2016 and from non-U.S. thermal coal companies in 2017 (CalSTRS, 2016).
Larry Fink, CEO of U.S. asset manager BlackRock, which managed nearly $7 trillion in
assets in late 2019, has publicly equated climate risk with investment risk and pledged
that his company will be increasingly likely to vote against company managers and board
directors when companies are not making sufcient progress in sustainable business
practices (Fink, 2020).
While U.S. nancial institutions have taken some signicant steps, most nancial sector
leadership on climate action has, in recent years, come from outside the United States.
European and British regulators, banks, asset owners, and insurers have been especially
active. Authorities from China, Mexico, and Canada have also been very engaged.
International organizations, including nancial standard-setting bodies and the International
Monetary Fund have devoted signicant time and attention to climate risk management.
Yet, because of its nancial system’s size and scope, engagement by the United States
is crucial if global nancial markets are to effectively manage climate risk and facilitate
the transition to more resilient, low-to-no-carbon economy. U.S. capital markets, both
equities and xed income, are the largest in the world and among the deepest and most
liquid. The largest futures exchange in the world is based in the United States and offers
the widest range of products across all asset classes. Four of the ve largest asset
managers in the world are based in the United States, and the United States represents
the largest insurance market globally by premium volume. Without active leadership by
U.S. regulators and nancial institutions, the mission of prudent climate risk management
will remain incomplete at best, and those gaps will remain a key weakness in the U.S. and
global nancial systems.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
8
Road Map of the Report
The rest of this report focuses on the climate-related risks the U.S. nancial system faces
and on how regulators and nancial institutions can address them. It is divided into eight
chapters. This chapter has provided the policy and global context for this report. Chapters 2
and 3 explain the climate-related physical and transition risks that the U.S. economy and
nancial system face. Chapter 4 examines the challenge of climate risk management from
the perspective of nancial regulators. It reviews their existing authorities and recommends
actions to address the risks outlined earlier in the report.
The remaining four chapters delve into topics of special interest to policymakers and the
private sector. Chapter 5 focuses on how nancial institutions and rms can manage climate
risk, including by using consistent, comparable and reliable climate data and analytics.
Chapter 6 looks more closely at climate scenarios and explains how they can provide
useful insights that help regulators and companies plan. Chapter 7 looks at the disclosure
of climate risk, outlining the evolution of the current disclosure regime and how it can be
strengthened. Finally, Chapter 8 explores how the nancial system can better facilitate
capital ows 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.
Collectively, these chapters provide recommendations that highlight a range of innovations
in the public and private sectors that help advance the economic resilience of the U.S.
nancial system. More fundamentally, these innovations offer the opportunity to adapt
the American economy to provide new nancial products, services, and technologies to
advance a broader global transition that removes or eliminates GHG emissions from the
global economy. These innovations and opportunities provide a foundation for Americans
to invest in a transition to a more environmentally sustainable and socially equitable future.
Recommendation
Recommendation 1: 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.
9
CHAPTER 1: INTRODUCTION TO FINANCE IN THE FACE OF CLIMATE CHANGE
Climate-related physical and transition risks are already impacting, or are anticipated to
impact, nearly every facet of the U.S. economy—a broad cross-section of markets, products,
instruments, and services. How material these climate-related risks will be varies depending
on time horizon, geographic region, and segment of the economy, as well as on climate
mitigation and adaptation actions. If these risks are misunderstood and mismanaged, they
could affect nancial assets and nancial markets, and in turn the ability of the nancial
system to serve the American economy. As summarized in this chapter, some climate
change impacts already can be seen in various asset classes. These impacts ultimately
undermine the economic welfare of American households and often disproportionately
burden low-to-moderate income (LMI) and historically marginalized communities—further
undermining environmental justice.
The risks associated with climate change are many and complex, but for simplicity, they
are often divided into physical and transition risk. Physical risk is dened as risk that arises
from the material, operational, or programmatic impairment of economic activity and the
corresponding impact on asset performance from the shocks and stresses attributable
to climate change. Transition risk, on the other hand, is dened as risk associated with
the uncertain nancial impacts that could result from a transition to a net-zero emissions
economy. These risks could arise, for example, from changes in policy, technological
breakthroughs, and shifts in consumer preferences and social norms (Bolton, et al., 2020).
Figure 2.1 summarizes the causal chains through which physical and transition risk could
affect economic activity and the nancial system. While both physical and transition risks
can directly impact asset values, the distribution of indirect wealth effects may further impair
assets. This chapter focuses on the causal chains ending with impacts on asset values.
Chapter 3 focuses on the impacts on nancial institutions and possible feedback loops.
11
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
Chapter 2
Physical and Transition Risks in
the Context of the United States
Physical Risks
The measurement and understanding of physical risk vary considerably from sector to sector
and remains, overall, in an early stage of development. The impacts of physical risks may
also vary signicantly within a sector depending on the risk and rms’ climate management
practices and capacities. In general, physical risks may be either acute or chronic. Their
severity depends on the physical exposure of assets, infrastructure, and populations.
Advances in attribution science that help distinguish climate trends from natural variability
(NASEM, 2016), together with advances in measurement technology, are improving the
understanding of physical climate risk (Keenan, 2019). With further advances in technology
and standardized disclosure practices, additional physical risks may be discovered, and
existing risks will be measured and reported with increasing precision and sophistication.
Through stress testing, scenario planning and other analytical measures, sectors and rms
may be better prepared to mitigate and adapt to climate change.
Estimates of physical risks are based on a variety of assumptions, scenarios, and Repre-
sentative Concentration Pathways (RCPs). RCPs are widely used, consensus-based
models that estimate how climate systems may respond to specic concentrations of
greenhouse gas in the atmosphere. Currently, no standardization exists within or across
sectors on which parameters to use for evaluating physical risk, and so these estimates
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
12
remain rst-order approximations. For instance, there is an ongoing debate concerning the
assumptions in RCP 8.5 (the most severe of the RCPs) and whether it underestimates
business as usual (Christensen, Gillingham, and Nordhaus, 2018) or overestimates physical
and economic impacts by disregarding gradual shifts in the global energy economy (Ritchie
and Dowlatabadi, 2017). However, these pathways and associated estimates neverthe-
less importantly help shape awareness among policymakers and the private sector on the
magnitude and nature of the risk.
With those caveats, the latest research suggests that, by the end of this century, the negative
impacts on the United States from climate change will amount to about 1.2 percent of annual
gross domestic product (GDP) for every 1 degree Celsius increase (Hsiang, et al., 2017).
This is roughly the equivalent of wiping out nearly half of average annual GDP growth rates
in recent years. There is great uncertainty about how those losses may be distributed across
the United States and within any given sector or asset class. But the research suggests
that the South, Central and mid-Atlantic regions likely will be more heavily impacted than
northern regions. This could affect how capital is distributed among regions (Hsiang, et al.;
NGFS, 2019a). The relationship between climate change, warming temperatures, and
economic output is not anticipated to be as linear as described in this chapter. Beyond
certain ecological and economic thresholds, economic losses could be signicantly greater.
Agriculture and Ecosystem Services
Agriculture is an important part of the U.S. economy. In 2017, agriculture, food, and
related industries contributed more than $1 trillion, or 5.4 percent of GDP (USDA, 2020).
Agricultural producers alone provided more than 3 million jobs in 2019 (USDA). Physical
risks to agriculture include a wide range of shocks and stresses. They include, for example,
localized heat stress impacting livestock (Rojas-Downing, et al., 2017) and farm workers
(Lundgren, et al., 2013; Gubernot, et al., 2014), as well as potential annual productivity
declines of 2 to 4 percent under moderate to severe emissions scenarios across the U.S.
agricultural economy (Liang, et al., 2017). One study projects that each degree-Celsius
increase in global mean temperature could, on average, reduce global yields of wheat by
6 percent; rice by 3.2 percent; maize by 7.4 percent; and, soybeans by 3.1 percent (Zhao,
et al., 2017). These potential declines in crop yields undermine the domestic capacity to
feed a global population that increases roughly 1.1 percent a year (World Bank, 2019).
While the magnitudes of the estimates and the extent to which adaptation may mitigate
future losses vary (Burke and Emerick, 2016), there is general agreement that climate
change will reduce average yields and total production for most crops in most regions.
(Porter et al., 2014). To this end, adaptation measures (for example, micro-irrigation) and
resilience technologies (for example, drought-tolerant biotechnology) offer great promise
for mitigating potential future declines in agricultural output.
Other risks include degradation in water and soil quality (Gowda, et al., 2018), quantity
(Dai and Zhao, 2017), and increased uncertainty and variability in crop and sheries yields
(Walthall, et al., 2012), increased range and virulence of pests (Taylor, et al., 2018), and
13
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
more frequent disruptions of distribution and processing from extreme weather (Bakker,
et al., 2018). More broadly, climate change is impacting, and is projected to impact, not
only commercial agriculture in the United States, but also the ecological systems and
biodiversity that agricultural systems rely on for everything from the provision of clean
water to healthy forests (Lipton, et al., 2018). Logistical constraints that prevent or delay
the shipment of crops, seeds and material, such as when the Mississippi River has too
little or too much water to safely support barge trafc, also impact the agricultural economy
(Attavanich, et al., 2013).
Financial market participants dealing in agricultural commodities must adapt to this wide
range of physical risks by devising new ways to value, price, and manage climate risk.
Another key challenge is the future capacity of the U.S. government to provide actuarially
sound crop insurance, based on best available data, to support changes in underwriting
and pricing attributable to climate change and natural variability (Antóni, et al., 2012; Rosa,
2018). Crop insurance for extreme events that can nancially devastate American farmers
is a crucial protection. In addition, future public and private investments in adaptation and
resilience—water conservation, drought-tolerant crops, and logistics and storage infra-
structure—are needed to manage physical risk in the sector.
Infrastructure
Awareness is growing across infrastructure sectors, including energy, water, transportation,
and communications, that physical risks do not just impact particular sites and locations
(Bertolotti, et al., 2019), but also shorten the lifecycle of infrastructure and degrade its
operational reliability (Maxwell, et al., 2018). Even slight degradations in lifecycle perfor-
mance can compromise the long-term yields and creditworthiness of revenue-producing
assets in both the public and private sectors. In addition, there is growing appreciation
that disruptions in energy, transportation, and communications infrastructure can impose
economic losses on communities, adding to the losses from damage to the infrastructure
itself. Even in low-to-middle income countries with signicantly less infrastructure than
the United States, infrastructure disruptions already impose between $391 billion and
$647 billion in annual costs to rms and households (Hallegatte, et al., 2019). It is reason-
able to assume that under a business-as-usual scenario annual losses in the United States
could far exceed these estimates.
In the context of longstanding deferred maintenance challenges, the U.S. power infra-
structure faces signicant vulnerabilities from more frequent extreme weather attributed
to climate change (ASCE, 2017). Aging infrastructure and climate change will require
signicant capital investments to ensure compliance with existing reliability and engineering
resilience standards for the delivery of electrical power and fuel (DOE, 2017). In addition,
regulated utilities are facing increased legal liability from their inability to fully account for
and mitigate physical risks (Gundlach, 2020). For example, the 2019 bankruptcy of the
Pacic Gas and Electric Company (PG&E) marked the rst-ever bankruptcy attributed, in
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
14
part, to liabilities arising from climate change-related impacts, namely, record wildres.
PG&E, with $71 billion in assets and $51 billion in debt, was confronted with $30 billion in
estimated wildre liabilities (MacWilliams, et al., 2019).
In addition, the adaptation measures themselves—such as periodically cutting-off power
in high-risk re zones in California—may impose collateral economic costs (Ovaere, et al.,
2019). Early-stage research suggests electrical transmission and distribution infrastructure
costs from climate change could increase 25 percent by 2090 (Fant, et al., 2020). Similar
costs associated with climate adaptation and direct losses likely will strain existing utility
credit quality and bonding capacity, as well as increase customer costs—potentially limiting
broader economic activity.
Transportation and water infrastructure share similar challenges from physical risk. For
example, single-point and cascading failures in infrastructure systems can result from
accelerated material degradation of concrete, steel, timber and earthen structures from
extreme precipitation, extreme temperatures, and changes in relative humidity, salinization,
and carbonization (Stewart and Deng, 2015; Bastidas-Arteaga, 2018). Location-specic
exposure to extreme precipitation events, coastal ooding, inundation from rising sea levels,
extreme heat, icing, subsidence and forest res challenge nearly every element of trans-
portation systems, from bridges and airports to pipelines and ports (Jacobs, et al., 2018).
The same can be said of infrastructure supporting the treatment, distribution and supply
of water (Maxwell, et al., 2018). Even without climate change, signicant resources will
be required to safeguard water infrastructure. A survey of local governments by the U.S.
Environmental Protection Agency estimated that state and local investments of $472 billion
(2018) will be required over the next two decades just to maintain drinking water infrastruc-
ture (EPA, 2018). One estimate puts future investments to maintain all domestic water
infrastructure at $123 billion per year (Ajami, et al., 2018). Climate change impacts likely
will add to ongoing capital investment decits in water infrastructure. Failure to adequately
invest in water infrastructure could result in the loss by 2040 of nearly a million jobs that
directly depend on water (EPA, 2018).
Growing demand for investments to protect infrastructure from climate-related physical
risk are likely to increase scal pressure on state and local governments. Many of them are
already straining under the weight of unfunded pension obligations and rising healthcare
costs (Gilmore and St. Clair, 2018). The COVID-19 pandemic will add to pre-existing scal
burdens. Some nancial markets are beginning to price in the expected scal burdens of
coping with physical risk. For example, municipal bond markets may already be pricing in
exposure to sea level rise in some coastal jurisdictions (Goldsmith-Pinkham, et al., 2019).
With greater discovery and reporting of physical risk, many public borrowers may face
higher capital costs to compensate investors for higher perceived default risk. That, in
turn, will increasingly limit governments’ capacity to invest in critical infrastructure and in
infrastructure that supports and protects their tax base. It may also result in higher local
property and sales taxes.
15
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
As represented in Figure 2.2, the economic costs of disasters to the public and private
sectors have been rising, as represented by the rising incidence of billion-dollar disasters.
This is a function of greater exposure of cities, populations and assets, and the greater
intensity and frequency of a variety of extreme weather events. Many of these extreme
events are already attributable in varying degrees to climate change. For local governments,
losses from such extreme events can have scal ramications for many years. Even without
climate change, the United States needs to make signicant investments in building new
infrastructure and maintaining existing infrastructure. Climate change and extreme weather
events add additional barriers of cost, time, uncertainty, and risk to these investments.
Commercial and Residential Real Estate
The real estate sector shares similar physical risks with the infrastructure sector. The real
estate sector is not only dependent on infrastructure, it also generates local property tax
revenue that supports most domestic infrastructure investment in the rst place (Shi and
Varuzzo, 2020). Since the value of real estate is closely linked to the value of the land it
is built on, physical risks, such as wildres and rising sea levels, can directly affect real
estate prices.
Indeed, emerging research shows that exposure to climate-related risks already affects
real estate values. For example, research has shown that increased perceptions of physical
risk in a local housing market depress the prices of homes exposed to sea level rise
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
16
(Giglio, et al., 2015a; Giglio, et al., 2015b). Bernstein, et al. (2019) and Baldauf, et al. (2020)
provide evidence that perceptions of ooding-related climate risk are currently priced into
some real estate markets. Even in high-value markets, such as Miami, evidence suggests
that the price appreciation of properties that have a high risk of climate-attributed ooding
may slow relative to lower-risk properties (Keenan, et al., 2018). Similarly, early-stage
research has demonstrated that the price of homes drops when they are designated to
be in a wildre risk zone (McCoy and Walsh, 2018; Garnache and Guilfoos, 2019). While
climate risk already appears to affect real estate values, these effects likely will increase
as physical risks become more frequent and severe. Commercial real estate is particularly
vulnerable to the shocks and stresses of climate change that may lead to declines in local
GDP, which drives demand for ofce, industrial, and retail space (BII, 2019).
A decline in real estate values can have larger implications for the U.S. economy and nan-
cial sector. For most U.S. households, housing constitutes the largest share of household
wealth, and substantial evidence suggests that household spending varies with housing
wealth (Mian, et al., 2013; Stroebel and Vavra, 2019). Declining real estate values—driven
by climate-related impacts or the perception of such impacts in the future—could substan-
tially depress economic activity. Some populations and local communities within the United
States may ultimately be required to relocate, with potentially signicant economic losses
for households and investors.
Since most residential real estate in the United States is purchased with a mortgage,
physical risk could also affect the underlying mortgages. Early-stage research suggests
that wildres and ooding cause increased residential mortgage default rates (Issler,
et al., 2020). As Chapter 3 will discuss, declines in mortgage values could affect nancial
market participants, including banks that hold these mortgages on their balance sheets,
investors in mortgage-backed securities, and government-sponsored enterprises (GSEs),
primarily Fannie Mae and Freddie Mac, which guarantee the default risk of the mortgages
they securitize (Ouazad and Kahn, 2019). Emerging evidence suggests that lenders are
passing along riskier mortgages (Ouazad and Kahn) to the GSEs, in part, to remove risk
from their own books (Keenan and Bradt, 2020). The federal guarantee of the GSEs
suggests that U.S. taxpayers may ultimately be on the hook for prepayment and default
risks associated with the impacts of physical risks on collateral values (Ouazad and Kahn,
2019; Keenan and Bradt, 2020).
Human Health and Labor Output
Human health is signicantly exposed to climate-related physical risks. Health impacts from
climate change include extreme heat exposure; degraded air quality; infectious, water- and
vector-borne diseases; food contamination and declining access to nutritious foods; chronic
physical and mental stress; and, physical injuries and mental distress from extreme events
(Ebi, et al., 2018). Many of these health impacts and corresponding nancial costs have
been shown to disproportionately burden low-wage workers and historically marginalized
populations (Schmeltz, et al., 2016; Wondmagegn, et al., 2019). Thus, mitigating climate
17
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
change would reduce economic burdens that amplify economic inequality. For instance, a
decline in the use of fossil fuels will improve air quality, which would have a disproportion-
ately positive impact in certain marginalized communities (Bullock, et al., 2018).
These impacts could also reduce labor capacity and productivity, which in turn could reduce
the capacity of workers and employers to pay for healthcare services. Most critically,
extreme heat is anticipated to greatly impact human health and lead to greater rates of
premature mortality. From extreme heat alone, annual damages from premature death
in 2090 were projected to be between $60 billion (2015) and $140 billion (EPA, 2017).
States in the Southeast and Great Plains could see declines in labor capacity approaching
3 percent (Dunne, et al., 2013; Houser, et al., 2015); some locations in Florida and Texas
could see a total loss in annual labor hours of 6 percent or more (Gordon, 2014; EPA,
2017). Six percent is the equivalent of losing two weeks of income a year. By 2090, total
impacts from extreme heat attributed to climate change could result in more than 2 billion
lost labor hours, corresponding to $160 billion (2015) in lost wages (Graff Zivin and
Neidell, 2014; Hsiang, et al., 2017; EPA, 2017). Indeed, companies that rely on outdoor
and manual labor may face physical risks from declining labor productivity and higher costs
associated with workers’ compensation, health insurance, and general liability insurance.
They may also face pressure to increase wages to attract workers for such physically
demanding employment (Day, et al., 2019). In cumulative terms, these emerging impacts
are anticipated to disproportionately impact LMI and historical marginalized communities.
Finally, as the COVID-19 pandemic has made clear, healthcare and public health systems
in the United States have limited excess capacity to treat patients during extreme events
(Bein, et al., 2019). Such events could include, for example, events stemming from infec-
tious diseases and tropical cyclones attributable, in part, to climate change (Wu, et al.,
2016). Public health infrastructure in the United States and around the world has been
affected by signicant reductions of public investment in recent decades (Masters, et al.,
2017). Unless this trend is reversed, the U.S. healthcare system may not be able to cope
with the burdens from climate-related physical risk. For instance, healthcare facilities,
networks and enterprises could face nancial challenges associated with the exposure of
highly vulnerable and aging populations subject to increasing climate-attributed stresses,
such as extreme heat and infectious disease, and shocks, such as stronger hurricanes
and wildres (Desai, et al., 2019).
Supply and Demand Shifts
Climate change likely will further affect both supply and demand in the economy. For
instance, demand for electricity for space cooling and water for irrigation may signicantly
increase. However, direct and indirect measures of demand may also decrease. There
is little empirical research on the extent to which output per worker may decline and the
extent to which wage pressure and nancial burdens may be redistributed demographi-
cally. However, climate change—within the context of broader trends such as the aging
of society, and income inequality—likely will put additional and disproportionate pressure
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
18
on consumers and taxpayers (Hallegatte and Rozenberg, 2017). In theory, with lower
wages and greater scal and nancial burdens, American consumers could have relatively
less spending power to support existing demand for the nancial services, tourism, and
retail sectors, with implications for manufacturing and wholesale trades. In some cases,
local demand may be affected by climate-driven migration that may lead to depopulation
in high-risk areas (Hauer, 2017). In these scenarios, historically marginalized populations
and frontline communities likely would disproportionately bear the economic burdens
(Kim, et al., 2018; Siders, 2019).
Beyond consumption and demand effects, many sectors of the economy face direct physical
risks to their primary production and distribution, as well as to their supply chains (Goldstein,
et al., 2019). Many sectors have beneted in recent years from rms within the sector
coordinating their operations and supply chains to make them more resilient to increases in
extreme weather that routinely directly impact 70 percent of all economic sectors (Brusset
and Bertrand, 2018). The greater the complexity within a supply chain, the greater the
system’s resilience to climate shocks likely will be (Lim-Camacho, et al., 2017). However,
increased redundancy in supply chains can come with the cost of reduced efciency. The
degree of supply chain re-optimization needed to respond to climate risks remains subject
to a great deal of uncertainty. As climate change impacts increase, consumers, producers,
and suppliers across all economic sectors will need to develop ongoing intelligence about
direct and indirect physical risks in order to advance the economy’s resilience and foster
disciplined risk-taking in consumption and production (Keenan, 2019).
Transition Risk
Transition risks arise from both uncertainties and substantive changes. They include market,
credit, policy, legal, technological, and reputational risks. These transition risks range from
the introduction of an explicit or implicit price on carbon to the economic obsolescence
of entire asset classes because of changing consumer preferences. Transition risks may
lead to economic losses for some, while at the same time yielding benets for others.
Transition risks may lead to both stranded capital, where asset-level capital is at-risk from
devaluation, or stranded value, where the market-value of a project or rm is at-risk from
devaluation or otherwise negatively discounted (NGFS, 2019a). In essence, transition risks
arise when rms fail to prepare for or recognize broader market transitions.
In a speedy transition to a net-zero economy, fossil fuel industry assets might become
stranded (Harvey, et al., 2018). To provide some context, 75 percent of total U.S. energy is
derived from fossil fuels (EIA, 2020). In 2019, fossil fuels provided the energy for 62 percent
of electricity generation and 95 percent of transportation (EIA). One estimate for stranded
capital from fossil fuel assets suggests a potential global loss of wealth between $1 trillion
and $4 trillion (Mercure, et al., 2018). In an alternative estimate, current stranded assets
within fossil fuel companies range between $250 billion and $1.2 trillion—depending on
how fossil fuel rms respond to global emissions reductions (IEA, 2020). Many of these
19
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
assets may or may not be fully depreciable given the signicant uncertainty around public
policies and consumer preferences concerning the timing, mode, depth, and cost-sharing
of many energy transition scenarios (Kefford, et al., 2018).
In terms of stranded value, emerging evidence suggests that, in some cases, markets
may already be pricing in transition risk. For example, a recent study suggests that uncer-
tainty associated with policy risk is already penalizing oil companies that are investing in
undeveloped fossil fuel reserves (Atanasova and Schwartz, 2019). Another study shows
that, even with recent domestic policy support, market forces likely already have reduced
domestic coal consumption past a point of no-return (Mendelevitch, et al., 2019). Between
2007 and 2017, total coal production in the United States declined by 32 percent, primarily
because of persistently low natural gas prices (Morris, et al., 2020). Modeling of climate
policy shows that risks to coal producers in the future will be even higher. One study
suggests that a price of $25 per ton of CO
2
rising at 5 percent a year more than ination
could by 2030 reduce U.S. coal production to 77 percent below 2016 levels (Morris,
et al.). Declines in coal may also negatively impact state and local tax and royalty revenue.
Concerns over stranded capital in coal assets are already impacting the nancing of assets,
even in high-growth countries that have strategically planned to expand coal generation
capacity (Ha-Duong, 2020).
Financial market participants are already looking for ways to manage transition risk in their
investment portfolios. For example, recent research suggests that portfolios that over-weight
“greener” rms will outperform during periods with negative climate news (Engle, et al.,
2020). Institutional investors already appear to be screening potential investments for
direct carbon emissions and demanding compensation for associated transition risks
(Bolton and Kacperczyk, 2019). This demand likely stems from the anticipated impacts of
transition risks across the economy. Investors likely will increase their efforts to identify
which assets are unduly exposed to a collapse in asset values that could threaten the
economic viability of entire asset classes (Carney, 2018).
As a subset of transition risk, technological risks also represent a challenge for nancial
and scal stability. A wide variety of new technologies are needed to advance net-zero
energy production, distribution, storage, and utilization. Firms and public policies will
inevitably seek to pick winners and losers among these technologies and among the
users of these technologies (Zurich, 2018). The risk is that investments will be made in
inferior technologies that either fail to achieve their stated level of performance or are
surpassed by superior technologies before their full economic utilization or depreciation.
The extent of the technological risk often depends on the speed and diffusion of inferior
technologies. Ultimately, consumers’ preferences for products and services of varying
degrees of sustainability represents its own category of transition risks, whether it is meat
consumption, gas powered vehicles, or even investment products.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
20
By the same token, public policies that seek to advance specic technologies represent a
policy risk if a technological beneciary does not achieve the desired level of performance
or economic return. Beyond misplaced technology preferences, policy risks may arise
from a variety of legislative and administrative actions, or inactions, that fail to address the
speed and depth of climate change. Risks for even the most well intended public policies,
whether local sustainable investment protocols or federal tax policies, are dened by their
distributional costs and benets, timing, effectiveness, uncertainty, and continuity. Policy
pathways could be classied along a continuum from smooth to disruptive. Disruptive policy
pathways may be out of line with social momentum or technological capacity. A policy
pathway may be disruptive because it is simply delayed too long or lacks the continuity to
guide long-term capital investments. As Chapter 6 will discuss, poorly designed and poorly
implemented policies can distort the allocation of capital across sectors and industries.
In addition, a pathway may be disruptive because it leads to unmitigated sector-specic
unemployment that is sensitive to the speed of energy transitions.
Current initiatives, such as the Inevitable Policy Response promulgated by the United
Nations’ Principles for Responsible Investment (PRI), have begun to provide a resource
for nancial markets to forecast short- to mid-term climate policies (PRI, 2019). Key policy
domains include coal phase-outs; bans on internal combustion engine vehicles; carbon
pricing; carbon capture and storage; net-zero power; energy efciency; land use-based
carbon management; and agricultural technologies and infrastructure policies. Each of
these policies is evaluated based on institutional, political, and technological readiness, as
well as metrics associated with social momentum and social equity (PRI). These are just
a few of many metrics and models for evaluating policy risk that are discussed in more
detail in Chapter 6.
Public and private sector actors also face a variety of climate-related legal risks, both physical
and transition, from litigation and contract liability. As of the date of publication, more than
1,100 climate-related lawsuits have been led in the United States (Sabin Center, 2020).
The most high-prole litigation has centered on complaints advanced by state attorneys
general for violations of state securities laws, among other allegations, against a fossil
fuel legacy rm for its alleged failure to adequately disclose material climate-related risks
to investors. In securities law, future legal risks likely will involve decisions about whether
climate-related risk factors are material enough to require disclosure, as well as the
adequacy of disclosures (Vizcarra, 2018; Vizcarra, 2020).
Finally, state and local governments have led more than a dozen lawsuits under various
tort theories, including state common law public nuisance claims, to recover climate-change
related expenses from energy industry defendants. None of these lawsuits have ultimately
satised the plaintiff’s cause of action or theory of damages. However, a great deal of
uncertainty is associated with an unbounded range of potential claimants and defendants.
In such a mass tort scenario, federal legislation may be needed to organize claims and
damage allocations, as with the tobacco litigation of the 1990s (Olszynski, et al., 2017).
21
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
Legal issues beyond tort and consumer protection claims may directly impact the nancial
economy. First, there are open questions about the extent to which ofcers, directors and
other duciaries may be violating duciary duties by investing in, or failing to disinvest in,
various carbon-intensive or otherwise highly exposed assets, companies, and industries
(Gary, 2019). A second challenge arises from uncertain legal liability for public and private
sector actors who fail to adequately disclose material physical risks on debt offerings and
other contracts (Keenan, 2018). For public entities, a broader range of legal liabilities relate
to limits on sovereign immunity arising from negligent mismanagement of physical risks
(Klein, 2015). Finally, professionals such as, architects, engineers, and corporate directors
face signicant questions about the consideration of climate change risks and their duty
of care (Hill and Martinez-Diaz, 2019).
An additional technical challenge relates to the evidentiary application of attribution science
to connect climate change with damage-specic events, as well as the causal relationships
associated with demonstrating legal standing to bring claims (Marjanac and Patton, 2018).
Overall, the accelerated pace of climate change is reorienting longstanding commercial
relationships, memorialized in public and private law, faster than governing principles can
be developed through appellate litigation. Additional legislation and regulation will ultimately
be required to calibrate many facets of the law and the regulatory state—adding additional
policy risk.
Integrating Physical and Transition Risk
While usually discussed as distinct concepts, physical and transition risk will not remain
in neatly separated boxes in the real world. The two are likely to interact in complex ways.
For example, dedicating more resources to accelerate the transition to net-zero energy
generation could create trade-offs, diverting resources from climate adaptation measures,
thereby amplifying vulnerability to physical risks. Conversely, adaptation investments that
mitigate the exposure and sensitivity of assets without regard for carbon management may
ultimately amplify transition risks. Importantly, the longer governments wait to adequately
cut emissions, the more rapidly physical and transition risks are likely to increase in
parallel. The physical impacts of climate change will intensify while the magnitude of the
response needed to arrest further warming grows. The public and private sectors must
simultaneously advance both climate mitigation and adaptation to effectively manage both
physical and transition risks.
In other areas, such as real estate, assets may be devalued simultaneously as a function
of both absolute losses from physical risks and from the transition risk of consumer
preferences shifting away from “non-green” assets that lack sustainability and resilience.
Even within sectors with high measures of physical or transition risks, organizational
resilience and risk management may dictate a wide variation in climate-related risk to any
given rm (S&P Global, 2019).
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
22
Figure 2.3 highlights four high-level scenarios that may be useful to frame assumptions
and parameters for future analysis of the adequacy of measures to address physical
and transition risks. The two primary factors represented in this framework are the total
amount of emissions reduction and the orderliness and continuity of any transitions (NGFS,
2019b). Understood along a continuum, these factors likely will shape emerging strategies
for managing market, credit, policy, legal, technological, and reputational risks. The goal
is for the public and private sectors to manage an orderly transition that also recognizes
and internalizes physical risks. As the following chapters will discuss, understanding the
various modes of the transmission of these physical and transition risks into the various
markets, instruments and assets classes of the nancial system is critical for understanding
the parameters shaping future investment analysis and prudential oversight.
23
CHAPTER 2: PHYSICAL AND TRANSITION RISKS IN THE CONTEXT OF THE UNITED STATES
As described in Chapter 2, climate-related physical and transition risks, if not well-managed,
likely will materially impact the value of a wide range of assets. This chapter explains how
those impacts may manifest throughout the nancial system, rst considering general
implications and then covering risks to nancial markets and institutions.
A Unique Challenge for Financial Stability
Our understanding of how climate change and societal responses to it will affect nancial
markets, institutions, and systems remains in its infancy. It is clear, however, that climate
change presents a uniquely complex set of nancial risks for three reasons. First, climate
change will affect multiple sectors, geographies, and assets in the United States, sometimes
simultaneously and within a short timeframe. This is no longer theoretical. For example,
in a recent span of 24 months, the United States experienced several unprecedented
extreme events. In 2017, for the rst time in history, three Category 4 hurricanes made U.S.
landfall in a single year, causing extensive damage to the Gulf Coast. In 2018, California
experienced its deadliest and most destructive wildre season in recorded history. And
in the year through May 2019, the United States experienced its wettest 12 months on
record, including devastating oods affecting 14 million people in the Midwest and South.
In the future, such impacts could compound, magnifying economic and nancial shocks.
Second, climate-related nancial risks are large but remain uncertain because climate
change is shifting fundamental environmental parameters, pushing planetary systems
to new extremes. This is true for both acute and chronic physical risk. As a result, the
climate in the future will fundamentally differ from today’s climate. Traditional risk-modeling
techniques, which rely heavily on historical data, will become increasingly unhelpful guides
to the future. That presents a signicant challenge to nancial market participants and
regulators, whose decisions hinge on having good information and data on which to ground
their views about future conditions. Thus, society’s ability to understand climate risk will
require forward-looking analysis, which is still being developed (Barnett, et al., 2020).
25
Implications of Climate Change
for the U.S. Financial System
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
Chapter 3
Third, the impact of climate change on a wide range of variables involves tipping points
and what economists call “discontinuities”—situations in which conditions can remain
stable for a long time but then deteriorate sharply and suddenly. Studies suggest that
variables such as economic growth, crop yields, and labor productivity deteriorate more
quickly and suddenly once a certain threshold temperature has been crossed (Burke, et al.,
2015). If these variables deteriorate non-linearly in response to climate change impacts,
sudden and disorderly price adjustments in nancial markets become more likely (Hong,
et al., 2020). Breakthroughs affecting low-to-zero carbon technologies can also lead to
discontinuities, and consumer preferences and energy consumption patterns can change
unexpectedly and rapidly (Kuran & Sunstein, 1998).
Systemic Shocks
Because of their scale, breadth, and complexity, the impact of climate-related risks could be
systemic. While no ofcial denition of systemic nancial risk exists under U.S. law, the most
widely-accepted denitions contain several elements: (i)
shock amplication
, which refers to
conditions in the nancial system that allow a given shock to propagate widely, magnifying its
disruptive effect; (ii)
disruption
or
impairment
of all or part of the nancial system, meaning
that portions of the system cease to effectively support economic activity; and (iii)
severe
externalities
, meaning spillovers affect the real (non-nancial) economy (Adrian, et al., 2014;
IMF, BIS and FSB, 2009). Climate-change related risks can produce all three of the elements.
Systemic shocks are more likely when the prices of a wide variety of nancial assets do
not fully reect climate-related physical and transition risks. Standard asset-pricing theory
suggests that market participants will demand a premium to hold assets exposed to
climate-related physical and transition risk. When those risks are not fully priced in, market
participants will accumulate larger exposures to risky assets than would otherwise be
desirable. A sudden revision of market participants’ perceptions about climate risk could
trigger a disorderly repricing of assets, which could have cascading effects on portfolios
and balance sheets and, therefore, systemic implications for nancial stability.
Evidence is accumulating that markets are pricing in climate-related risks imperfectly,
and sometimes not at all. As the previous chapter explained, the U.S. property market is
beginning to price in risk of sea level rise and climate-attributed ood risk—but unevenly. For
example, one study found that investors purchasing U.S. rental properties are demanding
risk premiums well aligned with scientic projections for homes exposed to sea level rise but
people purchasing homes for primary occupancy, on the other hand, are less likely to do so
(Bernstein, et al., 2019). Another study examined stock prices across multiple countries,
including the United States, and found no association between current stock prices and
measures of predicted changes in climate-related physical hazards, even after controlling
for fundamentals and for countries’ capacity to adapt to climate change (IMF, 2020).
An emerging body of research suggests that climate risk is currently underpriced in some
markets, and that climate-exposed nancial assets may be overvalued. Sudden and disruptive
repricing is therefore possible should market participants revise their perceptions about
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
26
physical and transition risk. A variety of factors could trigger revised investor perceptions,
including election outcomes, reports of technological breakthroughs that reduce the cost
of zero-carbon technologies, new research ndings about the speed and nature of physical
climate impacts, and the occurrence of major catastrophes that raise awareness of new risks.
In addition, the fact that climate-related risks do not operate in isolation makes a systemic
shock more likely. As Chapter 2 suggests, transition and physical risks could interact and
compound the disruption either would exert on its own. In addition, climate-related risks
could interact with existing, non-climate-related vulnerabilities in the nancial system. For
example, U.S. regulators have identied historically high levels of corporate leverage and
the expansion of mortgage origination by nonbanks as existing risks to nancial system
stability (FSOC, 2019). Another, even more important, vulnerability is the likely legacy of the
COVID-19 pandemic in the form of stressed nancial-institution balance sheets, depleted
household wealth, and growing business and government debt. Climate-related shocks
could magnify any of these already serious vulnerabilities, increasing the probability of an
overall shock with systemic implications.
Sub-Systemic Shocks
Climate-related risks need not threaten the entire nancial system to merit attention
from nancial regulators. Climate-related risks may well produce “sub-systemic” shocks,
which are dened here as those that affect nancial markets or institutions or a particular
sector, asset class, or region, but without threatening the stability of the nancial system
as a whole. Such shocks are especially relevant for the United States, given its size and
its nancial system, which includes thousands of nancial institutions, many regulated at
the state level.
Sub-systemic shocks can result, for example, in businesses, farmers, and residents in
particular communities losing access to hedging instruments, insurance, credit, and other
critical nancial services. In turn, that loss of access can result in business disruptions, lost
income, and reduced household wealth. Over time, repeated sub-systemic shocks could
lead to the gradual accumulation of stress in the U.S. nancial system and to escalating
economic and nancial losses—a systemic crisis in slow motion.
The spatially-concentrated nature of economic activity in the United States compounds
this risk. As shown in Figure 3.1, in 2018, just 31 counties—accounting for 1 percent of
all counties—were responsible for generating one third of U.S. gross domestic product
(GDP) (Tartar and Pickert, 2019). A majority of those counties are located along coastlines
and are exposed to physical climate risk. Depending on how interrelated physical and
transition risks become, economic activity in some of those counties could be adversely
impacted both by transition and physical risk. Multiple shocks affecting several of those
economic hubs over a short time horizon—a more intense version of what the country
experienced in 2017-19, for instance—could cumulatively translate into an economic and
nancial shock with nationwide consequences.
27
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
Risks to Financial Market Operation
Climate-related risks may affect the functioning of markets essential for economic activity.
This could happen through liquidity disruptions and through disruptions to nancial market
utilities.
Liquidity Disruptions
To function properly, nancial markets require adequate liquidity. However, liquidity can
deteriorate very quickly during shocks, for example when concerns about counterparty risk
spike, or when nancial intermediaries are unable or unwilling to perform certain functions.
For example, U.S. issuance of commercial paper maturing beyond one week seized up
in March 2020 during the COVID-19 pandemic, as did primary- and secondary-market
liquidity for nancial and nonnancial commercial paper. This occurred partly because
prime money market funds, anticipating investor outows, rushed to raise cash and build
liquidity buffers by selling commercial paper. Also, dealer banks were reportedly less
willing to intermediate, as they faced balance sheet and risk-limit constraints (IMF, 2020).
Intermediation difculties were also reported in the municipal bond market. Dealers, faced
with large outows from municipal bond funds, could not warehouse the surging supply
of bonds. Conditions eased only after the Federal Reserve injected liquidity into these
markets through large purchases of the relevant assets.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
28
A conuence of physical and transition risks in a short time could plausibly cause liquidity
problems in key markets. For example, a combination of highly destructive, climate-related
extreme events affecting key economic hubs, in the context of already-stressed balance
sheets and historically high levels of corporate and municipal debt, could trigger widespread
concern about creditworthiness across multiple sectors and regions. In turn, that could
lead to a sudden spike in risk aversion, pushing investors to scramble for cash by selling
commercial paper and rushing out of certain bond funds—causing liquidity shortages and
intermediation difculties.
A similar scenario is plausible in futures markets. A combination of slow-onset and sudden
extreme weather events in major agricultural states, for example, could lead to high volatility
in certain agricultural commodity prices. Commodity prices can become especially volatile
when storage facilities are damaged or storage capacity is otherwise constrained, forcing
contracting parties supplying the physical commodity to incur additional costs. High volatility,
in turn, could result in calls for variation-margin payments to clearinghouses and to greater
pressure on short-term funding markets at the same time as other institutions, such as
insurers and reinsurers, may be tapping the markets to fund large payouts related to the same
extreme weather events. The result could be a liquidity crunch that temporarily interferes
with the smooth functioning of the commodity futures market. Transition risk could plausibly
cause similar disruptions, for example with challenges to liquidity or energy futures markets.
Disruptions to Financial Market Utilities
Financial market utilities (FMUs) transfer, clear, or settle payments, securities, commodities,
or other nancial transactions among nancial institutions.
The CFTC is primarily concerned with commodities and derivatives clearinghouses (otherwise
known as designated clearing organizations, or DCOs), futures commission merchants,
swap dealers, and major swap participants. Some DCOs are so critical that the Financial
Stability Oversight Council has designated them as systemically important, which means
that their failure “could create or increase the risk of signicant liquidity or credit problems
spreading among nancial institutions or markets and thereby threaten the stability of the
U.S. nancial system” (Agnese, et al., 2017, p. 51).
1
The CFTC has primary jurisdiction over two of the eight designated entities, the Chicago
Mercantile Exchange (the CME Group) and ICE Clear Credit LLC. The CME Group, through
its U.S. clearing division, is one of the largest central counterparty clearing services
providers in the world. It clears all contracts traded on the designated contract markets
owned by CME Group, Inc., which includes the largest and most liquid futures contracts
1
Currently, eight clearing organizations have been designated as systemically important: (i) the Clearing
House Payments Company L.L.C. on the basis of its role as operator of the Clearing House Interbank
Payments System; (ii) CLS Bank International; (iii) Chicago Mercantile Exchange, Inc.; (iv) The Depos-
itory Trust Company; (v) Fixed Income Clearing Corporation; (vi) ICE Clear Credit LLC; (viii) National
Securities Clearing Corporation; and, (viii) The Options Clearing Corporation.
29
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
based on the S&P 500 Index, Eurodollars, U.S. Treasuries, and energy products, as well
as interest rate swaps. Signicant disruption of its operations would cause liquidity to dry
up in futures and options markets, which could threaten the stability of the U.S. nancial
system (Treasury, 2017). ICE Clear Credit clears a majority of the credit default swap (CDS)
products in the United States that are eligible for clearing by a central counterparty. Its
clearing members include global systemically important nancial institutions. Disruption of
its operations could lead to cascading defaults, which could create instability in U.S. CDS
and securities markets (Treasury, 2017).
Climate-related disasters, such as storms, oods, or damaging winds, could disrupt the
operations of FMUs, perhaps even systemically important ones, depending on the location
and climate-vulnerability of the FMU’s physical infrastructure. Prolonged disruptions could
have severe consequences for the markets they serve, including paralysis. While markets
have yet to experience major FMU disruptions, smaller episodes suggest this risk must
be considered. In 2012, for example, Superstorm Sandy ooded a vault of the Depository
Trust and Clearing Corporation (DTCC), an important clearing and settlement company
with three subsidiaries designated by regulators as systemically important FMUs. The ood
damaged or destroyed 1.7 million stock and bond certicates, as well as millions of other
documents. It took the company weeks to recover, restore, and reconcile the documents.
The company was unable to begin even a preliminary assessment of the damage for two
weeks, until water had been pumped out of its vault (DTCC, 2014).
Risks to Financial Institutions
In addition to affecting nancial market functioning, climate-related risks may also affect
nancial institutions, potentially including systemically important ones. Three sets of
questions are important here: Which combinations of assets could be affected by climate-
related risks, by how much, and how quickly? Who holds those assets, and what is their
ability to absorb the losses? And, to what extent are losses mitigated by public and private
shock absorbers?
Which combinations of financial assets are affected,
by how much, and how quickly?
As explained in Chapter 2, climate change will likely present a material risk to certain compa
-
nies and asset classes. But the extent to which the value of those securities and assets
is affected, and in what combination, also will have important implications for the holders
of those securities and for nancial markets more generally. As shown in Table 3.1, the
nancial assets most likely to be impacted fall in several categories—those tied to: (i) real
property; (ii) infrastructure; (iii) companies whose business is affected by climate-related
risks; (iv) coverage providers (namely insurers and reinsurers); and, (v) government revenue.
Key uncertainties include the size and frequency of the losses and the potential for simul-
taneous losses across different asset classes. In the case of physical risk, for example,
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
30
major ooding of residential and commercial property over a large region could result, in
a short time, in rising mortgage delinquency and prepayment rates and falling values of
residential mortgage-backed securities, securitized commercial real estate (CRE) loans,
the bonds of affected municipalities, and the stock of insurance companies (if insurance
companies must make large payouts for ooded commercial property). Importantly, the
extent of the climate-related damage and the nancial losses associated with them can
be reduced through investments in resilience, business continuity planning, and effective
climate risk management more generally.
Table 3.1: Categories of Assets Exposed to Climate Change Impacts
Categories Examples
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:
● Agriculture
● Airlines and the broader transportation sector
● Automobiles
● Cement, steel, chemicals, plastics
● Energy, including coal, oil, and gas production
● Hospitality
● Metals and mining
● Power generation
● Service and infrastructure providers to oil and gas
● Tourism
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
31
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
In the case of transition risk, a sudden adoption of ambitious climate policy—or, more
likely, a sudden shift in perceptions about the likelihood of a major policy change—aimed
at limiting greenhouse gas emissions, even if the policy is phased in gradually, could impact
the debt and equity values, investment, and payrolls of companies across several sectors,
assuming that the costs of compliance are not fully passed through to consumers. Aside
from companies in the oil, gas, and coal mining business, the shock could affect sectors
including electric and gas utilities, motor vehicles and parts, and transportation and ware-
housing (Jorgenson, et al., 2018). On the other hand, investments that incorporate climate
considerations, such as sustainable investments, can also provide nancial upside and
help hedge against climate-related losses.
Who holds the assets, and what is their ability to absorb the losses?
How climate-related losses impact nancial markets and institutions depends in part on
which entities hold affected assets, the entities’ risk management capability, and their
loss-absorbing capacity. A nuanced understanding of different types of nancial institutions
is required. The degree to which climate risks become material for specic banks and other
rms will depend in part on those institutions’ capability of measuring and managing those
risks. As Chapter 5 describes, nancial institutions can integrate climate into their risk
management framework in various ways. Subsequent chapters also describe how tools such
as scenario planning and climate stress testing can help regulators and nancial institutions
understand whether and how climate risk may constitute material risk for particular rms.
Credit-Providing Institutions. Commercial banks and other credit-providing institutions
lend to entities in locations and sectors that may experience climate-related impacts.
Banks could both suffer losses from impaired loans and be left less able to provide credit
to affected entities or even entire sectors.
In the case of transition risk, banks that lend to companies in carbon-intensive sectors
may have some time to course-correct when facing policy or technological change that
effectively increases the price of carbon and limits their clients’ nancial prospects. Average
commercial and industrial loans in the United States typically have a maturity of one-to-three
years. That gives banks frequent opportunities to modify loan terms and conditions and
incorporate newly understood credit risks. In extreme circumstances, banks can refuse to
roll over loans if they believe a company remains at high risk from sudden shifts in climate
policy, technology, and changes in consumer demand.
Over the medium and long-run, however, the risk for banks would grow if they stopped
lending to carbon-intensive companies and sectors but could not replace these loans
with enough new credits to companies better able to adapt to higher carbon asset risk.
If a bank, even a large one, was unable to adapt quickly enough, its nancial soundness
could be at risk. Certain policy paths—particularly major shifts in climate policy, or a shift
in perceptions about the likelihood of such a policy change—could trigger an abrupt
downturn in revenues and valuations for companies in carbon-intensive sectors, possibly
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
32
forcing banks to recognize credit losses on their loans and marked-to-market losses on
their securities holdings. It is worth noting that several large U.S. banks have set sizeable
“green” or “sustainable” nance goals, which suggests they are condent in their capacity
to expand that side of their business.
In the case of physical risk, it is worth distinguishing between large, well-diversied banks
and smaller institutions that serve particular regions or communities. In general, the largest
U.S. banks are relatively well positioned to cope with sudden climate-related extreme
events, such as storms, oods, and wildres. Large credit providers’ portfolios typically
are geographically and sectorally diversied. Research suggests that bigger banks may be
better able to offset temporary regional losses from natural disasters with earnings from
other regions (Landon-Lane, et al., 2011). Large banks also are more resilient to particular
climate-related extreme events than smaller banks because they have more diversied
business models and are required by regulators to hold more capital relative to their assets.
However, large banks are not immune to chronic physical risks, such as prolonged drought
and sea-level rise, which may materialize over multiple years or even multiple decades, and
they are not immune to major disasters of increasing frequency and pervasiveness. Both
these risks are more likely to simultaneously impact multiple sectors and regions, increasing
credit risk across many borrowers. For example, in 2017, nine major international banks
with combined assets of more than $10 trillion, including one large U.S. bank, conducted
a scenario analysis to assess how water stress might affect creditworthiness among a
sample of their borrowers (UNEP FI, 2017). The banks undertook the exercise voluntarily
to help them integrate and strengthen climate risk management.
The exercise showed that extreme droughts would increase loan default losses 10-fold for
certain bank portfolios. Even under milder climate change scenarios, most companies in
the analyzed portfolios experienced credit downgrades. The most affected sectors were
water supply, agriculture, and in certain countries, power generation. In several cases, most
of the nancial losses came from slow-onset, chronic impacts such as drought, not from
sudden extreme events. A key question for large banks remains not only how to manage
these longer-term physical risks, but also how to manage them in a context of potentially
growing transition risk.
Regional and community banks, in contrast, are more vulnerable to regionally concentrated
physical risk, including to sudden extreme events. In 2019, community banks held 30 percent
of all CRE loans, worth about $700 billion (FDIC, 2019). These banks’ property loans tend
to be more geographically concentrated than the loans of larger banks. In addition, CRE
loans constitute a much larger share—nearly a third—of the loan books of small banks,
as shown in Figure 3.2. In contrast, CRE loans represent only a small fraction (just over
5 percent) of the total loans of the largest banks. For this reason, climate-related shocks
that affect commercial property in a particular region can take a much heavier toll on small
institutions, which tend to be regional and community banks, than on banks with nationwide
or global balance sheets. Figure 3.3 highlights the regional nature of depository banks’
exposure to commercial real estate lending.
33
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
Similarly, small banks in the Midwest, in particular, hold proportionately more of certain types
of agricultural loans that could be affected by climate impacts. Flooding and extreme heat
reduce crop yields and disrupt agricultural production. For example, following severe ooding
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
34
in the spring of 2019, bankers lending in the Midwest reported to the Federal Reserve Bank
of Chicago that about 70 percent of their borrowers were at least moderately affected by
extreme weather events in the rst half of the year (Oppedahl, 2019). At the same time, the
portion of the region’s agricultural loan portfolios reported as having “major” or “severe”
repayment problems hit its highest level in 20 years (Oppedahl).
Agricultural banks—those whose combined agricultural production and farmland loans
account for at least a quarter of total loans—hold nearly half of all agricultural loans originated
by U.S. commercial banks (Humston, 2019). Most of those banks are in the Midwest, as
shown in Figure 3.4. Many agricultural banks are small and highly exposed to impacts that
reduce farmers’ ability to service their debts, including climate-exacerbated extreme weather
events. Indeed, more than 70 percent of nonperforming agriculture loans in the Midwest
sit on the balance sheets of banks with less than $10 billion in assets (Tariq and Duren,
2019). Should agricultural banks become credit-stressed, farmers could lose access to
affordable credit, making it more difcult for them to recover from climate-related shocks.
Institutions Holding Climate-Impacted Assets. This category includes a diverse range
of nancial institutions, including banks, pension funds, endowments, mutual funds, and
insurance companies. These institutions operate along a wide spectrum of investment
horizons and risk appetites, but prudent management of climate risk is essential for all.
Most of them hold assets that may be affected—and in some cases are already being
affected—by transition or physical risk. Ineffective management of these risks could
lead to large nancial losses, which in turn could trigger asset re sales and elevated
35
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
counterparty risk. These events can channel nancial contagion. Also, because climate
risk is expected to increase over time, asset holders with longer asset-liability structures
are more exposed to climate risk.
Commercial mortgage-backed securities (CMBS) offer one example. CMBS are made up
of commercial mortgages pooled together and secured by commercial property, such as
hotels, ofce and retail buildings, and warehouses. About half a trillion dollars of CMBS
were outstanding as of 2019 (MBA, 2019), much of it held by institutional investors. Some
of these loans, and the property that secures them, are at risk from ooding, wildres,
windstorms, storm surge, and sea level rise. As of March 2019, properties in New York,
Houston, and Miami—cities that are highly vulnerable to climate change-exacerbated
ooding because of sea-level rise and more intense storms—alone made up one-fth of
CMBS properties by market value in the Bloomberg Barclays Aggregate Index (BII, 2019).
The risk likely will rise. One analysis estimated that about 6 percent of the properties in the
CMBS market lie in Federal Emergency Management Agency (FEMA) ood zones, which
are at elevated risk of inundation (BII, 2019). Another recent study identied 2,000 CMBS
loans, worth more than $56 billion, that are exposed to climate change-exacerbated ooding
along the East and West coasts (Morgan Stanley, 2019). Alarmingly, more than half of
that exposure is estimated to lie outside FEMA ood zones. That means those properties
are at higher risk of being underinsured, and therefore the loans attached to them are at
higher risk of impairment, with increased risk for the value of the related CMBS.
Another example involves the $3.8 trillion municipal bond market, made up of debt issued
by U.S. municipalities. It provides crucial nancing to local governments, including for
infrastructure (MSRB, 2019). As shown in Figure 3.5, mutual funds, banks, and insurance
companies hold a majority—about 55 percent—of municipal bonds, with households and
non-prot organizations holding most of the rest.
Hurricanes, oods, and other disasters are already affecting the economies of issuing
municipalities, and that risk is expected to grow. One analysis calculated that within a
decade, if signicant climate action is not taken, more than 15 percent of the current S&P
National Municipal Bond Index by market value will be issued by cities suffering likely yearly
economic losses of 0.5 percent to 1.0 percent of GDP. By the end of the century, close to
40 percent of the index would be issued by cities facing 3 percent or more of yearly GDP
losses because of climate-related impacts (BII, 2019). Also, climate impacts could be even
more devastating to municipalities in the aftermath of the COVID-19 pandemic, which likely
will weaken the scal condition of many state and local governments. Climate-related losses
could impair municipalities’ ability to service their obligations and lead to downgrades and
eventually defaults and losses for municipal debt holders.
Spillover effects that undermine local industries and economic activity could also affect
municipal revenue. For example, a climate-related disaster could lead businesses, workers,
and residents to relocate permanently out of a highly affected area, resulting in lower
economic activity, falling property prices, and declining real estate taxes. Climate change
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
36
can also damage the economic base in locations where, for example, sh have moved
to other areas because of warming seas, or where waterfront tourism is ruined by algae
growth. These impacts would affect the creditworthiness of municipalities, particularly
where tax revenue sources are not sufciently diversied.
Transition risk could affect the municipal bond market as well. Unless state and local
governments in areas that mine coal and extract oil and gas succeed in rebasing their
economies, shifts away from the use of fossil fuels could result in falling royalties and taxes.
Some municipalities depend on energy revenues for up to half of their total tax revenue.
Revenue losses could cause scal stress and, eventually, municipal bond downgrades
(Morris, et al., 2019; Morris, 2016). Although regulations require disclosure of municipal-
ities’ scal risks, disclosure of climate-related risks by municipalities remains minimal, as
discussed in Chapter 7, exacerbating risks to municipal bond holders (Morris, et al., 2019).
To what extent are losses mitigated by public and private shock absorbers?
Whether and how nancial institutions incur destabilizing losses because of climate risks
depends crucially on the presence of shock absorbers, namely private insurance and
reinsurance. In addition, the federal government’s assistance to people and businesses
during extreme events plays a crucial role in directly mitigating risks for those who are
impacted, and indirectly in terms of how risks are transmitted across the nancial system.
37
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
Evidence on the aftermath of disasters in the United States illustrates the importance
of these shock absorbers in reducing potential losses to nancial institutions. After
Hurricane Katrina devastated parts of the Gulf Coast in 2005, for example, household debt
declined
because homeowners used large government ood-insurance payouts to pay off
mortgages (Gallagher and Hartley, 2015). Similarly, a study showed Hurricane Harvey did
not hurt consumers’ access to credit, thanks in large measure to public and private shock
absorbers, including FEMA assistance, Small Business Administration disaster loans, auto
and property and casualty insurance payouts, and aid from the National Flood Insurance
Program (NFIP) (Hartley, et al., 2019). Also, the National Crop Insurance Program was an
important source of support to farmers in the Midwest following the catastrophic oods
of 2019 (USDA, 2019). As long as these mechanisms continue to cushion the losses, the
nancial system will be at least partially shielded from climate-related shocks.
However, these shock absorbers should not be taken for granted. As past disasters have
repeatedly demonstrated, private insurers often raise premiums in the aftermath of major
events to ensure that they have sufcient reserves to cover future losses. Insurers may
also exclude coverage for risks that are too large to cover even at a higher price. In some
cases, insurers may exit a state, regional, or national market altogether. For example, home
insurers left the home ood insurance market decades ago.
State legislatures and state regulators, when they have the authority, may limit premium
hikes or compel insurers to provide certain levels of coverage. This has been the case
in states such as Florida and California. But insurers can decide to exit markets if the
premium limits or the coverage requirements mean they would not be able to cover their
losses. Fundamentally, if the risk is too high for private insurers, the risk may ultimately
be left with the property owner, the government, or both.
Climate change can cause insurance companies to fail. After the catastrophic 2018 Camp
Fire in California, for example, a medium-sized insurer that had written many of its policies
to cover re had to be taken over by the California Department of Insurance (Koren, 2018).
This danger could be exacerbated if private insurers underestimate the probable maximum
losses they are insuring because their models do not fully capture long-term climate trends
(DNB, 2017). Insurers typically provide one-year policies, and their underwriting decisions
tend to be made using retrospective models with short time horizons. Thus, they, their
reinsurers, and their regulators could neglect to account for climate change-related shifts in
the frequency or intensity of catastrophic events that unfold over multiple years or decades.
Another challenge is that shock absorbers may themselves exacerbate risk by creating moral
hazard. For example, the NFIP, which is the principal mechanism for providing residential
ood insurance in the United States, subsidizes the insurance premiums of some properties,
typically those in the riskiest areas. This feature effectively promotes excessive risk-taking
in areas most exposed to ooding, inundation from sea level rise, and extreme precipitation
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
38
events (Kousky, 2018). The implications of this moral hazard range widely from encouraging
continuing development of residential property in risky areas to local governments’ continued
reliance on an unsustainable property tax base. Additionally, not enough attention is being
paid to long-term solutions, such as relocation and investing in long-term resilience measures
(Hill and Martinez-Diaz, 2019). This moral hazard is not unique to insurers—the demonstrated
willingness of governments to bail out nancial institutions could create an incentive for
them to mismanage climate risk.
Finally, a critical question is whether federal insurance and other government backstops
can in the longer-term sustain signicantly higher claims than they were designed to meet.
For example, a 2019 analysis by the U.S. Department of Agriculture’s Economic Research
Service found that under different emissions and agricultural adaptation scenarios, the
cost of the Federal Crop Insurance Program could increase by 3.5 percent to as high as
37 percent by 2080 (Crane-Droesch, et al., 2019).
Another example of a government shock absorber is the government-sponsored entities
(GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home
Loan Mortgage Corporation (Freddie Mac). Congress created the GSEs to make mortgages
more available by enhancing the liquidity and stability of the U.S. secondary mortgage
market. The GSEs were endowed with certain competitive advantages which, taken
together, conveyed an implicit government guarantee on their nancial obligations. After
the 2008 nancial crisis, the GSEs began transferring a meaningful portion of this credit
risk to the private market via Credit Risk Transfer securities, which are purchased by hedge
funds, money managers, Real Estate Investment Trusts (REITs), insurance companies and
pension funds, though the GSEs retain considerable risk on their own balance sheets.
As major holders of mortgages and originators of residential mortgage-backed securities,
the GSEs are exposed to physical climate risk affecting property, particularly ood risk.
Because Fannie Mae and Freddie Mac are limited by rules governing how they underwrite
mortgages, they may have limited room to screen for and manage climate risk (Ouazad and
Kahn, 2019). In addition, some of this opaque risk could be transferred to other parts of
the nancial system through the GSEs’ sales of Credit Risk Transfer securities. Ensuring
that the GSEs are effectively measuring, monitoring, and managing climate risk will be
imperative for their continued ability to enhance the stability of the U.S. mortgage market.
The limitations of government shock absorbers will be an especially pressing issue in the
face of the enormous scal burdens from the COVID-19 pandemic. Responding to the
pandemic has already resulted in federal debt levels not seen since World War II. If, for
any of the reasons cited above, investors lost condence that public and private shock
absorbers would continue absorbing climate-related losses to the extent that they have,
fear in nancial markets could trigger a disorderly adjustment of prices in one or more
asset classes.
39
CHAPTER 3: IMPLICATIONS OF CLIMATE CHANGE FOR THE U.S. FINANCIAL SYSTEM
In the face of climate change, U.S. nancial regulators must ensure that emerging risks are
identied, measured, and effectively managed before they result in systemic or sub-systemic
nancial shocks.
2
This chapter explains how nancial regulators should undertake this
task. It also provides a high-level review of the authorities available to them under existing
legislation and assesses the extent to which these authorities are sufcient to start
addressing climate risk immediately. Finally, the chapter provides recommended actions that
nancial regulators can take to better protect the U.S. nancial system from climate risk.
Five Functions of U.S. Financial Regulators
Regulators, in an ideal world, should be able to perform ve important functions to address
climate-related risks. These functions are consistent with how regulators manage more
traditional risks to the nancial system, such as credit, market, and operational risk. The
ve functions are:
Identify and provide oversight of physical and transition risk at a systemic level. Regulators
should be able to monitor and assess how climate risk is affecting and could affect
the nancial system. That includes impacts on the functioning of nancial markets and
systemically important bank and nonbank nancial institutions, impacts that cut across
multiple asset classes and markets, and potential channels for nancial contagion and shock
magnication. Regulators should also be able to monitor “sub-systemic” shocks to parts
of the nancial system that serve particular sectors or regions of the country. This should
2
As explained in Chapter 3, “sub-systemic” shocks are those that affect nancial markets or institutions
in a particular sector, asset class, or region of the country, but without threatening the stability of the
nancial system as a whole.
41
Chapter 4
Existing Authorities and
Recommendations for
Financial Regulators
CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
include institutions that fall under the threshold of “systemically important” but may be
affected by sub-systemic shocks or more generally by the migration, motivated by climate
risk, of nancial activity from one part of the nancial system to another.
Ensure that nancial institutions, dealers, and other key market actors can monitor and
manage climate risks. Financial regulators should have condence that the entities they
supervise have mechanisms and capabilities to manage climate risk effectively. These include,
for example, effective governance arrangements, managerial incentives, risk identication
protocols, and risk modeling and risk quantication tools and methods. Regulators should
also encourage market participants to build capacity, develop data and tools, and share
good practices.
Ensure that nancial institutions, dealers, and other key market actors have the capacity
to absorb climate-related nancial impacts without causing system-wide or regional
disruptions. Regulators should be condent that key market participants can cope with
climate-related impacts such as credit, mark-to-market, and underwriting losses.
Ensure that investors, customers, and counterparties have adequate information to
understand material climate risk. Publicly traded companies, entities registered with the
CFTC and other regulators, and nancial institutions should disclose information about
material climate-related risks in an adequate and timely manner.
Identify and address climate-related operational vulnerabilities in nancial market
utilities (FMUs) and critical service providers. Financial regulators should have condence
that FMUs have adequately assessed their vulnerability to physical climate risk and have
adequate contingency protocols, business continuity measures, and redundancies to ensure
operational resilience in the face of a range of extreme climate events.
Existing Authorities and Practices
To what extent are U.S. regulators able to fulll the roles identied above? Existing legislation,
in general, provides U.S. nancial regulators with broad and exible authorities to perform
the key functions outlined above. However, regulators are not fully utilizing their authorities
and tools to effectively monitor and manage climate risk. Further rulemaking, and in some
cases legislation, may be necessary to ensure a coordinated national response.
Systemic Risk Oversight
Regulators have signicant, exible authority to monitor and manage system-wide risk.
The Financial Stability Oversight Council (FSOC)—created by the 2010 Dodd-Frank Wall
Street Reform and Consumer Protection Act (DFA)—is charged with identifying risks
and emerging threats to the nancial stability of the United States, including those “that
could arise outside the nancial services marketplace” (DFA, 2010, Section 112). To that
end, the FSOC is responsible for monitoring the nancial services marketplace to identify
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
42
potential threats to nancial stability, identifying gaps in regulation that could pose risks
to nancial stability, and facilitating information sharing and coordination among the FSOC
member agencies and other federal and state agencies on rulemaking and examinations
(DFA, 2010, Section 112), among other things. The CFTC is a voting member of the FSOC.
The FSOC is authorized to determine that a nonbank nancial institution should be supervised
by the Board of Governors of the Federal Reserve and subject to prudential standards
(DFA, 2010, Section 113). It can make this determination if it judges that the institution,
because of its nature, scope, size, scale, concentration, interconnectedness, mix of
activities, or “any other risk-related factors that the Council deems appropriate” could pose
a threat to nancial stability (DFA, 2010, Section 113). (So far, FSOC has made four such
determinations; all four designations have since been rescinded, three by the Council itself,
and one by a federal court.) The FSOC can also recommend to the Board of Governors
of the Federal Reserve—in the case of nonbank nancial companies supervised by the
Board of Governors and large, interconnected bank holding companies—that prudential
standards and reporting and disclosure requirements be made “more stringent” than
those applicable to other institutions that do not present similar risks to nancial stability
(DFA, 2010, Section 115).
The FSOC is supported by the Ofce of Financial Research (OFR) at the U.S. Department
of the Treasury. The OFR is charged with performing long-term research and developing
tools for risk measurement and monitoring (DFA, 2010, Section 153).
The Dodd-Frank Act also created the Federal Insurance Ofce (FIO) of the Department of
Treasury, which is charged with monitoring “all aspects of the insurance industry, including
identifying issues or gaps in the regulation of insurers that could contribute to a systemic
crisis in the insurance industry or the U.S. nancial system” (DFA, 2010, Section 502).
The FIO can also recommend to the FSOC that it designate an insurer as an entity subject
to regulation by the Board of Governors of the Federal Reserve.
Risk Management
Under existing authorities, regulators have wide latitude to help ensure that nancial
institutions, dealers, and other key market participants are identifying and managing risk
effectively, including in the context of the ve functions mentioned above.
Banks and nonbank nancial companies. Regulators enjoy broad authority to prudentially
supervise and regulate banks and nonbank nancial companies.
Under the Dodd-Frank Act, regulators can prescribe more stringent prudential standards
based on the riskiness, complexity, size and “any other risk-related factors the Board of
Governors deems appropriate” in the case of nonbank nancial companies supervised by
the Federal Reserve and for bank holding companies of a certain size (DFA, 2010, Section
165). Those prudential standards may include enhanced risk-based capital requirements and
43
CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
leverage limits, liquidity requirements, overall risk management requirements, concentration
limits, contingent capital requirements, and “such other prudential standards as the
Board of Governors [of the Federal Reserve]…determines are appropriate” (DFA, 2010,
Section 165). The Federal Reserve can supervise bank and nonbank nancial rms’ risk
management frameworks, including requiring that rms establish risk committees to ensure
that corporate managers appropriately govern risk, that rms use enterprise-wide risk
management practices, and that rms clearly dene oversight responsibilities in their boards
of directors.
One important supervisory and regulatory tool is stress testing. Within its existing authorities,
the Federal Reserve stress tests large bank holding companies periodically through its
Comprehensive Capital Analysis and Review (CCAR). The CCAR’s goal is to ensure that
nancial institutions have forward-looking capital planning processes that incorporate relevant
risks, and that they hold sufcient capital to continue operations through adverse economic
conditions. In the CCAR, regulators evaluate capital adequacy, internal capital adequacy
assessment processes, and capital distribution plans. Once the nancial institutions’ boards
have approved the capital plans, they are submitted to the Federal Reserve for review.
Also, banks with total consolidated assets of more than $250 billion are required to conduct
their own annual stress tests (DFA, 2010, Section 165, as amended by the Economic
Growth, Regulatory Relief, and Consumer Protection Act of 2018). Regulators set deni-
tions and rules that govern the stress tests, including the scope of application, scenarios,
reporting, and disclosure. The company-run stress tests provide forward-looking information
that enables regulators and the rms to better understand their risk prole. But the CCAR
and company-run stress tests do not consider climate-related risks. In addition to stress
testing, the Dodd-Frank Act authorizes to the Board of Governors of the Federal Reserve
to “develop and apply such other analytic techniques as are necessary to identify, measure,
and monitor risks to the nancial stability of the United States” (DFA, 2010, Section 165).
Regulators in some jurisdictions are experimenting with climate risk stress testing. For
example, the Bank of England in 2019 announced plans to conduct climate risk stress tests
of major U.K. banks and insurers. That year, the Bank of England’s Prudential Regulatory
Authority (PRA) required insurers to conduct a climate risk stress test based on three
scenarios and a prescribed methodology. Also, as part of the Bank’s Biennial Exploratory
Scenario (BES), scheduled to start in 2021, it will ask major U.K. banks and insurers to
estimate the size of climate change risks in three scenarios over a 30-year time horizon and
consider how they would adjust their business models under each scenario. To facilitate
this analysis, the Bank will provide a set of climate scenarios alongside pathways for
macro-nancial variables. This will build on the work of the Central Banks and Supervisors
Network for Greening the Financial System (NGFS), which has recently developed reference
scenarios for central banks and supervisors.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
44
Similarly, the Bank of France, the Australian Prudential Regulation Authority, and the Bank
of the Netherlands have completed or are in the process of launching climate risk stress
tests for banks and insurers. In March 2020, the European Central Bank (ECB) announced
preparations for a macroprudential stress test aimed at understanding how climate risks
could propagate across the non-nancial economy and the nancial system.
Central bank asset purchases. Under existing emergency authorities, the Federal Reserve
can purchase nancial assets to inject liquidity into stressed markets and to maintain rms’
access to nance during adverse conditions. Asset purchase programs were crucial to
the central bank’s effort to address the nancial crisis in 2008 and 2009, and have been
revived and expanded to combat the nancial impacts of the COVID-19 pandemic. As
a result, the Federal Reserve has announced its intention to buy not only the agency
mortgage-backed securities and federal government debt it purchases as part of its
monetary policy operations to support the macroeconomy, but also municipal bonds and
corporate debt in primary and secondary markets, including bonds of companies that fell
below investment grade after March 22, 2020. These nancial assets will sit on the central
bank’s balance sheet for an undened period. If the value of these assets deteriorates,
the public ultimately bears the risk. Currently, the Federal Reserve, in conducting asset
purchases, does not systematically consider, measure, or disclose transition and physical
climate risks.
Commodities and derivatives markets. The Commodity Exchange Act empowers the CFTC
to regulate commodities and derivatives markets. That authority includes the regulation of
market participants, such as futures commission merchants (FCMs), swap dealers and
major swap participants (MSPs), and market infrastructure, including designated clearing
organizations (DCOs), designated contract markets (DCMs), and swap execution facilities
(SEFs) (CFTC, 2020). Following the nancial crisis, the Dodd-Frank Act signicantly
extended the CFTC’s jurisdiction to cover over-the-counter (OTC) derivatives or swaps.
Several CFTC authorities are especially relevant in the context of managing climate risk.
The CFTC’s regulations require swap dealers to maintain an effective risk management
program that covers various risks. DCOs, DCMs and SEFs also must satisfy capital
adequacy requirements and maintain a framework for monitoring and managing risk.
Also, the CFTC requires swap dealers to “establish, document, maintain and enforce”
a system of risk management policies and procedures designed to monitor and manage
risks, including market, credit, liquidity, and foreign currency risks, as well as “any other
applicable risks” (CFTC Rule 23.600). Other applicable risks presumably could include
climate-related risks if they are deemed material. Swap dealers also are required to satisfy
all capital and margin requirements established by the CFTC or any prudential regulator
(CFTC Rule 23.600(c)(6)).
45
CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
CFTC Rule 23.600(c)(2) requires swap dealers to make quarterly written reports to their
senior managers and governing body, setting forth their market, credit, liquidity, foreign
currency, legal, operational, settlement and any other applicable risk exposures, as well
as any recommended or completed changes to their risk management program. These
quarterly reports must be submitted to the CFTC within ve business days of providing
them to senior managers. The CFTC also conducts clearinghouse supervisory stress tests.
Three have been conducted so far. The tests have included clearinghouse liquidity risks,
though the tests have not covered operational risks, including risks from climate-related
physical impacts.
Insurance. The U.S. system for regulating insurance markets vests authority with state
insurance regulators. Under this system, unless a federal law explicitly preempts states
from regulating some aspect of insurance, state insurance regulators’ authority is governed
by state laws and regulations. Because climate change-related impacts can pose risks to
insurance companies as underwriters or investors, insurance regulators could use their
authority under state laws and regulations to identify, monitor, and address climate-related
physical and transition risks facing individual insurance companies and the insurance
sector more broadly. If state insurance regulators need additional authority, states can
enact laws granting it.
Insurance regulators can require stress testing to better understand insurers’ risk proles
and capacity to absorb losses. For example, California’s Insurance Commissioner conducted
a climate risk scenario analysis of insurers’ investment portfolios—the only state so far to
do so (CDI and UC Berkeley CLEE, 2018). Unlike insurance regulators in other countries,
including the Bank of England, the Bank of the Netherlands, and the Bank of France, no U.S.
state insurance regulator has undertaken climate risk stress tests of insurance companies.
Credit rating agencies. Credit rating agencies provide information that is actively used
by investors in the nancial marketplace. The U.S. Securities and Exchange Commission
(SEC) can prescribe rules requiring rating agencies to submit an annual internal controls
report, which must contain, among other things, “an assessment of the effectiveness of the
internal control structure” of the agencies (DFA, 2010, Section 932). The control structure
governs the implementation of “policies, procedures, and methodologies” for determining
credit ratings (DFA, 2010, Section 932).
In recent years, credit rating agencies have started to consider climate-related risks in
their ratings. For example, one rating agency cited environmental, social, and governance
(ESG) risks as material credit considerations in a third of the more than 7,600 private
sector rating actions published in 2019 (Mutua, 2020). Progress has been notable in the
incorporation of physical climate risk variables into sovereign and municipal bond ratings,
as well as into ratings of some corporate debt.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
46
Disclosure and Investor Protection
Under existing authorities, nancial regulators have broad authority to require disclosure
of material information to regulators, investors, customers, and counterparties. Chapter 7
provides an additional discussion of disclosure-related authorities.
Banks and nonbank nancial companies. Under the Dodd-Frank Act, the Board of Gover-
nors of the Federal Reserve can require periodic public disclosures by nonbank nancial
companies it supervises and by bank holding companies of a certain size “to support
market evaluation of the risk prole, capital adequacy, and risk management capabilities”
of those companies (DFA, 2010, Section 165). These disclosures are in addition to the
disclosures required by the SEC for publicly listed banks and nonbank nancial institutions.
Securities issuers. The SEC is charged with protecting investors and maintaining fair,
orderly, and efcient capital markets. Firms issuing securities to the public must register
with the SEC and disclose information about the company, its management, how the
rm intends to use the funds raised through the sale of securities, and material risks to
investors. Not only are publicly traded corporations required to register, but so are other
securities-market participants, such as stock exchanges, securities brokerages, mutual
funds, auditors, and investment advisers.
SEC Regulation S-K provides disclosure requirements for publicly traded companies. Under
Regulation S-K, public companies are required to disclose material information—known
trends, events, or uncertainties that are “reasonably likely to have a material effect” on the
company’s nancial condition or operating performance—through annual or other public lings
(SEC, 1989). In 2010, the SEC issued guidance “to remind companies of their obligations
under existing federal securities laws and regulations to consider climate change and its
consequences as they prepare disclosure documents to be led with us and provided to
investors” (SEC, 2010). As discussed in more detail in Chapter 7, the guidance has not
had a signicant impact on actual climate risk disclosures by companies because of its lack
of specicity and uneven application (Stevenson, 2019; Gelles, 2016).
Commodities and derivatives markets. Under the Commodity Exchange Act and CFTC
regulations, the CFTC can require a range of upstream and downstream risk disclosures,
including scenario analyses, in some circumstances. For example, certain market participants
are required to make upstream nancial disclosures to DCOs, DCMs and SEFs. Under
the CFTC’s rules, risk disclosures primarily are made downstream, such as from swap
dealers and FCMs to their counterparties and customers. In contrast to the broad company
disclosures required by the SEC and other regulators, the CFTC-required disclosures are
primarily product disclosures. However, they could be interpreted to specically require
addressing climate-related risks to certain commodity contracts.
47
CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
For example, under the CFTC’s business conduct rules, swap dealers must disclose to
their counterparties, before entering into a swap, material information concerning it. This
must be done in a manner reasonably designed to allow the counterparty to assess,
among other things, the material risks of the swap (such as market, credit, liquidity, foreign
currency, legal, and operational risk).
3
Before entering into a swap, the swap dealer also
must notify the counterparty of its right to request and consult on the design of a scenario
analysis. The purpose of the scenario analysis is to allow the counterparty to assess its
potential exposure in connection with the swap over a range of assumptions, including
severe downside stress that would result in signicant losses (CFTC Rule 23.431(b)).
Insurance. State insurance regulators can require insurance companies to disclose a
variety of risk-related information, including climate-related risks. Those disclosures can
be made public by the regulators (NAIC, 2019; CDI, 2018). For example, since 2011,
the National Association of Insurance Commissioners (NAIC) Climate Risk Disclosure
Survey has been administered to insurance companies by regulators in California, New
York, Washington, Oregon, and Connecticut. The California Department of Insurance
(CDI) publishes the survey results on its website. The Climate Risk Carbon Initiative of
the California Department of Insurance requires insurers above a certain annual premium
threshold to report their investments in thermal coal, oil and gas enterprises, and utilities
deriving 50 percent or more of their electricity from fossil fuels. The Department discloses
the results on its website. In addition, state laws grant state regulators broad powers of
nancial examination as well as the authority to request information from insurers through
mandatory “data calls.”
State insurance regulators do not require insurers to make climate risk disclosures as
recommended by the Task Force on Climate-related Financial Disclosures (TCFD). Six
state insurance regulators require insurers with premiums in excess of $100 million a year
to answer the annual NAIC Climate Risk Disclosure Survey. The survey effectively covers
about 1,000 insurers representing 70 percent of U.S direct written premiums. However,
the survey is outdated (it was designed in 2009 and not updated since), it does not collect
quantitative information, and it falls far short of the disclosures recommended by the TCFD.
Financial Market Utilities
Finally, U.S. regulators have broad authority to oversee the operational and nancial
resilience of nancial market utilities and other critical service providers. For example, the
FSOC can designate FMUs or payment, clearing, and settlement activities as systemically
important based on, among other things, “the effect that the failure of or a disruption to the
nancial market utility or payments, clearing, or settlement activity would have on a critical
markets, nancial institutions, or the broader nancial system” (DFA, 2010, Section 804).
3
Note that swap dealers utilize standard disclosures prepared by International Swaps and Derivatives
Association (ISDA), including the Physical Commodity Disclosures, which generally address risks
regarding underlying physical commodities and markets.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
48
Once designated an FMU or other nancial institution is designated as systemically important,
the Board of Governors of the Federal Reserve can prescribe risk management standards
governing their operations related to the payment, clearing, and settlement activities. The
CFTC and the SEC can do the same for the operations of critical service providers under
their jurisdiction. Climate-related impacts are not incorporated into these risk management
standards. Financial regulators are studying the potential impacts of cyberattacks aimed
at disrupting FMUs (OFR, 2017). Lessons drawn from this exercise may be relevant and
useful in the context of climate-related operational risks to FMUs.
Recommendations
Market participants and the regulatory community, in the United States and abroad, are
in the early stages of understanding and experimenting with how best to monitor and
manage climate risk. Given the considerable complexities and data challenges involved,
regulators and market participants should adopt pragmatic approaches that stress continuous
monitoring, experimentation, and learning. Regulatory approaches in this area are evolving
and should remain open to renement, especially as the understanding of climate risk
continues to advance and new data and tools become available.
At the same time, regulators should establish a clear framework with appropriate
milestones. This is what nancial regulators are already doing in some jurisdictions and is
consistent with recommendations of nancial regulatory bodies (Bank of England, 2019;
Bank for International Settlements, 2020; NGFS, 2020). As explained above, in general,
regulators have sufcient authority to start tackling climate risk immediately. The following
recommendations provide, in our view, a good starting point.
Systemic Risk Oversight
Recommendation 4.1: All relevant federal nancial 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. Regulators should
further develop internal capacity on climate-related risk measurement and management,
including through their strategic planning, organizational structure, and additional resourcing.
Recommendation 4.2: The Financial Stability Oversight Council (FSOC), of which the
CFTC is a voting member, should undertake the following:
●
As part of its mandate to monitor and identify emerging threats to nancial stability,
incorporate climate-related nancial risks into its existing oversight function, including
its annual reports and other reporting to Congress;
●
Encourage and coordinate, across the Council’s member agencies, the sharing of best
practices concerning the monitoring and management of climate-related risks, the
building of relevant institutional capacity, the integration of climate-related risks into
49
CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
the risk monitoring function of the agencies and into nancial supervision and regula-
tory frameworks, and the potential for second-order impacts, such as the migration
of nancial activity from one part of the nancial system to another; and
●
Task the Ofce of Financial Research with developing a long-term program of research
on climate-related risks to the nancial system, paying close to the potential intercon-
nectivity and spillovers of climate-related risks across the nancial system; monitoring
relevant developments; and developing tools that regulators can use for the monitoring
and management of climate-related risks.
Recommendation 4.3: Research arms of federal nancial regulators should undertake
research on the nancial implications of climate-related risks. This research program
should cover the potential for and implications of climate-related “sub-systemic” shocks
to nancial markets and institutions in particular sectors and regions of the United States,
including, for example, agricultural and community banks and nancial institutions serving
low-to-moderate income or marginalized communities. Research should also include the
impact of climate risk on nancial system assets and liabilities, including by sensitivity of
specic sectors to climate change, geographic location, and tenor. In doing so, regulators
should identify data gaps and approaches to address these shortcomings. Regulators
should develop assessments of the magnitude of the impact of climate on these assets
and liabilities, for example through scenario analysis.
Recommendation 4.4: Relevant federal regulators should assess the exposure and
implications of climate-related risks for the portfolios and balance sheets of the government-
sponsored enterprises (GSEs) and strongly encourage the GSEs to adopt and implement
strategies to monitor and manage those risks.
Recommendation 4.5: The Federal Insurance Ofce, in collaboration with state insurance
regulators, should undertake an assessment of the insurance sector’s systemic vulnerability
to climate-related impacts and report the ndings to the FSOC. FIO should also evaluate
the adequacy of state insurance regulators’ oversight of climate-related risks.
Recommendation 4.6: Federal nancial regulators should actively engage their interna-
tional counterparts to exchange information and draw lessons on emerging good practice
regarding the monitoring and management of climate-related nancial risks. U.S. regula-
tors should join, as full members, groups convened for this purpose, including the Central
Banks and Supervisors Network for Greening the Financial System (NGFS), the Coalition
of Finance Ministers for Climate Action, and the Sustainable Insurance Forum (SIF). The
United States should also engage actively to ensure that climate risk is on the agenda
of Group of Seven (G7) and Group of Twenty (G20) meetings and bodies, including the
Financial Stability Board (FSB) and related committees and working groups. The Federal
Reserve already participates in the Basel Committee on Banking Supervision’s climate
task force, and the Securities and Exchange Commission participates in the International
Organization of Securities Commissions’ (IOSCO) sustainable nance network.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
50
Risk Management
Recommendation 4.7: Financial supervisors should require bank and nonbank nancial rms
to address climate-related nancial risks through their existing risk management frameworks
in a way that is appropriately governed by corporate management. That includes embedding
climate risk monitoring and management into the rms’ governance frameworks, including
by means of clearly dened oversight responsibilities in the board of directors.
Recommendation 4.8: Working closely with nancial institutions, regulators should
undertake—as well as assist nancial institutions to undertake on their own—pilot climate
risk stress testing as is being undertaken in other jurisdictions and as recommended by the
NGFS. This will enable stakeholders to better understand institutions’ exposure to climate-
related physical and transition risks, as well as to explore climate-related opportunities.
The pilot program should include the testing of balance sheets against a common set of
scenarios (elaborated on in Chapter 6 and Recommendation 6.6), covering how nancial
institutions might respond to climate-related risks and opportunities over specied time
horizons. This climate risk stress testing pilot program should include institutions such as
agricultural, community banks, and non-systemically important regional banks.
Recommendation 4.9: Regulators should closely monitor international experience with
climate risk stress testing of banks and insurers and apply relevant lessons to the U.S.
context. U.S. regulators should engage in international forums, such as the NGFS, to
ensure that climate risk stress testing conducted in the United States is comparable to
similar exercises in other jurisdictions and avoid duplicative exercises for institutions with
a multi-jurisdictional footprint.
Recommendation 4.10: Financial authorities should consider integrating climate risk into
their balance sheet management and asset purchases, particularly relating to corporate
and municipal debt.
Recommendation 4.11: The CFTC should:
●
Undertake a program of research aimed at understanding how climate-related risks are
impacting and could impact markets and market participants under CFTC oversight,
including central counterparties, futures commission merchants, and speculative traders
and funds; the research program should also cover how the CFTC’s capabilities and
supervisory role may need to adapt to fulll its mandate in light of climate change and
identify relevant gaps in the CFTC’s regulatory and supervisory framework;
●
Drawing on the conclusions of the research program above, review the extent to which
existing CFTC rules are adequate to monitor and manage climate-related risks. For
example, CFTC should review the extent to which rules for non-centrally cleared over-
the-counter derivatives (NCD) are appropriate for monitoring and managing climate-
related risks. It should also review rules related to capital and margin requirements of
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CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
futures commission merchants and swap dealers, as well as initial margin and default
fund rules, risk management rules, and capital requirements pertaining to central
counterparties;
●
Expand its own central counterparty stress testing to cover the operational continuity
and organizational resilience of central counterparties, including organizational resilience
of operations, contingency planning, and engineering resilience for facilities exposed
to climate-related physical risks. Where central counterparties and market infrastruc-
ture are not within the CFTC’s direct supervisory remit, the supervision of physical
risks should be addressed by the relevant FSOC member in a consistent fashion; and
●
As better understanding emerges of the risk-transmission pathways and of where
the material climate risks lie, consider expanding the CFTC’s risk management rules
and related quarterly risk exposure reports to cover material climate-related risks.
Recommendation 4.12: State insurance regulators and insurance regulators’ supervisory
colleges, which are convened by regulators where an insurer or its subsidiaries or afliates
operate in multiple jurisdictions, 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; and
●
To facilitate the risk assessment mentioned in the point above, insurance regulators
should conduct, or require insurance companies to conduct, climate risk stress tests
and scenario analyses to evaluate potential nancial exposure to both the physical
and transition impacts of climate change; state insurance regulators should provide
the scenarios, assumptions, and parameters for the stress testing exercise.
Recommendation 4.13: Regulators should require insurers to integrate consideration of
climate risks into insurers’ Enterprise Risk Management (ERM) and Own Risk Solvency
Assessments (ORSA) processes.
Recommendation 4.14: Regulators should require credit rating agencies to disclose the
extent to which their ratings take into account climate risk, including for issuers of corporate,
municipal, and sovereign debt. This should include a disclosure of applicable methodologies
for those credit rating products that consider climate risk.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
52
Disclosure
See
Chapter 7 for recommendations on disclosure.
Financial Market Utilities
Recommendation 4.15: Federal regulators should ensure that risk management standards
governing the operations related to the payment, clearing, and settlement activities of
FMUs incorporate measures to monitor and manage physical climate risks. The CFTC, in
its capacity as an FSOC member, should recommend that the Council oversee and coor-
dinate this process as it pertains to FMUs designated as systemically important.
Recommendation 4.16: The CFTC should review the extent to which nancial market
infrastructure—including but not limited to systemically important FMUs for which it is the
primary regulator—is resilient against losses that could arise through the physical impacts
of climate change.
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CHAPTER 4: EXISTING AUTHORITIES AND RECOMMENDATIONS FOR FINANCIAL REGULATORS
This chapter examines climate-related risk management by nancial institutions. It reviews
the components of physical and transition risk, building on the description of ongoing
and potential climate impacts in Chapter 2. It then explores several important questions:
How can more robust climate risk data and better analytics be developed, and how can
nancial institutions continue to build their capacity to utilize climate analytics to inform
business decisions? What kind of analysis should be undertaken to complement existing
risk management? How can climate-related risk analysis support and strengthen risk
management across different parts of the nancial system?
As referenced in Chapters 2 and 3, climate change has broad implications for macroeconomic
performance, including ination, interest rates, balance of payments, productivity, wealth,
and gross domestic product (GDP) growth. Physical and transition risks could profoundly
impact, among other things, valuation, credit risk analysis, and asset-liability matching.
Climate change also has specic locational considerations and impacts on individual physical
assets and the rms that own those assets. It can also affect complex supply chains,
as well as public and private infrastructure that supports the economy. Understanding
and developing tools to analyze and monitor qualitative uncertainties and quantitative
risks, including location-specic risks, requires a variety of datasets, methodologies, and
measurement technologies. Effectively managing climate risk requires understanding
the vulnerability and resilience of economic actors and markets to climate risks because
transition and physical risks from climate change do not uniformly impact companies,
countries, sectors, or geographies.
While there is no one-size-ts-all methodology, tool, or scenario, many approaches may
be appropriate for different cases. Integrated environmental and economic datasets and
methods are relatively new and evolving so any climate risk management approach should
be exible and allow for ongoing learning and the incorporation of best available science
and technology. Climate risk management should recognize that condence intervals and
the accommodation of uncertainty may vary considerably between scientic and nancial
stakeholders.
55
Chapter 5
CHAPTER 5: A CLOSER LOOK AT CLIMATE RISK MANAGEMENT AND DATA
A Closer Look at Climate Risk
Management and Data
Required levels of condence, spatial and temporal scales, and the range of potential
climate-attributed shocks and stresses associated with physical and transition risks will
govern the most suitable approaches for any given nancial institution. In each instance,
the inherent uncertainties, non-linearities and feedback sensitivities associated with climate
change need to be considered; they increase the further into the future one attempts to
look. Scenario analysis, covered in Chapter 6, seeks to inform and identify parameters
and indicators to better manage deep uncertainties. This chapter focuses on how climate
risk analysis can be applied to support and strengthen climate risk management, and the
barriers to achieving this goal.
The Demand for Climate Risk Management and Data
To undertake climate risk management, rms need reliable, consistent, and comparable
data and methodologies. Climate risk management helps rms adapt to changes in markets
arising from physical and transition risks and it helps them build resilience so they can
continue to deliver products and services in the face of those risks. Drawn from several
decades of international consensus building through the Intergovernmental Panel on Climate
Change (IPCC) and the U.S. National Climate Assessments (NCA), these concepts
have been widely applied and internalized into the governance and management of rms
(Winston, 2014; Linnenluecke, 2017; McKnight and Linnenluecke, 2019). The following
summarizes the key concepts framing current climate risk data and management practices.
These concepts are consistent with the ofcial denitions promulgated by the interagency
U.S. Global Change Research Program (USGCRP), as ratied by the National Academies
of Sciences, Engineering, and Medicine (NASEM).
Adaptation and Resilience
Firms’ two-pronged goal should be to adapt to climate change by addressing physical
climate impacts and transitioning to a net-zero economy.
Adaptation
is dened as, “[an]
[a]djustment in natural or human systems to a new or changing environment that exploits
benecial opportunities or moderates negative effects” (USGCRP, 2020). In this sense,
adaptation is not only about managing risk, it is also about taking advantage of opportunities
that may arise in broader transformations of markets, including transformations shaping a
more sustainable and equitable economy. For rms, the goal is to develop a robust
adaptive
capacity
, which can be dened as, “[t]he potential of a system to adjust to climate change
(including climate variability and extremes) to moderate potential damages, take advantage
of opportunities, and cope with the consequences.” (USGCRP). (A system could include,
for example, a rm or a market.) Because of the many uncertainties of climate change, rms
should strategically build a capacity to adapt to a variety of knowns and unknowns. To build
the adaptive capacity of a rm, its executives may institute
adaptive management
processes
that involve “iteratively planning, implementing, assessing and modifying strategies for
managing resources in the face of uncertainty and change” (Keenan, 2018, p. 146). In 2019,
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
56
the International Organization of Standardization (ISO) published the rst adaptation
standard (ISO 1490:2019) aimed at supporting rms’ adaptive management (ISO, 2019).
While adaptation and adaptive capacity frame the broader ambitions of rms and markets, in
the near-term they must also build a capacity for
resilience
, which is dened as, “[a] capability
to anticipate, prepare for, respond to, and recover from signicant multi-hazard threats with
minimum damage to social well-being, the economy, and the environment.” (USGCRP,
2020). The resilience of a market or a nancial system can be understood as its capacity
to withstand various shocks and stresses and still maintain critical levels of performance.
At the rm level,
organizational resilience
is the capacity to identify, diagnose, and manage
external shocks and stresses to continue operations and regular business activities
(Sahebjamnia, et al., 2015). Firms’ organizational resilience activities may include everything
from business continuity planning to contingent contracting for alternative supply chains.
Other types of resilience, including
community resilience
and
ecological resilience
, are
also central to supporting impact driven decision-making.
Defining Climate Risk Management and Data
Firms should focus their risk management and long-term governance on building their
capacity to adapt to new markets, products and services, while at the same time developing
the organizational resilience to be able to actually deliver those products and services in
the face of immediate shocks and stress, including both climatic and non-climatic events.
Beyond preparing for physical risks, rms should adapt their businesses to facilitate and
participate in a transition to a net-zero economy. Managing transition risks includes taking
advantage of opportunities associated with new forms of sustainable production and
consumption.
Climate risk is categorized as either transition or physical risk. But as Chapter 2 explains,
sometimes these categories are not easily bifurcated. In other cases, certain types of
physical risks are widely understood as known natural, technological, and human-caused
hazards (FEMA, 2009). Both physical and transition risks, because they are novel, represent
a challenge to the analytical parameters of conventional risk management, which often
focus on specic plausible, but extreme events that have some basis in prior experience.
Because risk is technically a probabilistic function of exposure, sensitivity and consequence,
the novelty of climate change means that there is greater uncertainty and ignorance
about the range of possible outcomes (USGCRP, 2020). Climate risk should properly
be conceptualized as a combination of physical and transition risks—and uncertainties.
To build their adaptive capacity and organizational resilience, businesses must develop
near real-time intelligence that allows them to better understand a range of plausible
events and scenarios. U.S. nancial regulators, who are the stewards of the stability of the
nancial system, also must build these capacities for climate risk management. Together,
the processes of adaptation and resilience within climate risk management dene the
demand for climate risk data.
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CHAPTER 5: A CLOSER LOOK AT CLIMATE RISK MANAGEMENT AND DATA
Climate risk data is highly complex and relies on translating scientic and economic models
into nancial transmission pathways and then into decision-useful nancial variables and
metrics. In developing this data, time horizons should be considered, given that nancial
exposure can be somewhere between short-term, relative to certain climate risks, and
long-term, for the duration of a durable asset class. Data should allow for both bottom-up
and top-down analysis at the appropriate level of detail for the use case (the specic
situation in which a product or service will be used). Ideally, available data would support
a wide variety of estimates and projections, covering appropriate time horizons with levels
of detail, geographical coverage, and condence relevant to the particular use case. In this
ideal situation, these models would produce decision-useful data that are comprehensive,
consistent, and comparable and that would inform assessments of the underlying risk,
uncertainty, and vulnerability of rms, counterparties, assets, and markets.
Vulnerability
is a composite measure of exposure, sensitivity and, in this case, the adaptive
capacity of a rm to manage the climate risks of a particular asset.
Exposure
reects the
presence of nancial assets coinciding with climate impacts—namely acute extreme events
or recognizable patterns of stress. Exposure is the prerequisite to the transmission of climate
risks to nancially relevant metrics.
Sensitivity
reects a measure of the responsiveness of
exposed assets to any given shock or stress. For instance, an asset with high exposure and
low sensitivity may not be too adversely impacted. Table 3.1 provides examples of nancial
assets exposed to climate risks. While an ecosystem of climate data is emerging, much
of the advances in measuring and evaluating asset exposure have not been accompanied
by corresponding advances in evaluating the sensitivity of exposed assets or the adaptive
capacity of rms to manage sensitivity and exposure. Physical risk data and projections
need to be overlaid with exposure data at the asset level. Some nancial institutions may
have asset-level data to overlay with physical risk data, for example, a bank providing project
nance loans. However, most nance use cases will not have direct access to asset-level
data for counterparty analysis, let alone analysis of multiple counterparties in a portfolio
(such as a listed equities portfolio). Understanding the vulnerability of exposed assets and
counterparties to climate risk requires a wide variety of qualitative and quantitative metrics,
and detailed data is largely unavailable across most use cases.
Expanding Climate Risk Data
The increasing adoption of climate risk management practices should incentivize the
development of more robust climate risk data. However, while physical risk data is more
widely available than transition risk data, both are generally insufcient, and several barriers
impede the development of robust decision-useful data. Effective risk management in
general, including scenario analysis as described in Chapter 6, relies on the analysis of
physical and transition risk data. The two primary barriers to expanding the quality and
availability of climate risk data are (i) availability and (ii) standardized denitions.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
58
Availability
Climate data and supporting measurement technologies and analytical methodologies
are rapidly advancing in what is now understood as an emergent climate services sector.
However, the quality and interoperability of these services is at a relative early stage.
Signicant gaps in sectors and across asset classes are impeding not only climate risk
management, but also aspects of operations and investment analysis that depend on
data-informed processes.
The availability of climate data depends on a variety of public, private and civic sector
sources. Historically, climate data was largely environmental and weather data produced
by government agencies. Today, climate data serves to help market actors understand
climate-related vulnerability in both qualitative and quantitative terms. It may reside:
(i) in company disclosures to nancial markets, regulators, and government agencies
(in multiple jurisdictions and in different languages); (ii) in voluntary disclosures; (iii) in existing
proprietary and non-proprietary databases; (iv) in public and private research institutions;
and, (v) in academic research. However, the challenge is nding the relevant sources if
they exist, and then validating, cleaning, and standardizing the data in an accessible form
or format. Chapter 7 addresses corporate disclosure of climate risk information.
Ideally, relevant data would be available and structured to facilitate extraction for nancial
or sustainability reporting. However, many companies currently either do not report, or
report only limited information. Further, calculation methodologies and reporting formats
are not standardized. As a result, information is not comparable, causing measurement
divergences. It is extremely difcult for individual institutions to secure all the data necessary
for detailed datasets. Innovative technologies, such as “data mining” and remote sensing,
could open new avenues for generating, at low cost, detailed climate risk data relating to
both listed and non-listed companies.
Several organizations offer solutions to address these data and methodological challenges.
Different providers collect carbon emissions data, largely based on company disclosures,
while other providers use proprietary methods to estimate emissions data. For physical risk,
several providers have developed models to assess the frequency and severity of physical
perils based on future emissions pathways, predominantly IPCC scenarios. Coverage,
including geography and level of detail, varies across these providers. This data and related
services can be expensive, and licensing may restrict or otherwise impede integration into
broader climate risk tools. It can often be too expensive for smaller rms, which instead
rely on public data from government sources or academic institutions, which may specialize
within local geographies. However, the value of this data is a key driver of related nancial
and risk management innovation. U.S. nancial regulators or industry bodies may be able
to develop common data platforms and technical standards to enable the ow of data
in accessible formats. External organizations and public open access platforms also are
seeking to address costs that may be incurred by parties that use and disclose climate
risk data, including from internal specialists, technology systems, and consulting services.
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CHAPTER 5: A CLOSER LOOK AT CLIMATE RISK MANAGEMENT AND DATA
At the heart of efforts to make climate-related data more accessible are two objectives,
which can at times be in tension with each other: the expansion of public open access to
climate data on one hand, and the development of proprietary intellectual property related
to climate data and services, on the other. There is great demand for public open access
to climate data, including primary data based on public and civil sector measurement
infrastructure. The American Meteorological Society has taken steps to support principles
that guide further development of open access environmental and climate data (AMS, 2019).
These efforts are important for ensuring that a robust process can inform decision-making
in both the public and private sectors. Market participants who want to compare publicly
available disclosure information and sustainability-benchmarked nancial products also would
benet from open access data. Open access data is important for consumer transparency,
scientic integrity and market development.
At the same time, proprietary intellectual property that will drive innovation in technologies
and climate-related data and services also is needed. These technologies and services
are necessary to facilitate the data underlying climate risk management and disclosure.
In recent years, increased investment in climate data technologies has been a positive
sign for the commercialization of underlying intellectual property and the recognition in
the private sector of its value. The challenge ahead will be to balance both the public and
private objectives in the interests of both transparency and innovation. Appendix Table 1
includes a sample of public and civil society efforts to increase the availability of climate
risk data. There are a wide range of private sector activities, not covered in the Appendix.
Standardized Definitions
A common set of denitions for climate risk data—including modeling and calculation
methodologies—is important for developing consistent, comparable, and reliable data. For
data to be decision useful, it is necessary to know which climate-related variables materially
impact the performance of markets, countries, sectors, asset classes, companies, projects,
and securities, and how these variables interact. While these interactions often defy analysis,
the ambition to better understand them remains. These fundamental research questions
inform what data should be disclosed, including unit of measurement, frequency, and format.
Common denitions for climate risk data include reporting formats and calculation meth-
odologies that can help mitigate limitations. However, lack of standards, and differences
among standards, can create barriers to climate risk management. Voluntary disclosure
frameworks, as described in Table 7.1, have helped signicantly, but in the aggregate
these frameworks identify more than 165 potentially “material” metrics, an overwhelmingly
large number for many nancial institutions. In some cases, different units of measure are
stipulated for similar metrics across frameworks. Organizations are actively working to
address some of these standards issues, but further work is needed.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
60
An example of the challenges around climate risk data is the wide variation in available ESG
(environmental, social, and governance) and climate scores. Massachusetts Institute of
Technology research has found that ESG scores from the main ve ESG data providers are
uncorrelated for any given company (Berg, et al., 2019). Many practitioners are uncertain
about which factors are best suited for particular use cases, a problem compounded by
lack of transparency into underlying data and methodologies.
There is little international coordination on data and methodology standards, and existing
efforts may conict with the direction the United States may take. In 2018, The European
Commission (EC) established a technical expert group (TEG) on sustainable nance to
develop a European Union (EU) classication system—the EU taxonomy—to determine
whether an economic activity is environmentally sustainable, as well as other related
denitional standards for climate-related data and nancial products. A goal of the EU
taxonomy is addressing data inconsistencies by providing a single, methodologically
transparent, and rigorous standard to judge the environmental attributes of nancial
products as sustainable and non-sustainable. However, explicitly setting thresholds poses
challenges, particularly given the diversity of the U.S. economy and the context of the
U.S. regulatory structure.
In general, taxonomies, standardized denitions and classication systems can help enable
transparency and comparability. Consistency and reliability in climate risk data would then
allow nancial institutions to compare assets and companies, among other objectives. This
could unleash competitive dynamics around managing climate risk that would increase
resilience, including via “green” activities.
The United States should develop guidance supporting the comparison and reliability of
climate risk data and nancial products and services. The guidance should account for the
nuances of the U.S. economy and regulatory system and build on the lessons learned in the
EU and other jurisdictions, including China and Brazil. Development of this guidance could
occur through the establishment a Standards Developing Organization (SDO) composed
of public and private sector members. Given the potential downsides of standardization,
the SDO should ensure it does not overly raise barriers to entry or restrict innovation.
The SDO can work with international counterparts and the private sector to memorialize
emerging best practices that advance climate risk management and the development of
sustainable nancial products and services. The NASEM can provide a foundation for
the scope of SDO activities by convening public, private, civic, and international stake-
holders to promulgate a consensus study report to Congress. Currently, market-based
opinion and assurance bodies are serving this function for nancial products, and these
services are important for continued market development. For standards and guidance
to be optimally effective, there will ultimately need to be multilateral global coordination
in the development, maintenance, and benchmarking of relevant indicators, reinforced by
robust disclosure practices.
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CHAPTER 5: A CLOSER LOOK AT CLIMATE RISK MANAGEMENT AND DATA
Scope 3 Emissions and Transition Risk
The Greenhouse Gas Protocol is a widely used global standardized framework for categorizing emissions
as Scope 1, 2 or 3. Scope 1 emissions are direct emissions from owned or controlled sources, and Scope 2
emissions are indirect emissions from purchased energy (electricity, steam, heat and cooling) generated by
external entities. Scope 3 emissions encompass all other indirect emissions across the value chain, including
both upstream and downstream. Scope 1 and 2 data is much more available than Scope 3 data.
Scope 3 emissions are a proxy for and an important input to transition risk, particularly for bottom-up company-
specific analysis, as they reflect transition exposure. For automakers, Scope 1 and 2 emissions include vehicle
manufacturing, while Scope 3 emissions include the upstream supply chain as well as the downstream
gasoline, diesel, or electricity that customers use to operate vehicles. The Scope 1 and 2 emissions from
operating a building are dwarfed by the Scope 3 emissions from steel, cement, and other materials used during
construction. However, Scope 3 emissions represent only a portion of transition risk, and complementary data
is required to make Scope 3 emissions fully decision useful. Among other factors, emissions intensity, demand
and supply elasticity, and the associated pass-through of production prices to consumers impact vulnerability
in the short-term, while transition plans, evolving consumer preferences and technology innovation impact
vulnerability in the longer-term. Effective risk management requires focus on the full spectrum of transition
risk. For example, to assess oil and gas company transition risk from carbon pricing, key inputs include capital
structure, marginal cost of production, emissions intensity of products, and duration of reserves.
Financed emissions are a special category of Scope 3 emissions, reflecting the indirect emissions underlying
financial portfolios, products and services. Financed emissions can help highlight the point-in-time carbon
exposure of a financial institution, portfolio or product, but need to be complemented with a range of other
data (for example, use of proceeds from a financing and companies’ emissions trajectories and financial
capabilities) and specifics of the underlying portfolio or financial product (such as asset class, duration,
diversification, geographic exposure, hedging, and risk mitigation) to be decision useful for transition risk
management. Businesses are increasingly committing to net-zero emissions, and increased sustainable
investments by an institution could cause its financed emissions to decline.
In addition, design issues specific to financed emissions raise challenges, particularly around allocating
emissions to the wide range of financial activities. Financed emissions from owning 1 percent of a company
might include 1 percent of that company’s emissions; a portfolio can rapidly double count if aggregate
financed emissions include each underlying company’s own Scope 3 upstream and downstream emissions.
The calculation becomes significantly more complex with other activities, such as when a financial institution
serves as a counterparty or is one of multiple underwriters of a financing.
There is no agreed standard for financed emissions and little consistency or comparability to date, but a
wide range of methodologies are being developed. Existing estimation methods present significant challenges
and regulators should encourage the market to develop a more consistent way of measuring and reporting
Scope 3 emissions across sectors where they are material and relevant.
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62
Climate Risk Analysis
Effective traditional risk management includes identifying risks, dening risk categories,
setting the company’s risk appetite, quantifying the risks, and then monitoring and mitigating
risks to stay within the determined risk appetite. Effective climate risk management needs
to be integrated into this existing risk management process, including dening the risk
categories impacted by climate risk—credit, market, strategic, insurance, liability, underwriting,
operational, and reputational.
With reliable, consistent, and comparable data, analytical tools and methodologies can be
developed to identify, assess, monitor, and manage climate risk within nancial markets,
as indicated by relevant risks, uncertainties, and vulnerabilities. Then rms may be able to
develop an ongoing management capacity to adapt to physical and transition risks and to
develop the resilience of their organizations, supply chains, and markets. Many nancial
institutions are already starting to do this, but climate risk analysis requires a different set of
evolving methodologies, tools, and data sets to account for the many assumptions, inherent
uncertainties, and long time horizons. These factors will be applied differently depending
on roles, asset classes, relevant available climate risk data, and investment horizons. As
an illustration, the following are steps that a nancial institution can take in applying climate
risk analysis.
Risk Identification
The rst step in identifying potential vulnerabilities to different types of climate risks is a quali
-
tative or quantitative exercise that categorizes climate risks and then applies the categories to
the relevant asset classes, sectors, and geographies. This can be done, for example, through
a heat-mapping exercise. For transition risk, the identication exercise may use exposure
and vulnerability data on the carbon intensities of different sectors and assumptions about
a rm’s elasticity and ability to pass-through costs. For physical risk, the exercise may use
forward-looking climate data to discern the exposure and vulnerabilities of different sectors to
specic climate impacts based on their geographic location, as well as their ability to improve
resilience with hardening measures. Mapping out risks should include the transmission mech-
anisms of climate risk into nancial products and services. For example, banks that have more
concentrated long-dated loans are likely to face greater credit risk exposure through their
lending than asset managers, which have greater market risk exposure.
Risk Assessment and Measurement
Next, nancial institutions need to quantify their risks. Climate risk is particularly difcult to
assess and measure since it is highly uncertain, non-linear and can affect different types of
assets, companies, sectors, and geographies differently. Financial institutions may use various
approaches, including top-down or bottom-up, based on the type of risk, the structure of
their business, and the balance between the efciency of the analysis and its effectiveness
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in informing risk management decisions. For example, to assess its liquidity position, a bank
may consider a top-down climate stress test, applying a set of asset-based shocks to its
tradable assets. Such a top-down approach may be relevant for a bank that has a diverse
global portfolio of credit counterparties and a loan book that is more short-term and marked-
to-market. Bottom-up approaches often require asset-level data, which is often limited.
A range of analytical methods may be necessary to manage credit risks and distinguish relative
vulnerabilities within a portfolio. Examples could include portfolio review by sector or specic
analysis of more material exposures, such as bottom-up analysis at the company-level. This
may require enhanced due diligence of companies to gather the relevant climate risk data
such as Scope 1, 2 and 3 emissions exposure, elasticity studies to understand vulnerability
to price adjustments, and organizational resilience efforts, including insurance and business
model transition plans. Physical risk assessment for material exposures in particular requires
asset-level analysis since it is location specic. However, some transition risk assessments
may also require geographic data (for example, for a power company, the electricity generation
mix of coal, gas, renewables, and nuclear and whether it operates in jurisdictions with current
or future carbon regulations). Resilience and the application of risk mitigation measures are
critically important and may be evaluated by a rm’s (i) utilization of risk transfer mechanisms;
(ii) ability to pass through costs; and, (iii) nancial wherewithal to manage risk, among other
structural mitigants. While nancial institutions may have different levels of capacity today,
all should work to enhance their assessment protocols and frameworks.
Scenario Analysis
As explored more broadly in Chapter 6, scenario analysis can help incorporate uncertainty
into decision-making and is increasingly being used to analyze climate risk. Rather than trying
to predict the future precisely, which is inherently unrealistic, scenario analysis attempts
to put contours around the range of possible outcomes—from best case to extreme but
plausible—by testing scenarios that are the most relevant to business planning and risk
management. In doing so it can elucidate the risk of assets and portfolios in inherently
hard to predict events. Scenario analysis can inform existing risk management processes,
such as counterparty due diligence, concentration monitoring, and industry limit settings,
and allow adjustment over time.
Risk Monitoring and Management
Finally, as nancial institutions conduct analyses to quantify climate risks and understand risk
concentrations and material exposures, they should consider how to effectively size their
risk appetite and monitor and manage their climate risk to stay within their risk appetite. For
example, metrics such as climate-related value at risk
4
or exposure to high carbon intensity
4
Value at risk (VaR) quanties the size of loss on a portfolio of assets over a given time horizon, at given
probability. Estimates of VaR from climate change can be seen as a measure of the potential for asset-
price corrections due to climate change (Dietz, et al., 2016).
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
64
sectors could be monitored and managed against established industry limits dened by
risk appetite. Monitoring would not only enable institutions to assess changes to climate
risk exposure and sensitivity over time, but also to identify appropriate adjustments to
mitigate the risk. Depending on the nature of their business, nancial institutions could
shift the allocation of capital in their portfolio from higher climate risk companies to lower
climate risk companies, adjust their underwriting and investing exposures to different
sectors or geographies, adjust the tenor or other structural aspects of their loans, or reduce
insurance underwriting exposure to higher climate risk companies. Financial institutions
also could manage climate risk by increasing their sustainable investments (as described in
Chapter 8) and by encouraging companies to improve resilience through climate mitigation
and adaptation activities.
Building the Necessary Capacity and Skills
A key step in establishing and executing a climate risk framework, including incorporating
any requirements by nancial regulators as described in Chapter 4, is developing knowledge
of the topic and a process for accountability. The assessment of climate risk requires novel
capabilities for complex forecasting and data interpretation. Clearly dened governance
structures, including at the senior management and board level as well as within existing
risk owners, will help guide capacity building.
Firms currently are not investing sufciently in employees with the analytical skills and
experience necessary to understand the suitability of different datasets and methodologies
for different use cases. Education and awareness training sessions at various levels of an
organization can help, along with a growing number of external resources. For example, a
signicant body of research has been published, and industry groups and regulators have
convened to pilot tools and share best practices. Climate risk management will improve—and
regulators’ expectations for it will grow—as companies embrace lessons learned from the
ongoing development of effective datasets, analysis, and best practices. Overall, sufcient
investments in human capital and market intelligence are critical for adaptive capacity and
organizational resilience.
Approaches to Climate Risk Analysis Across the Financial System
The nancial system comprises a wide variety of nancial institutions that play a range of
roles. Most institutions will—at some point—likely need to undertake climate risk analysis.
However, the specic methods of climate-related risk analysis, as well as its urgency,
will vary widely. The following section illustrates how key participants in the nancial
system could accrue value from climate risk management, depending on the nature of
their particular business. Chapter 8 further discusses climate risk management through
sustainable investment.
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CHAPTER 5: A CLOSER LOOK AT CLIMATE RISK MANAGEMENT AND DATA
Fiduciary Duty
A wide variety of nancial institutions owe various types of duciary duties to their bene-
ciaries and clients. The extent to which duciary duties allow or require the consideration
of climate risk and other nancial ESG factors is an evolving debate in American law
(Gary, 2019; Schanzenbach and Sitkoff, 2020). In general, duciaries need to consider
material risks in supporting the nancial goals of their beneciaries or clients. The duty
of loyalty requires the adviser or asset owner to act in its clients’ or beneciaries’ best
interests, while the duty of care requires the duciary to maintain a reasonable standard
of care when acting for its client or beneciary. In many cases, duciary duty incorporates
an investor’s consideration of material risks and the appropriate integration of those risks
in investment strategies to support beneciaries’ or clients’ nancial goals.
Fiduciary duty requires the assessment of material risks and the management of these risks
on behalf of stakeholders in keeping with their stated long-term goals, and climate risk is
increasingly being recognized as one such risk. As duciaries, many asset owners have
a responsibility to manage assets on behalf of others and in many cases also match the
timing of liabilities (such as, beneciary payouts) with returns from investments (for example,
asset liability management, (ALM)) and ensure that investments are managed for future
generations. Climate risk is therefore a key consideration for long-term asset owners who
are looking to meet ALM and intergenerational goals. Asset owners with a given mission,
including the long-term support of an institution or beneciary population, should consider
the benets climate-related investments could bring to their nancial and mission-given
goals. A duciary adviser or asset manager owes each of its clients a duty of loyalty and
a duty of care and must act consistent with these obligations. As with the beneciaries
of asset owners, the clients of asset managers may have different risk appetites, time
horizons and nancial objectives. Fiduciary duty also applies to other aspects of the nancial
system, such as the duty of corporate managers to their shareholders.
Asset Owners
Asset owners, whether they are individual investors or large institutional investors such
as pension funds, take risks they deem appropriate to meet their individual or institutional
goals. In most cases, and for pension funds in particular, their investment goals are generally
focused on maximizing long-term return while minimizing risk. Climate risk impacts are
likely to be material at these time horizons. Climate risk management can inuence asset
owner decisions and activities in many ways.
The impact of climate risk on asset values in different sectors, geographies, and asset
classes can inform decisions about strategic asset allocations. Over a longer horizon (10-plus
years), a signicant portion of returns and risk are attributable to strategic asset allocation, in
other words, the relative weighting of investments across different asset classes or different
regions. An asset owner with a longer time horizon will want to factor in climate-related
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
66
risk when determining, for example, which regions or asset classes to focus on and which
to avoid when deploying capital. Subject to normal nancial considerations such as asset
values, the asset owner might reduce capital allocations to more carbon intense sectors
and to countries that are more vulnerable to climate change and increase allocations to
transition-resilient asset classes such as clean energy. Asset allocation decisions can act
as a hedge to climate risk. For example, allocations to climate-resilient asset classes can
be added to hedge against unavoidable climate risk in other asset classes. In addition,
for asset owners who invest based on market benchmarks, allocation considerations will
need to consider the underlying benchmark.
In screening and constructing their portfolios, asset owners can invest through external asset
managers or make direct investments. When investing through external managers, they can
at times co-invest alongside these managers. For direct investments and co-investments,
asset owners make investment decisions within chosen asset classes such as corporate
equity, debt, or infrastructure and project level investments. Climate risk analysis can
be incorporated directly into due diligence and screening of investments and can inform
investment decisions, including whether to go long or short on, or overweight or underweight,
particular opportunities. An investor who forecasts the manifestation of a transition risk,
such as imminent climate policy action, may want to create a portfolio that underweights,
excludes, or goes short on companies with signicant transition risk. Asset owners also can
incorporate climate risk analyses in screening and selecting external asset managers—for
example, looking at whether a manager’s processes appropriately account for and manage
“non-traditional” risks, including climate risk, and whether a manager’s strategies reect
strong investment processes and fall within risk tolerance guidelines. Asset owners
may decide to use thematic asset managers such as those that have a clean energy or
sustainable transport focus.
Through portfolio management and stewardship, asset owners monitor and engage with
managers and companies to ensure performance over the lifetime of their investments.
Knowledge of emerging climate risks, such as increased regional vulnerabilities to wildres
or impacts on assets or company value due to transition risks, can motivate asset owners
to encourage asset managers or company managers to enhance their management of
climate-related risks—for example, by encouraging resiliency planning and accelerating
net-zero transition plans. Through this engagement, asset owners use their inuence to drive
changes that align with their investment objectives, including objectives for climate risk.
Asset Managers
Asset managers work on behalf of asset owners to meet return objectives while minimizing
risk. Asset managers are an extremely varied group, and therefore appropriate approaches
to risk management may vary among types of rms, though rms’ approaches also have
much in common. Like asset owners, asset managers want to understand potential exposure
and sensitivity to all types of risk, including climate risk. This is true for individual investment
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decisions, portfolio construction, portfolio management and stewardship, and—in the case
of certain asset managers that, for example, perform outsourced chief investment ofcer
functions—strategic asset allocation. Asset managers generally have a duciary duty to
the asset owners whose funds they are managing.
Asset managers generally focus rst on meeting investment goals, and second on increasing
assets under management. As described above, climate risk analysis is relevant for meeting
investment goals through investment screening, portfolio construction, portfolio management
and stewardship. In addition, asset managers attract new customers by demonstrating a
strong track-record and by aligning with the goals of asset owners. Asset managers that
manage climate risk have the potential to generate better risk-adjusted returns than asset
managers who do not. In addition, asset managers whose investment approaches align
with asset owners’ duciary and mission goals can benet from increased interest and
assets under management.
To enhance a variety of investment approaches that align with asset owners’ goals, asset
managers can use climate risk analysis. Asset managers can develop portfolios to meet
the growing interest in investing in companies that are actively decarbonizing the economy
and avoid investing in companies that are carbon intensive. Asset managers can actively
encourage companies to meet their investment goals, including by reducing their climate
impact. Climate risk analysis can also be used to create climate-friendly passive investment
products, which provide a low-cost way for asset managers to meet client investment
objectives.
Commercial and Investment Banks
Banks have wide-ranging risk management frameworks for a variety of risks. Bank risk
management frameworks are highly regulated, and Chapter 4 includes recommendations
to address climate risk in existing risk management frameworks in a way that is consistent
with banks’ board-approved risk appetites. Within this risk appetite, banks provide a variety
of nancial services, each with its own potential use cases for climate risk analysis. These
include lending, underwriting, asset management, direct investing, and liquidity and risk
management.
In managing climate risk, banks are responding not only to the potential for increased
climate risk from vulnerable assets, asset classes and sectors, but also to the wide
range of opportunities from nancial services and products that integrate physical and
transition resilience. Banks are increasingly directing capital to the transition to a net-zero
economy and communicating the positive impact of their activities, as are asset owners,
asset managers and other types of nancial institutions. Climate risk analysis can support
the identication of opportunities to direct capital to sustainable investments and provide
transparency about these efforts, as discussed in Chapter 8.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
68
As lenders, banks need to understand the risks associated with their loans, including
climate risk. For instance, a bank would be wary of lending to projects that faced signicant
physical risk as well as to companies that faced transition risk that was signicant enough
to potentially impair their ability to repay. Climate-related risk analysis is important both to
individual lending decisions and to loan portfolios. For instance, how would a rapid transition
away from fossil fuels change the probability of default of oil and gas borrowers? Scenario
analyses and stress tests may increasingly factor into this type of consideration.
Investment banks underwrite securities, facilitating investors’ purchase of equity or debt
issued by corporations and governments. Securities underwriting depends on investor
interest and sentiment, and integrating climate risk may reduce or increase demand for
securities on a company and sectoral level. In addition, underwriters can be legally liable
regarding appropriate disclosures in selling securities, and often use independent counsel
to judge disclosures. Chapter 7 examines adequate disclosure of material climate risk.
Banks can have asset management divisions, with roles and climate risk use cases like
those of asset managers. In addition, in certain cases, banks can invest directly, like asset
owners. Banks also provide liquidity and risk management products by engaging in a wide
variety of transactions with a wide variety of counterparties. As with other nancial services,
understanding the risk of doing business with these counterparties requires a holistic view
of the risk that counterparties will default. Climate risk may be severe enough to jeopardize
the counterparty’s ability to meet its obligations. Chapter 8 discusses developments in
reducing exposure to climate risk within existing derivative instruments and providing new
derivative products to hedge against climate risks.
Insurers
Climate-related risks have the potential to affect the performance of insurance companies’
core lines of business and, perhaps, the viability of the companies themselves. Climate risk
analysis should play a key role in the companies’ risk management processes. For instance,
insurance companies should consider climate-related physical risk when determining whether
to insure consumer and corporate assets, such as homes and ofces. To understand their
own exposure and vulnerability to climate risk, they also should understand the aggregate
risk in their portfolio of policies. Insurance companies should consider climate risk, including
applicable measures of resilience, when determining which types of policies, which sectors,
and which regions they want to focus on. Finally, insurers are also signicant asset owners
and therefore should incorporate climate risk analysis into their investment decisions.
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Recommendations
Recommendation 5.1: Financial regulators, in coordination with the private sector, should
support the availability of consistent, comparable, and reliable climate risk data and analysis
to advance the effective measurement and management of climate risk.
●
Regulators and nancial institutions should support the range of platforms for climate
data and analysis, including improving public access to governmental data and expertise
that can enable climate risk management. They should also support new and existing
open source platforms, as well as proprietary efforts to develop new climate risk
datasets and tools that leverage innovative technologies.
Recommendation 5.2: Financial regulators, in coordination with the private sector, should
support the development of U.S.-appropriate standardized and consistent classication
systems or taxonomies for physical and transition risks, exposure, sensitivity, vulnerability,
adaptation, and resilience, spanning asset classes and sectors, in order to dene core
terms supporting the comparison of climate risk data and associated nancial products
and services.
●
To develop this guidance, the United States should study the establishment of a Stan-
dards Developing Organization (SDO) composed of public and private sector members.
●
Recognizing that this guidance will be specic to the United States, this effort should
include international engagement in order to ensure coordination across global
denitions to the extent practicable.
Recommendation 5.3: Financial regulators should proactively encourage capacity building
for climate risk management. This should be consistent with the education and training
practices supported by agencies in implementing the Sarbanes-Oxley Act of 2002. It should
align with and aid in meeting regulator expectations around embedding climate risk in
governance frameworks.
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This chapter takes a closer look at the importance of climate scenarios in climate risk
management. Scenario planning, also known as scenario analysis, is a systematic process
for making strategic decisions in the face of uncertainty. It has a long history of use in
military, political, and corporate planning. Climate scenarios, as advocated by the Task
Force on Climate-related Financial Disclosures (TCFD) and others, are used by researchers,
policymakers, and, increasingly, corporations to analyze potential climate-related futures,
including the economic, social, and environmental implications of achieving different
temperature and emissions goals.
Scenarios illustrate the complex connections and dependencies across technologies,
policies, geographies, societal behaviors, and economic outcomes as the world strives
toward a net-zero future. Climate scenarios can help policymakers and nancial institutions
identify effective and efcient policies for emissions mitigation and carbon sequestration
and indicate what measures particular goals would require.
Why Use Scenario Analysis?
Decision-makers can use scenario planning to consider the effectiveness of climate risk
reduction and management measures, including both emissions mitigation and investment
in adaptation and resilience. For example, cities facing increased heat stress could plant
trees in high-trafc areas, increase the reectivity of road and building surfaces, provide
subsidies for low-income households to buy air conditioning, and provide more cooling
centers for high-heat days. Areas facing projected increases in drought could select more
drought-resistant crops, produce genetic innovation of seeds, evolve irrigation practices,
and improve soil health practices. Together, adaptation interventions undertaken locally
can stabilize the overall food production system.
73
Chapter 6
A Closer Look at Climate
Scenarios
CHAPTER 6: A CLOSER LOOK AT CLIMATE SCENARIOS
Scenario analysis is an important tool for understanding and integrating climate risks and
opportunities into a broader risk management framework. Scenario analysis is less about
forecasting the most probable outcomes than it is a “what-if” analysis of different potential
projections of the future. A common motto in the scenario planning world rings true—All
climate scenarios are wrong, some are useful.
For example, practitioners can analyze scenarios that differ in their global trajectories
of greenhouse gas emissions and atmospheric concentrations and thus pose different
physical risks and damages from climatic disruption and ocean acidication. These scenarios
can express the range of effects that different levels of radiative forcing would have on
extreme weather events, sea level rise, agricultural productivity, public health, and other
environmental and economic outcomes. Similarly, practitioners can analyze a low-carbon
transition scenario in which the United States adopts an ambitious climate policy and
compare it to a scenario—called a baseline, business-as-usual, or reference scenario—in
which no new policies are adopted. In so doing, analysts gain insights into the potential
outcomes (positive and negative) for individual assets, entities, or industries, as well as
to the overall macroeconomy.
5
Climate-related scenario analysis is gaining traction in several contexts, both domestically
and internationally. Climate scenarios are being used within companies for internal decision-
making; in analyses for disclosure of climate-related risks to investors and regulators; by
banks and other nancial institutions to assess individual investments and overall portfolios;
and by nancial regulators as discussed in Chapter 4. Each of these applications may
require different scenarios that capture different risks. They may involve different modeling
tools, underlying data, assumptions, and time scales. While useful, climate scenarios have
limitations. The optimal design of climate scenarios will depend on the goals and methods
of analysis. A wide variety of scenarios and of models to analyze the scenarios can be
useful depending on the application.
What Are Climate Scenarios?
Temperature Scenarios
One common scenario design posits a future in which atmospheric concentrations of
greenhouse gases are stabilized at a level at which global mean temperatures do not rise by
more than a certain amount, such as 2 degrees Celsius above pre-industrial levels. Lower
temperature targets require that greenhouse gas concentrations stabilize at lower levels,
5
One option for standardizing baseline projections would be to calibrate a model to a projection from the
U.S. Energy Information Administration’s Annual Energy Outlook. These projections, however, apply only
to fossil fuel-related CO
2
emissions and thus would not include projections of other gases and sources
in the United States.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
74
meaning that fewer net emissions can be emitted globally. Achieving a lower temperature
target reduces the physical impacts of climate change but requires more aggressive and
disruptive policies to achieve the necessary transition. As represented in Figure 6.1, a
temperature scenario analysis can emphasize the physical climate outcomes, the policy
outcomes, or both. Because temperature scenarios play out over at least several decades,
they tend to involve longer-term projections of both physical and transition risks.
To study how the world can limit warming to a certain level, analysts specify a baseline
policy, technology, and socioeconomic future. These scenarios generally include a set of
assumptions that incorporate existing or planned global or regional policies, a business-as-
usual sociodemographic projection, and projections for technological progress (including
negative emissions and sequestration technologies), as highlighted by Figure 6.2. Scenarios
can also incorporate disorderly or orderly transitions by specifying how gradually or sharply
emissions fall. Policy scenarios specify government interventions that depart from the
baseline—such as a carbon price trajectory or emissions limits—that then drive changes in
the economy that reduce emissions. Depending on the kind of model and analysis, policy
scenarios can apply economy-wide or to a subset of industries, for example just the power
sector. In models of the global economy, scenarios can also apply internationally, allowing
the investigation of spillovers across countries.
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CHAPTER 6: A CLOSER LOOK AT CLIMATE SCENARIOS
In scenarios with no or limited emissions mitigation relative to business-as-usual, the
likelihood and severity of major physical events will increase over time. These scenarios
can encompass a broad range of impacts—including ooding, wind, heat, drought, and
wildre—or be restricted to physical risks of most concern to a given area.
Even under a 2 degrees Celsius scenario, the probability of major physical impacts will
increase signicantly over successive decades. If global mean temperature rises above
2 degrees Celsius, the probability of major physical impacts increases sharply, as does the
probability that multiple perils impact a given region simultaneously. For example, without
signicant emissions abatement policies, the number of electric substations in Houston
that would be exposed to acute ooding is forecasted to rise, signicantly increasing risks
for communities, chemicals plants, and oil and gas facilities (Jupiter Intelligence, 2020).
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
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Event-Based Analysis
Event-based scenarios focus on the potential short-term impact of one triggering event,
such as the sudden implementation of a major emissions regulation, a technological
breakthrough, or an extreme weather event. Triggers can also include sharp changes in
preferences, such as increased consumer demand for carbon-neutral products or the
refusal of market actors to insure coal mines.
Event-based scenarios could be particularly useful for stress testing by rms and regulators
because abrupt or disorderly outcomes may pose special risks for companies and the
nancial sector because the risks may not be priced into asset values. Modeling shorter-
term, disorderly scenarios can also highlight the importance of near-term decisions in
managing risks. Event-based scenarios are particularly appropriate for nancial institutions.
For example, an event scenario that species sea-level rise 30 years from now is not
necessarily relevant to a trading company whose average risk duration is one year, but it
is relevant to a potential mortgage investor.
Event-based analysis is also useful for modeling agricultural production. It allows for the
management of short-term weather events within a growing season or annual variance in
growing conditions. Decision-makers can then model the point at which the geographic
scale, severity, or frequency of localized events collectively drive structural changes or
risks to the overall system, informing policies that bolster food security.
Another important component of event scenario design is the potential for multiple
simultaneous (and potentially uncorrelated) events—such as this year’s sudden precipitous
drop in oil prices as the COVID-19 growth shock was taking hold. Future examples could
include a harvest shock in a breadbasket region of the world, which in turn could cause a
spike in international food prices and trigger instability in food importing countries. In the
face of multiple events, nancial risks previously regarded as non-material could suddenly
become material. In sum, plausible, relevant scenarios get risk managers’ attention. This
achieves the desired outcome of the event-based analysis: informing near-term decisions
around managing climate risk.
Policy Pathways
To analyze the implications of achieving a given emission or concentration target, modelers
run “solve-to-match” scenarios in which they estimate the carbon prices or other policy
features that would be consistent with achieving a goal. For example, modelers may
estimate the greenhouse gas (GHG) price trajectory that, when applied globally, stabilizes
atmospheric concentrations of GHGs at a particular level. Alternatively, a climate policy
scenario may reect the actual policies countries are implementing or plausibly could
implement. In that case, modelers would simulate different policies in different countries.
For any given country, these scenarios may be much less stringent than those that achieve
a temperature target of 2 degrees Celsius or less.
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Policies can have both near-term and long-term impacts on the economy and the environment.
Outcomes of interest to policymakers and stakeholders include policy impacts on prices,
economic growth, structural changes in the energy system and other sectors, household
welfare, trade, government revenue, and investment. Like any modeling, the further out
the projection, the greater the uncertainties. Thus, modelers often caution policymakers
to focus on comparisons across scenarios and the direction of change rather than point
estimates within one scenario’s results.
Plausibility
Finally, climate scenarios should be both
plausible
and
relevant
, all the while informed
by climate science. For physical risks, plausibility comes rst and foremost from being
based squarely on the latest climate science. Transition policies may vary considerably in
their ambition. Because any number of changes in policies and market actor behavior are
plausible, regulators should offer a range of climate scenarios. Relevance comes from
ensuring that scenarios’ time frames and impacts are material to an institution’s business.
Limitations of Scenario Analysis
While useful, climate scenarios and the models that analyze them have limitations: they
are sensitive to key assumptions, most have been developed for purposes other than
nancial risk analysis, and they cannot fully capture all of the potential effects of climate-
and policy-driven outcomes. Like many modeling exercises, climate scenario outcomes
are sensitive to key assumptions and parameters, such as the rate of technical change.
For example, the Intergovernmental Panel on Climate Change (IPCC) projects that substan-
tial deployment of negative emissions technologies, such as biomass energy with carbon
capture and storage (CCS), would be required to achieve a 1.5 degrees Celsius outcome,
and many analyses draw similar conclusions about reaching 2 degrees Celsius. The cost
and availability of such technologies has an enormous effect on the estimated price of
carbon that would be required to deploy them. Models that assume the availability of
low-cost CCS, battery storage, hydrogen fuel cells, or other as-yet-nascent technology will
project that the requisite carbon taxes, cap and trade systems, or other policy measures
to achieve stringent goals can be modest.
Likewise, models that assume limited availability of low-cost low- or negative-carbon
technologies will project that the policies to achieve ambitious temperature targets will
be quite costly. Understanding these sensitivities and considering multiple scenarios is
useful not only to put the results in relative perspective, but also to motivate policies to
promote technological development.
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78
Most climate scenarios are intended for a purpose other than nancial risk assessment.
For example, the modeling studies assessed in IPCC reports typically involve energy-
economy-climate models used for policy analysis and research applications. They may
report high-level results, such as shifts in fuel sources, but not critical outputs for nancial
analysis such as the number of electric vehicles on the road. Future enhancements could
include more-detailed models, further calculations to generate new relevant variables, and
models that better represent the direct and indirect transmission channels through which
physical and transition risk could affect nancial outcomes (NGFS, 2020a).
Finally, models cannot fully capture the range of how market actors will respond to climate
change, how their responses will affect climate change, and how they will inuence policies
around climate change. As the climate continues to change, decision-makers will respond
in ways that can both create and alleviate risks. Damages from climate change may
be lower with appropriate adaptation and risk management—or substantially higher if
potential low-probability but high-impact risks materialize. Market actor and policymaker
responses are complex and should be considered qualitatively along with a quantitative
scenario analysis. Some of these limitations are inherent to many models but are in this
case further exacerbated by the often-multi-decade time horizon and the complexity and
interdependencies of the effects modeled, from ice sheet melting to agricultural yields
and migration. To mitigate the limitations of scenarios and modeling, practitioners should
analyze multiple scenarios with various underlying assumptions and parameters.
Practical Applications of Scenarios
Climate Scenarios and the Role of Regulators
Climate risk is in part a manifestation of the failure of the current economic system to
price externalities and capture them in current accounting, performance measurement, and
incentive systems. Scenarios help elucidate the nature of the externalities and translate
climate risk into nancial risk. Climate risk derives in part from a lack of policies, like a
price on carbon, that would internalize the external costs of damaging emissions, but it
also comes from traditional accounting practices that ignore these externalities and the
prospect of their regulation. This mispricing naturally leads to the misallocation of capital,
including the continuing distortions in energy systems that promote climate change.
Financial regulators around the world are aware of this misallocation and mispricing and
some are adopting policies to address it. They do not have the authority to directly regulate
emissions, but they can, through their nancial stability objectives, promote climate risk
management—which in turn can facilitate the orderly transition to a net-zero economy.
Scenario analysis is an important tool that regulators can use to encourage climate risk
management: Have you thought about these risks? Have you discussed them with your
clients? What are you doing about it?
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For instance, the Bank of England’s Prudential Regulation Authority (PRA) has imposed
supervisory expectations on climate risk management. The expectations include incorporating
risks related to climate change into the risk management framework, raising the issue
to the board-level, and performing climate scenario analysis. By focusing on enhanced
disclosure, the TCFD is also aiming to inuence the allocators of capital by enabling the
market to better price these risks (TCFD, 2017).
Clear parallels exist between macro-economic stress testing and climate scenario
analysis. Both use scenarios and are undertaken to estimate a firm’s level of
risk. Despite these high-level similarities, macro-economic risk and climate risk
assessment have several significantly different features. The scope, time frame,
and use of risk assessment exercises vary widely.
Since the 2008 global financial crisis, the term “stress testing” has generally
been used to qualify a comprehensive, firm-wide scenario analysis. In such
analyses, most elements of the profit and loss statement and balance sheet are
estimated under a set of macro-economic scenarios designed to test the bank’s
resilience to a specific shock. Macro-economic stress testing is generally used
in a regulatory context for the purpose of estimating capital needs and planning
capital management for a period of two to five years.
In contrast, climate scenario analysis is not primarily a capital management
exercise. Where macro-economic stresses are assumed over a period of only a
few years, climate-related risk evolves over decades, though policymaker, consumer,
and investor climate-related preferences could change much more abruptly.
In our view, the primary purpose of climate stress testing is to understand
and evaluate the sensitivity of a bank’s current portfolio to climate scenarios.
Capturing projected impacts on the current business profile can facilitate strategic
planning and portfolio construction. In other words, climate scenario analysis
is more a “what-if” analysis under different transition and physical scenarios
rather than holistic stress testing exercise as undertaken for modern capital
management analyses.
Climate Scenarios in the Context of Financial Stress-Testing
(UNEP FI and Oliver Wyman, 2018)
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Central banks and regulators—including the Central Banks and Supervisors Network for
Greening the Financial System (NGFS)—are also moving ahead on climate risk management
and scenario development (Vaze, 2019; NGFS, 2020b). The NGFS provides practical
advice on scenario analysis, along with eight high-level climate scenarios (NGFS, 2020c)
and detailed technical documentation and modeling data (NGFS, 2020d). The scenarios
reect different projections of future temperature targets, policies, technology development,
and climate damages with an eye to providing a foundation for decision-useful analysis by
both governments and private sector actors.
Should Institutions Use a Common Set of Climate Scenarios?
Both common and tailored scenarios are useful. From a practical perspective, it makes
sense for practitioners and risk managers to converge on a common menu of scenarios.
It would allow better comparability across results and encourage the development of
universal scenario analysis capabilities. Policymakers and regulators, in consultation with
experts and stakeholders, should develop and prescribe a consistent and common set of
scenarios and assumptions, which will help align the collective action necessary to mitigate
climate risk. Common scenarios render best practices transparent, minimize gaming, and
serve to raise the collective bar. Internationally and domestically, alignment of scenarios
across industry and regulatory bodies would also prove benecial.
However, since policies and climate effects depend on location, it makes sense to customize
the basic scenario frameworks with parameters that work for a particular context. For
example, a common policy scenario design could specify an economy-wide carbon tax
trajectory, but the pertinent initial values and the rate of change in the tax may differ from
country to country.
While establishing a set of common standards would clearly be useful, over reliance on one
model or scenario may generate systemic issues. It is therefore important that institutions go
beyond running prescribed scenarios and use additional scenarios tailored to their exposures
and vulnerabilities. By going beyond a pure compliance exercise, tailored scenarios will
maximize the benet for the institutions. Climate scenario analysis can inform adjustments
to their risk management practices and improve their decision making more broadly.
Having common and tailored scenarios in place is not dissimilar to the stress testing
exercises established during the nancial crisis. Regulators deployed a set of scenarios to
build investor condence in the banking system and later also required institutions to run
their own scenarios. Once armed with climate scenario modeling capabilities, institutions
will naturally be able to run scenarios more tailored to their business needs.
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Recommendations
Scenarios and Scenario Analysis
Climate scenario analysis should focus on potential material impacts to the institution’s
nancial portfolio, whether loans, derivatives, or investments. In this context, the following
guidelines should be useful:
Recommendation 6.1: Analyze more than one warming path. Various long-term paths for
climate change exist and can be used for scenario analysis. Three common scenarios are
(i) Paris-aligned (for example, consistent with limiting temperatures well below 2 degrees
Celsius above pre-industrial levels), (ii) current trajectory and (iii) in-between (for example,
late policy adoption with a more abrupt and disruptive response). Each will produce different
impacts on institutional portfolios and provide insights that will help to more effectively
manage risk, particularly bookends of best- and worst-case scenarios. Scenarios should
include both shorter- and longer-horizon paths as appropriate.
Recommendation 6.2: Analyze disruptive policy. It is particularly important to analyze a
scenario involving a major policy disruption. Transition scenarios have wide implications
across the economy, industries, and markets. Unanticipated policies can abruptly strand
long-lived capital assets or induce rapid reallocation of capital across sectors and industries.
Increasing physical impacts may increase the risks of a disorderly transition as res, oods, and
hurricanes, and the attendant shifts in public sentiment, force governments into unanticipated
policy responses. Scenarios are therefore especially relevant for risk management.
Recommendation 6.3: Analyze both broad and specic impacts. Scenarios should capture
the breadth of impacts but with a focus on materiality, covering a global perspective but
enabling regional, country, and sectoral analysis appropriate to the rm’s business.
Recommendation 6.4: Map macroeconomic and nancial impacts. Scenarios should take
into account macroeconomic and nancial outcomes since these are likely to be most
material to nancial institutions. Coming up with additional temperature scenarios, for
example, is less important than providing some common guidance on potential transmission
mechanisms and implications for macroeconomic and nancial factors.
Recommendation 6.5: Account for adaptation actions to the extent feasible. Tackling
climate change necessarily involves myriad adjustments by a range of actors. Modeling
the effects of such adaptation actions on portfolios is complex but may become more
feasible with future technology and scenario modeling development.
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82
Policymakers and Regulators
Recommendation 6.6: Prescribe a consistent and common set of broad climate risk
scenarios, guidelines, and assumptions and mandate assessment against these scenarios,
as described in Chapter 4. Regulators, in consultation with industry participants, external
experts, and other stakeholders, should develop and prescribe a consistent set of broadly
applicable scenarios, guidelines, and assumptions and require institutions to assess their
exposure to those scenarios. Climate scenarios should be both plausible and relevant,
all the while informed by climate science. Regulators should require a range of climate
scenarios, including scenarios covering severe but plausible outcomes. Key assumptions
(including policy pathways) and limitations should be transparent. Scenarios, assumptions,
and guidelines should be updated as relevant factors are better understood and as policy and
technology evolve. There should be a recognition that climate risk will manifest differently
across various parts of the nancial system.
Recommendation 6.7: Provide analytical discretion, to the extent practicable, as long as
regulatory needs for consistency and comparability are met. Given the many unknowns
and complexities inherent in modeling the economy, climate change science, and policy,
regulated entities will need some discretion in how they perform their analysis based on
the prescribed scenario. On the other hand, regulators need consistent approaches across
rms so they can ensure risks are responsibly analyzed and reported. Investors would
benet from better comparability across scenario-related disclosures. To achieve a balance
across these needs, regulators, in consultation with the rms they regulate, should specify
key assumptions, scope, and the outputs they expect. As long as regulators’ prescribed
expectations are satised, regulators should allow nancial institutions to provide additional
context and analysis informed by the nature and complexity of their business.
Recommendation 6.8: Encourage domestic and global coordination across regulators to
provide a coherent approach. This is an overarching theme of this report and especially
applicable to the use of scenarios for risk management. Requiring entirely different stress
scenario exercises from institutions operating under different jurisdictions would be costly
while generating uncertain value. Harmonizing requirements and prioritizing practical, actionable
exercises where feasible would be useful. The high costs associated with multiple regulatory
regimes is a lesson of post-nancial crisis regulation that can be applied now to climate risk.
Recommendation 6.9: Focus on materiality and risk management. Climate risks can
manifest in many different ways. Institutions should focus on what matters for them and
what decisions need to be made given their specic exposures and vulnerabilities. Such
an approach facilitates effective risk management by laying out plausible ways climate
risk-related nancial losses could occur.
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Recommendation 6.10: Ensure a mechanism for ongoing renement and improvement. As
science, data, tools, conditions, and policy change, it is important for regulatory guidelines
to evolve as well. Data in particular is evolving rapidly. Creating a mechanism for regular
updating, rather than relying on ad hoc adjustments, would be benecial to ensure effective
and pragmatic oversight. As regulators better understand the material risks in the system
and their spillover effects across industries and markets, a mechanism for ongoing learning
and timely renement from these lessons learned will ensure they are most effectively
managing risk across the system.
Capabilities and Applications
Given the uncertain nature of how the climate will evolve and the limited ability to rely on
historical data and back-testing, robust scenario analysis calls for a new set of capabilities
that combines statistical, nancial, and environmental knowledge.
Recommendation 6.11: Tailor analysis to specic exposures. How an institution analyzes
scenarios should be determined based on the unique nature of its portfolio. Not every
scenario will be material to an institution’s portfolio, depending on its largest asset
concentrations, longest-dated assets, and highest potential sensitivities.
Recommendation 6.12: Use results to upgrade risk management capabilities. Regulators
and risk managers can use insights coming from scenario analyses to strengthen and
augment existing institutional risk management. Each institution should determine how
to do so within its own framework but could include climate-related limits, adjustment to
underwriting processes, client engagement, and climate risk appetite.
Recommendation 6.13: Beware of false precision. Scenario analysis can provide great
value in understanding a range of potential outcomes (particularly between worst and
best cases) and in identifying concentrations and relative sensitivities in a portfolio. But
results, especially quantitative ones, will be illustrative, not precise, and so should be used
accordingly in risk management decisions.
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84
Risk Managers
Recommendation 6.14: Risk managers should develop in-house capabilities, as relevant
and in line with best practices, to analyze climate scenarios, understand the key underlying
assumptions, and recognize the limitations.
Recommendation 6.15: Firms and institutions should consider additional climate scenarios,
guidelines and assumptions tailored to their specic needs and vulnerabilities, in addition to
those provided by policymakers and regulators, to enhance internal risk management and
decision-making. This can focus on generating decision-useful information for identifying
and managing climate risk given their specic exposures and vulnerabilities.
Recommendation 6.16: The scope, depth, and complexity of the analyses performed by
institutions should be proportionate to the materiality of the impact measured.
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As earlier chapters of this report have shown, the physical and transition risks of climate
change are increasingly material to rms, investors, and the U.S. economy. When
climate-related issues materially impact a rm’s underlying operations and capital investments,
the rm’s nancial statements should address them. When these issues pose material risks
to rms, other sections of nancial lings, such as Management’s Discussion and Analysis,
Risk Factors, and Description of Business (collectively, MD&A), should address them.
As the physical and transition risks of climate change have manifested with greater intensity
and frequency, it has become increasingly clear that these risks affect capital markets
writ large. The Sustainability Accounting Standards Board (SASB) nds that industries
totaling 93 percent of U.S. market capitalization are materially exposed to climate risk
(SASB, 2016). As rms, investors and other capital market actors seek to make informed
decisions in the face of these risks, demand is growing among market stakeholders for
comprehensive disclosure evaluating climate-related risks and uncertainties.
Climate risk disclosure offers a variety of potential benets to issuers, investors, and
society. For issuers, potential benets include the improved ability: (i) to identify, assess,
manage, and adapt to the effects of climate change on operations, supply chains and
customer demand; (ii) to relay risk and opportunity information to capital providers, investors,
derivatives customers and counterparties, markets, and regulators; and, (iii) to learn from
competitors about climate-related strategy and risk management best practices. Peer
group disclosures create an information platform where companies can learn from each
other and, as a result, increase their organizational and network resilience.
For other market actors, the benets of comprehensive climate disclosure are several.
Investors can better assess a more rened measure of the long-term cost of capital, as
well as risks to rms, margins, cash ow and valuations. In addition, investors and society
can gain greater assurance that issuers take these risks seriously. In the absence of robust
disclosure, market participants may presume that a company is unprepared for climate-related
risks, especially at a time of heightened volatility, such as during an extreme climate-attributed
event. Ultimately, a lack of disclosure could also affect market condence in management,
valuation multiples and the cost of capital.
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A Closer Look at Climate Risk
Disclosure
Chapter 7
CHAPTER 7: A CLOSER LOOK AT CLIMATE RISK DISCLOSURE
By building on the rm-level disclosures provided by issuers, U.S. nancial regulators would
be better able to understand the impacts of climate change on nancial markets. This greater
understanding would allow them to issue relevant guidance or regulation needed to improve
the resilience of nancial markets in the face of this risk and uncertainty. By the same token,
state and local governments—and community members themselves—would be better able to
understand how companies in their localities are preparing for climate risks and opportunities
that could impact the local economy, labor force, and tax base.
The Current State of Climate-Related Disclosure
Disclosure frameworks have been developed to enhance the quality and comparability of
corporate disclosures. Examples include CDP (formerly, the Climate Disclosure Project),
the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the
International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board
(SASB), and, most notably, the Task Force on Climate-related Financial Disclosures (TCFD).
The TCFD recommendations have been integrated into several of the other frameworks. Many
of these organizations, together with accounting and standardization groups, have formed
the Corporate Reporting Dialogue to strengthen cooperation, coordination, and alignment
among key standard setters and framework developers (CRD, 2019).
Investors and nancial market actors have recognized this need and have long called for
“decision useful” climate risk disclosures (CalPERS, et al., 2007). In 2019, 631 investors
managing more than $37 trillion signed the
Global Investor Statement to Governments on
Climate Change
, which called on world governments to improve climate-related nancial
reporting. The statement specically called on governments to “commit to implement the TCFD
recommendations in their jurisdictions, no later than 2020” (IAFP, 2019). As noted by the TCFD:
There is a growing demand for decision-useful, climate-related information by a range
of participants in the nancial markets. Creditors and investors are increasingly
demanding access to risk information that is consistent, comparable, reliable, and
clear. There has also been increased focus, especially since the nancial crisis of
2007-2008, on the negative impact that weak corporate governance can have on
shareholder value, resulting in increased demand for transparency from organizations
on their risks and risk management practices, including those related to climate
change (TCFD, 2017, p. 1).
In response to market participants’ informational needs, the number of entities disclosing
climate-related information has increased, and the quality of the disclosed information has
improved over the past several years (Ohm, et al., 2020). Yet, despite this progress, the
information disclosed falls signicantly short of what capital market actors need to adequately
integrate climate risk into their decision-making (TCFD, 2019a).
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Table 7.1: Sample of Leading Voluntary Frameworks
CDP CDP issues an annual global questionnaire that collects information
on climate change and other sustainability issues to help organizations
measure and manage these risks and opportunities.
Climate Disclosure
Standards Board
(CDSB)
The CDSB Framework provides guidance on how and what to report on
climate and other environmental issues in a mainstream annual report.
Global Reporting
Initiative
(GRI)
The GRI Standards outline how and what to report regarding the material
economic, social, and environmental impacts, such as climate change of
an organization on sustainable development. The GRI Standards can be
used in sustainability reports, as well as in annual or integrated reports.
It is oriented at a broad range of stakeholders.
Integrated Reporting
(IR)
The International Integrated Reporting Council (IIRC) has developed a
reporting framework that explains how an organization can report on
the value it creates for itself and others. Reporting on the basis of the
framework results in an integrated annual report or in a separate
integrated report, and the main audience is providers of financial capital.
Sustainability
Accounting
Standards Board
(SASB)
SASB’s Standards guide reporting on financially material environmental,
social and governance issues by means of indicators (called metrics)
and disclosures for 77 industries. Its main use is intended to be in the
communications to investors, such as the annual report, and it has the
objective of informing financial stakeholders.
Task Force on
Climate-Related
Financial
Disclosures
(TCFD)
Established by the Financial Stability Board, the TCFD developed
voluntary, consistent climate-related financial disclosures, building on
existing disclosure regimes to develop a singular, accessible framework.
The TCFD developed four widely adoptable core recommendations
on climate-related financial disclosures of universal applicability to
organizations across sectors and jurisdictions, divided into these topics:
governance, strategy, risk management, and metrics and targets.
The widespread use of these frameworks underscores that collecting, assessing, and
disclosing climate risk information is a practical process, in which most large companies
are already engaged. Table 7.1 shows a range of active frameworks. In 2020, 515 investors
with $106 trillion in assets and 147-plus large purchasers with more than $4 trillion in
procurement spending have requested thousands of companies to voluntarily disclose their
environmental data through the CDP. More than 7,000 companies globally use the CDP
questionnaire (CDP, 2020). More than 10,000 reporting organizations across 90 countries
use GRI instrumentation (GRI, 2019), including 74 percent of the largest 250 corporations
(GRI, 2020). More than 100 companies have adopted SASB standards (SASB, 2020).
Finally, 785 companies have committed to support the TCFD and many already disclose in
accordance with at least some of the TCFD’s recommendations (TCFD, 2019a).
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Task Force on Climate-Related Financial Disclosures
To accelerate global collaboration to improve climate disclosure, the TCFD was
established by the Financial Stability Board at the request of Group of Twenty
(G20) nations in 2015 to develop recommendations to help financial market
participants understand their climate-related risks. Made up of 26 members
representing investors and companies from a range of industries, the Task Force
developed 11 recommended climate-related disclosures across four broad areas:
governance, strategy, risk management, and metrics and targets. Central to the
TCFD’s recommendations is the application of forward-looking scenario analysis,
which the TCFD states is critical for understanding the strategic implications of
climate-related risks and opportunities.
The TCFD’s recommendations apply to corporations in financial and non-financial
industries, asset owners, and asset managers. The recommendations form
a strong foundation for use by securities regulators as the basis for climate
disclosure rules. They are based on existing regulatory reporting requirements
related to material risk disclosure, including climate risks, as well as the work
of CDP, CDSB, GRI, IIRC, SASB and others. Table 7.2 highlights the TCFD’s
principles for effective disclosure.
Table 7.2: Principles for Effective Disclosures
1
Disclosures should represent relevant information
2
Disclosures should be specific and complete
3
Disclosures should be clear, balanced, and understandable
4
Disclosures should be consistent over time
5
Disclosures should be comparable among companies
within a sector, industry, or portfolio
6
Disclosures should be reliable, verifiable, and objective
7
Disclosures should be provided on a timely basis
Source: TCFD (2017)
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At the same time, the slow rate of growth in the number of rms and other market participants
disclosing under the current disclosure regime, which relies to a large extent on voluntary
disclosures by companies and other market participants, is not sufcient to meet investor
needs, given the urgency of mitigating and adapting to climate change. The TCFD’s most
recent status report included a review of reporting by more than 1,100 companies from
2016 to 2018, and found that, while disclosure rates were increasing, surveyed companies
only made, on average, 3.6 of the 11 total TCFD recommended disclosures (TCFD, 2019b).
An analysis of Russell 3000 companies found that 30 percent discussed climate change as
a risk in their 10-K lings, but only 3 percent of companies discussed climate risks in the
MD&A section of those lings (Rozin, 2019).
Large companies are increasingly disclosing some climate-related information, but vary
signicantly in the specic information they disclose, presenting a challenge for investors and
others seeking to understand exposure to and management of climate risks. The TCFD found
variations across its 11 recommended disclosures. For instance, climate disclosure rates varied
from as low as 9 percent for one of its recommended disclosures to as high as 47 percent for
another disclosure (TCFD, 2019b). In many industries, it is challenging to determine how a
company is exposed to climate-related risks in its value chain (Bolton, et al., 2020). Progress
has been made in classifying emissions impacts into Scope 1, 2 and 3 emissions, which allows
for a risk assessment to evaluate potential weaknesses throughout the value chain (Bolton,
et al.). Chapter 5 addresses Scope 3 emissions and transition risk in greater detail.
For all industries in which climate risk is material, the lack of comprehensive and comparable
disclosure not only poses a challenge to investors seeking to assess, manage, and mitigate
climate risk, but it also impedes the ability of disclosing organizations to inform their strategic
responses to climate risk by benchmarking their performance against peer organizations.
To illustrate the point, a U.S. Government Accountability Ofce (GAO) report provides
examples of two contrasting disclosures, with excerpts from U.S. Securities and Exchange
Commission (SEC) lings (GAO, 2018). The GAO characterized the rst example as
containing boilerplate and unquantied information, and the second as containing some
quantitative information and metrics.
The rst example states, in part, that:
[c]limate change initiatives may result in signicant operational changes and
expenditures, reduced demand for our products and adversely affect our business …
We assess, monitor and take measures to reduce our carbon footprint at existing
and planned operations. We are committed to complying with all Greenhouse Gas
[(GHG)] emissions mandates and the responsible management of GHG emissions
at our facilities (GAO, 2018, p. 35).
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By contrast, the second example states:
Examples of legislation or precursors for possible regulation that do or could
affect our operations include: European Emissions Trading Scheme [(ETS)], the
program through which many of the European Union [(EU)] member states are
implementing the Kyoto Protocol. Our cost of compliance with the EU ETS in 2015
was approximately $0.4 million (net share pre-tax). … Carbon taxes in certain
jurisdictions. Our cost of compliance with Norwegian carbon tax legislation in 2015
was approximately $31 million (net share pre-tax)(GAO, 2018, p. 36).
The disclosing rm goes on to highlight concrete actions in response to the risks:
The company has responded by putting in place a corporate Climate Change Action
Plan, together with individual business unit climate change management plans in
order to undertake actions in four major areas: … Reducing GHG emissions—In
2014, the company reduced or avoided GHG emissions by approximately 900,000
metric tonnes by carrying out a range of programs across a number of business
units. … The company uses an estimated market cost of GHG emissions in the
range of $8 to $35 per tonne depending on the timing and country or region to
evaluate future opportunities (GAO, 2018, p. 36).
These examples highlight the great disparity between intent and disclosure quality. Given
the disparity in the quality and extent of disclosures under the existing regime, clearer and
more consistent guidance as well as mandatory disclosure requirements may be needed
for climate risk disclosure that covers materiality assessments.
U.S. Legal Authorities and Practices Related to Climate Risk Disclosure
This section complements the discussion of authorities in Chapter 4. It provides additional
detail of existing legislation, regulations, and practices in climate risk disclosure, as well a
discussion of the key barriers to more effective climate risk disclosure.
Publicly Traded Corporations
In the United States, the SEC’s Regulation S-K provides disclosure requirements for publicly
traded rms. They are required to disclose, through annual or other public lings, known
trends, events, or uncertainties that are “reasonably likely to have a material effect” on
the rm’s nancial condition or operating performance. Information is material if there is
a substantial likelihood that a reasonable investor would consider it important in making
an investment decision.
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In response to a petition from 22 institutional investors and other organizations managing
more than $1.5 trillion in assets, the SEC in January 2010 published,
Commission Guidance
Regarding Disclosure Related to Climate Change
(the
SEC Guidance
or
Guidance
).
It interprets SEC disclosure requirements, as they apply to business or legal developments
relating to climate change (SEC, 2010). In addition to the review of the applicability of
requirements under Regulation S-K to climate risks, the
Guidance
also discussed several
topics that represent “some of the ways climate change may trigger disclosure required by
these rules and regulations” and which “a registrant may need to consider” (SEC, 2010,
p. 22). These include the impacts of legislation and regulation, international accords, indirect
consequences of regulation or business trends, and the physical risk of climate change.
The SEC
Guidance
discussed disclosure requirements applicable to material climate risks:
Description of Business, Legal Proceedings, Risk Factors, Management’s Discussion
and Analysis, and Foreign Private Issuers. The
Guidance
also addressed disclosure in
nancial statements, where the SEC noted that “[i]n addition to the Regulation S–K
items discussed in this section, registrants must also consider any nancial statement
implications of climate change issues in accordance with applicable accounting standards,
including Financial Accounting Standards Board [(FASB)] Accounting Standards Codication
Topic 450, Contingencies, and FASB Accounting Standards Codication Topic 275, Risks
and Uncertainties” (SEC, 2010, p. 22).
The Sarbanes-Oxley Act of 2002 also set out requirements related to corporate disclosure
that have resulted in rulemaking by the SEC. Section 302 of the law discusses disclosure
controls, including the requirement to establish, maintain, and regularly evaluate the
effectiveness of the issuer’s disclosure controls and to have corporate ofcers certify that
such controls are in place (SEC, 2002). Building on this, Exchange Act Rules 13a-14 and
15d-14 require that the issuer’s principal executive ofcer and principal nancial ofcer
certify that the nancial statements and other nancial information included in the report
do not omit a material fact. The purpose of the rules is to avoid misleading quarterly and
annual reports and ensure the fair presentation in all material respects of the nancial
condition, results of operations and cash ows of the issuers.
To the extent climate risk is material to an issuer, Section 302 of Sarbanes-Oxley applies.
The SEC’s 2010 climate disclosure guidance points this out and discusses management’s
obligation, when determining materiality, to “consider all relevant information even if that
information is not required to be disclosed” and “consider whether they have sufcient
disclosure controls and procedures to process this information” (SEC, 2010, p. 19).
The impact of the 2010
Guidance
has been limited. A report by the GAO found that
“[c]limate-related disclosures vary in format because companies may report similar climate-
related disclosures in different sections of the annual lings,” which may result in “SEC
reviewers and investors [nding] it difcult to navigate through the lings to identify, compare,
and analyze climate-related disclosures across lings...” (GAO, 2018, p. 19). The report
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also found that “climate-related disclosures in some companies’ lings use boilerplate
language, which is not specic to the company, and information is unquantied,” thereby
limiting the utility of the information to investors (GAO, 2018). While the SEC has not
updated the guidance since it was issued in 2010, global expectations for increasingly
sophisticated and robust climate risk disclosure in nancial lings have grown.
The quality of climate disclosure in the United States by issuers largely remains inadequate
for the needs of investors (Mahoney and Gargiulo, 2019). Disclosure in SEC lings has
been inadequate, in part, because materiality under U.S. law is often interpreted as limiting
required disclosure to short- and medium-term risks, and rms may have assumed that
climate risks are relevant only over longer time horizons. However, different rms and
industries may have different time horizons over which climate risks are deemed material,
taking into account factors like the economic life of assets, the percentage of valuation
that can be attributed to future growth, the nature of climate-related risk exposure, and
corporate strategy. Physical risk exposure of a company or industry may fall somewhere
between near-term acute shocks and long-term chronic stresses. These factors should be
evaluated when determining which climate risks—including medium- to long-term transition
risks—are material and should be included in SEC lings.
Moreover, even in the case of long-term physical and transition risks, investors have asked
the SEC to consider the perspective of shareholders investing for the long-term benet
of their beneciaries. For example, the California Public Employees' Retirement System
(CalPERS), the second largest pension fund in the United States, “urge[d] the SEC” to
consider improvements to its disclosure regime, including “clarifying the denition of materi
-
ality to reect long-term investor needs” (Hoffner, 2016). Guidance published by BlackRock
(the largest asset management rm in the United States) and CalPERS for engaging the
companies they own make clear their emphasis on long-term value creation and their need
for climate risk disclosures to ensure that value is sustained (CalPERS, 2019; Fink, 2020).
Municipal Securities
The Municipal Securities Rulemaking Board (MSRB) and the Financial Industry Regulatory
Authority (FINRA) oversee the municipal securities market. Rules require that underwriters
in most municipal securities offerings ensure that municipal issuers make information about
themselves and their securities available both at the time of the offering and on an ongoing
basis. Voluntary guidelines for primary and ongoing municipal bond disclosure, such as
those promulgated by the Government Finance Ofcers Association (GFOA) and the
National Federation of Municipal Analysts (NFMA), emphasize that issuers should provide
information necessary to ensure a clear understanding of their condition (NFMA, 2019;
GFOA, 2020).
Congress and the SEC oversee the MSRB, and its rules generally must be approved by
the SEC before becoming effective. The MSRB is not responsible for enforcing its rules
or conducting compliance examinations. The SEC, federal nancial regulators, and FINRA
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
94
share responsibility for enforcement and compliance examinations in the municipal securities
market. In 2010, Congress broadened the MSRB’s mandate to include protection of state
and local governments and other municipal entities, and extended the jurisdiction of the
MSRB to include the regulation of municipal advisers. The MSRB’s Electronic Municipal
Market Access (EMMA) website aims to protect investors and municipal entities in the
municipal market by increasing the transparency and availability of market information,
including offering documents, ofcial statements, and continuing disclosures.
To date, municipal regulators and the bodies that oversee them have not issued guidance
or rules related to climate risk disclosure for municipal bonds. Two reports have examined
applicable disclosure laws and examples of municipal securities disclosure and found climate
risk disclosure to be inadequate (Rhodes and Magrini, 2019; Hamilton, 2010). However,
the SEC’s stance appears to be evolving. At a 2018 SEC municipal securities disclosure
conference, the director of the SEC’s Ofce of Municipal Securities asked attendees how
market participants were grappling with climate risk. Several panels discussed disclosure
of extreme weather events and climate risks, with speakers noting increased investor
demand for climate-related information (Olsen, 2018; SEC, 2018).
Federal Government Entities
The federal government also could strengthen disclosure practices for its own portfolio of
assets. The Federal Accounting Standards Advisory Board (FASAB) issues federal nancial
accounting standards and guidance. FASAB guidance covers the annual Financial Report
of the United States Government, as well as disclosure specic to federal departments,
agencies and administrative units. In scal year 2019, the federal government collected
$3.6 trillion in taxes and other revenues, had a net cost of $5.1 trillion, and had a balance
sheet with $4 trillion in assets and $27 trillion in liabilities (Treasury, 2020). Thus, its disclosure
of climate risk could be substantial. The federal government may be able to advance
innovation in the measurement and disclosure of climate risks across the wide variety of
asset classes that the federal government owns and manages. These innovations may
reciprocally support disclosure practices and guidance among state and local governments,
as well as the private sector.
Global Climate Risk Disclosure Developments
Climate disclosure has become increasingly important to foreign nancial regulators as
recognition has grown that climate risks can have signicant effects on nancial systems.
Foreign regulators increasingly recognize that they can do more to both ensure the
stability of capital markets in the face of these risks and enable market actors to assess
and mitigate the risks. This recognition is coming not only from securities regulators, but
also from central banks, prudential supervisors, accounting and auditing overseers, and
other regulators.
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A consensus is growing among regulators that disclosure, as an important element of a
climate risk management strategy, helps market participants better understand and act
on the climate risks that they face, and provides comparable information that benets
investors, regulators, and other stakeholders. The International Organization of Securities
Commissions (IOSCO), whose members represent 115 countries and more than 95 percent
of the world’s securities markets, has stated, “[s]ecurities market regulators have a key
role to play in reminding issuers to consider such risks and to disclose material ESG
[(environmental, social and governance)] information to investors” (IOSCO, 2019, p. 3).
IOSCO has several workstreams to advance this disclosure.
Several foreign nancial regulators have recently put forward or are exploring rules for
climate risk disclosure, which could act as models to be adapted for the U.S. context. The
European Commission (EC) adopted
Guidelines on Reporting Climate-related Information
in June 2019. The guidelines structure the proposed climate-related disclosure into ve
reporting areas: (i) business model; (ii) policies and due diligence; (iii) outcome of policies;
(iv) principle risks and risk management; and, (v) key performance indicators (EC, 2019).
Article 173 of France’s Energy Transition Law lays out climate disclosure requirements for
both listed companies and investors. The regulation uses a “comply or explain” approach
that provides exibility for how rms disclose their risks. Additionally, Article 173 calls for
an assessment of reporting progress made during its rst two years. This review may lead
to more explicit guidance on reporting methodologies. Similar models are being explored
by Spain and Sweden, among others.
The United Kingdom’s
Green Finance Strategy
called on all listed companies and large asset
owners to disclose in line with the TCFD recommendations by 2022 (HM Government,
2019). The strategy also announced that the U.K. government will form a task force to
examine potentially effective disclosure approaches, including climate disclosure rules.
In 2019, the nal report of Canada’s Expert Panel on Sustainable Finance proposed that
Canada adopt the TCFD recommendations on a “comply or explain” basis (Canada, 2019).
Additionally, in 2019, the Canadian Securities Administrators (CSA) issued guidance on
how issuers could more effectively disclose their material risks, opportunities, nancial
impacts, and governance processes relating to climate change (CSA, 2019).
The International Financial Reporting Standards (IFRS) Foundation published a mapping
exercise discussing when it would be appropriate for companies to disclose climate
issues according to the following IFRS standards: (i) Presentation of Financial Statements;
(ii) Impairment of Assets; (iii) Property Plan and Equipment; (iv) Intangible Assets; (v) Fair
Value Measurement; (vi) Financial Instruments; and, (vii) Provisions, Contingent Liabilities
and Contingent Assets (Anderson, 2019). The Australian Accounting Standards Board
and Auditing and Assurance Standards Board discussed the potential nancial implications
of climate risks that issuers should consider, such as changes in the useful life of assets,
changes in the fair valuation of assets, and changes in expected credit losses for loans
and other nancial assets (AASB and AUASB, 2019).
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96
The Case for Regulatory Action
Given the inadequacy of the current climate risk disclosures, U.S. regulators should build
on their global counterparts’ models and issue rules for climate risk disclosures. They
should monitor the rules for effectiveness. Such action by regulators would be directly
responsive to market demand for enhanced climate disclosure.
Investors are increasingly demanding more comprehensive and useful climate-related
information. The Climate Action 100+ initiative—where more than 450 investors representing
more than $40 trillion in assets engage the largest carbon intensive companies—identies
TCFD-based climate risk disclosure as a foundational principle (CA100, 2019). Recent
proxy seasons have continued to demonstrate strong investor interest in climate change.
Investors and investor groups have called on companies to voluntarily adopt frameworks and
standards, proffered by organizations such as the TCFD and SASB, to improve the quality
of climate-related disclosure (Fink, 2020; Taraporevala, 2020). Additionally, they have called
on the G20 nancial regulators to incorporate TCFD into their standards (IAFP, 2019). The
Investor-as-Owner Subcommittee of the SEC Investor Advisory Committee recommended
in May 2020 that the reporting requirements of issuers be updated to cover material,
decision-useful ESG factors (SEC, 2020).
Currently, although many large companies voluntarily disclose their climate-related risks,
disclosure generally exhibits inconsistent quality, lacks comparability, and varies by industry
(TCFD, 2019b). In its 2019 status report, the TCFD found that, on average, the banking
industry was a relative leader in adhering to the TCFD’s disclosure recommendations,
whereas industries like transportation, agriculture, forestry, food, technology and media,
and consumer goods tended to have the lowest rates of disclosure (TCFD, 2019b). This
disclosure gap is particularly concerning because nancial institutions require effective
climate-related disclosures to adequately factor climate risks into their decisions. This
imbalance between the climate-related disclosure provided and the information needed
for analysis and decision-making underscores the importance of regulatory action to close
the gap.
Disclosure of material climate risk is essential, but the existing disclosure regime cannot ll
the reporting gaps discussed in this chapter. The primary barrier is the signicant ambiguity
about when climate change rises to the threshold of materiality, particularly for medium- and
long-term risks. Without further clarity on what is material and therefore on what must be
disclosed, companies concerned about being disadvantaged by moving sooner than their
competitors are unlikely to proactively expand their disclosure. Comparable disclosure
cannot develop without clear rules about what metrics companies should consider.
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Investors need robust climate risk disclosure to fulll their duciary obligations. Fiduciaries
and investors, surveys show, consider ESG risks, including climate risk, as a part of their
duciary duties (Comtois, 2019), and believe that ignoring ESG factors could lead to
“material risk” (Idzelis, 2019). From a global perspective, the IOSCO recommended in 2019
that securities regulators ensure that institutional investors, consistent with their duciary
duties, incorporate ESG issues into investment analysis, strategies and governance, and
consider the material ESG risks of the companies in which they invest (IOSCO, 2019).
As discussed in Chapter 8, that is not possible without comparable, reliable and decision
useful information.
Credit rating agencies are starting to factor in climate risks in assessing the creditworthiness
of public and private sector organizations and transactions because, among other things,
climate change can impact cash ows and borrowers’ ability to meet their debt obligations.
The continued absence of reliable, relevant, and comparable climate disclosures, both
across and within sectors, will hamper credit rating agencies’ ability to fully account for
the potential impacts of climate risk on creditworthiness.
U.S. regulators are well positioned to facilitate the process of enhancing the availability and
quality of decision-useful climate-related information. Existing regulatory guidance largely
applies to climate risk, where climate risks are material to a regulated security (SEC, 2010).
However, the unique nature of climate risk means that clearer rules are needed to increase
the level and improve the quality of disclosure. Absent this clarity, lack of information will
continue to impede the efciency of markets and their ability to accurately price climate
risks and opportunities (Krueger, 2015).
Recommendations
In developing and implementing the recommendations below, nancial regulators and the
entities they oversee should consult with stakeholders, including investors, businesses,
global peers, and other market intermediaries to create a U.S. climate disclosure regime.
They also should closely coordinate with international bodies and foreign regulators to
ensure the U.S. regime is aligned internationally. Because the understanding of climate
risk remains at an early stage, any regulatory approach to climate-related disclosure should
evolve in line with emerging best practices. Regulators should continually monitor the
state of corporate climate disclosures, evolving clarity on the nancial impacts of climate
change and emerging best practices. This will allow regulators to continually monitor the
quality of the information disclosed in a sophisticated manner, and issue supplemental
guidance or begin rulemaking where needed to reect emerging best practice and market
needs. A mandatory, standardized disclosure framework for material climate risks, including
guidance about what should be disclosed that is closely aligned with developing international
consensus, would improve the utility and cost-effectiveness of disclosures.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
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Financial Market Regulators
Recommendation 7.1: All nancial regulators should consider the following principles for
effective disclosure, which are mainly derived from principles developed by the Task Force
on Climate-related Financial Disclosures, when developing rules on climate risk disclosure,
implementing existing rules or guidance, or seeking public comment on actions they should take:
●
Disclosures should represent relevant information.
●
Disclosures should be specic 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, veriable, and objective.
●
Disclosures should be based on current consensus science (and updated as the
science evolves) and the best available projections regarding climate change impacts.
●
Disclosures should be provided on a timely basis.
Recommendation 7.2: 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, nancial regulators should clarify the denition of materiality for disclosing
medium- and long-term climate risks, including through quantitative and qualitative factors,
as appropriate. Financial lings should include disclosure of any material nancial risks
from climate change in a consistent but non-boilerplate manner, as well as a qualitative
description of how rms assess and monitor for potential changes in climate risks that
may become material.
Recommendation 7.3: Regulators should consider additional, appropriate avenues for rms
to disclose other substantive climate risks that do not pass the materiality threshold over
various time horizons outside of their lings. Regulators should consider that a growing
number of companies are creating greenhouse gas reduction targets and strategies out to
the year 2035 or 2050, and targeted disclosure related to these items may be appropriate
to facilitate robust efforts toward this positive trend.
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Recommendation 7.4: Recognizing the costs associated with collecting, assessing and
disclosing climate risk information, nancial regulators should consider whether smaller
companies could be provided a longer period of time to provide their initial disclosures,
and the specic disclosures required of those companies could be different and less
burdensome than those required of larger issuers.
Recommendation 7.5: In light of global advancements in the past 10 years in understanding
and disclosing climate risks, regulators should review and update the SEC'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
. Such an update could incorporate advice on:
●
Information that is needed from all companies in order to enable nancial regulators to
assess the systemic risks posed by climate change. Federal nancial market regulators
should work closely with prudential regulators to develop these rules.
●
Industry-specic climate risk information. Rules should build from existing standards
that provide industry-specic climate disclosure recommendations, for example,
those developed by the TCFD, SASB, CDSB, the Physical Risks of Climate Change
(P-ROCC) framework, and the Global Real Estate Sustainability Benchmark (GRESB)
standards for real estate and infrastructure. Because these standards are already
sophisticated, regulators do not need to create their own standards or metrics from
scratch. Regulators should encourage stakeholders to partner with these standard-
setting bodies to further develop, standardize, implement, and validate these metrics
over time. Regulators should also acknowledge, in any rulemaking, that climate
disclosure standards continue to evolve, and it could provide issuers exibility, where
appropriate, to adopt these evolving standards.
●
Governance, risk management and scenario planning information that demonstrates
how well companies are situated for a clean energy transition. Federal nancial market
regulators should work closely with prudential regulators to develop these rules.
Scenario planning disclosure is discussed in Chapter 6. Regarding governance and
risk management disclosure, regulators should consider the TCFD’s recommendations
and the Committee of Sponsoring Organizations of the Treadway Commission/World
Business Council for Sustainable Development (COSO/WBCSD) guidance, applying
enterprise risk management to environmental, social and governance-related risks.
Recommendation 7.6: 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, nancial regulators should require their disclosure, to
the extent they are material.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
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Recommendation 7.7: Regarding derivatives, nancial regulators should examine the
extent to which climate impacts are addressed in disclosures required of the entities they
regulate and consider guidance and rulemaking if disclosure improvements are needed.
This could include, for example, swap dealers registered with the CFTC, risk management
rules that govern risk identication approaches; Quarterly Risk Exposure Reports, and
business conduct rules that govern disclosure of material information to counterparties
prior to entering into a swap.
Accounting Standards Regulators
Recommendation 7.8: Once climate risk disclosure standards are well advanced, accounting
standards regulators should undertake a mapping exercise of the applicability of accounting
standards to climate-related disclosure and subsequently issue guidance on disclosure,
as appropriate. This would provide U.S. companies greater clarity about how climate risks
may be integrated into nancial statements.
Recommendation 7.9: The United States should direct the Federal Accounting Standards
Advisory Board (FASAB) to study and pilot the development of climate-related federal
accounting standards, disclosure procedures and practices for U.S. government
departments, agencies and administrative units.
Municipal Securities Regulators
Recommendation 7.10: Municipal securities regulators should provide improved tools on
the EMMA website to search for climate-related disclosure in municipal bond lings, similar
to that provided for publicly traded companies, to allow better assessments of potential
climate risk exposure in such assets and how they are being addressed.
Recommendation 7.11: Municipal securities regulators and the federal nancial market
regulator overseeing them should examine the quality of climate-related disclosures in
municipal bonds’ ofcial statements and continuing disclosures, and whether the disclosure
provided is adequate for market participants to assess any underlying climate risk exposure.
If disclosure is found to be decient, they should issue a public statement calling on key
stakeholders to improve disclosure, including municipalities, municipal advisers, and banks.
Recommendation 7.12: Municipal securities regulators and federal nancial market and
prudential regulators should study how risks facing municipalities differ from—and could in
some cases be more impactful than—risks facing issuers and explore options to enhance
disclosure on these issues. Some municipalities already disclose information, as part of
their bond issuances, about oods, storms, dam safety, droughts, wildres, sea level
rise, and risk mitigation efforts, and further study could demonstrate that such disclosure
should be enhanced.
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This chapter examines how nancial regulators can accelerate the transition to a net-zero,
climate-resilient economy. It focuses on the structural changes and market innovations
that can expand capital ows to sustainable nance solutions, which are a key component
of managing physical and transition risk in the U.S. nancial system. As Chapter 1 notes,
it is essential that the United States establish a price on carbon. This is the single most
important step to manage climate risk.
Financial products have a variety of risks, and this report has articulated the nancial
implications of climate risk in detail. Financial innovation is required to further develop
the tools and resulting products that can efciently manage climate risk and facilitate the
allocation of capital to an economy-wide, net-zero transition. The transition to a resilient,
net-zero emissions future is the linchpin in managing long-term climate risk to the U.S.
economy and households. Doing so requires embedding climate risk within the risk
management frameworks of nancial institutions, expanding climate risk data, building
expertise in managing climate risks, leveraging scenario analysis, and improving disclosure.
This chapter highlights a selection of the many measures that regulators, nancial institutions,
and market participants can adopt to catalyze climate-related investment. Once carbon
pricing is adopted, these measures will be equally if not more important in facilitating orderly
shifts in investment decisions. While some nancial products are already available to assist
market participants interested in investing in the transition, this chapter focuses on the
scale of investment needed and the gaps where further institutional effort is necessary to
facilitate the development of climate-related nancial products and services.
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A Closer Look at Financing
the Net-Zero Transition
Chapter 8
Estimating the Scale of Investment Needed
Reducing emissions and limiting warming and adapting to the changing climate will require
signicant public and private investment. Key objectives include deploying low or zero
carbon technologies, accelerating innovation in carbon capture, utilization and storage
technologies (CCUS), sequestering emissions through natural climate solutions, and
developing infrastructure and technologies needed to adapt to physical risks.
Investment needs are broadly estimated to be in the trillions of dollars. One estimate comes
from the International Renewable Energy Agency (IRENA), which charts an ambitious yet
technically and economically feasible path for limiting warming to “well below” 2 degrees
Celsius, in line with the Paris Agreement. IRENA estimates that $110 trillion of cumulative
worldwide investment in the energy sector will be needed leading up to 2050 (IRENA,
2019). That equates to roughly 2 percent of average global gross domestic product (GDP)
per year over the period. Of the $110 trillion, $95 trillion is already required under the
reference case scenario of current plans and policies but would need to be redirected from
investments in high-carbon to low-carbon activities. An additional $15 trillion is necessary
to further reduce emissions. This transformation is estimated to boost total global GDP by
2.5 percent, or 5.3 percent when considering the avoided climate-related damages relative
to the reference case (maintenance of current plans and policies). The transition would
result in $11.8 trillion in stranded assets by 2050, but delaying action would nearly double
total stranded assets to $19.5 trillion by 2050. However, the cumulative benet in terms of
avoided climate-related and air pollution damages ranges from $50 trillion to $142 trillion,
and reducing fossil fuel subsidies would generate further savings of $15 trillion by 2050,
relative to the reference case.
Decarbonizing the U.S. power grid over the next 10 to 20 years has been estimated to
cost upward of $4.5 trillion (Wood MacKenzie, 2019). This and other estimates generally
focus on the direct costs of transitioning domestic energy infrastructure, while there are
additional costs to transition transportation, agriculture, and industry. However, these
cost estimates reect signicant economic opportunity, and it is useful to consider them
alongside the counterfactual costs of business-as-usual, as well as the co-benets that
arise from technological innovation, new categories of labor and expanded employment,
and the avoided costs associated with the improved resilience of infrastructure.
Mobilizing the trillions of dollars necessary to nance the technologies and activities that
support the net-zero transition will require tapping into vast pools of capital. In a nancial
environment characterized by ultra-low interest rates, institutional investors are seeking
higher returns, as long as investments meet their preferred risk-return prole and investment
horizons. Despite inadequate incentives to reduce emissions and various structural barriers,
U.S. investors are already starting to position themselves for the inevitable transition.
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Barriers to Sustainable Investing
Misperceptions about Risk-Return
Multiple barriers may be holding back U.S.-based institutional investors. One involves a
common, long-held misperception among investors that sustainable or environmental, social
and governance (ESG) investments necessarily have lower returns relative to traditional
investment strategies. This is based on the historical view that ESG investing is a values-
driven activity, and that ESG data and principles may be incongruent with a duciary duty to
seek the highest returns. This perspective underlies historical practices like omitting certain
companies or sectors via ESG screens. These misperceptions ignore the evolution of a
wide range of nancial ESG factors and strategies, as well as the proposition that impact
investing may yield additional returns. This report in general, particularly Chapter 5, details
the variety of ways climate risk management could drive improved risk-return.
The nature of nancial markets perpetuates these misperceptions. Asset owners and
managers set investment strategies and evaluate returns based on benchmarks and strategic
asset-allocation targets. Managed funds often raise capital based on explicit terms including
investment theses and lock-up periods ranging from months to years. Return targets tend
to be based on historical returns or on capital market forecasts premised on economic
growth and other factors. This practice drives a strong status quo bias that undermines
a more complete evaluation of what the future may bring, including future opportunities
associated with managing climate risk. Without a historical track record or clear empirical
justication, it is often difcult for traditional investors to integrate sustainable investments
into their portfolios. Ultimately, empirical evidence does not support these collective barriers
characterizing sustainable investments as inferior. Studies analyzing nancial performance
across a large sample of ESG approaches show that making investment decisions using
ESG factors does not hurt investment performance across the sample, and, in some cases,
it enhances risk-adjusted returns (Friede et al., 2015; Morgan Stanley, 2015a; Morgan
Stanley, 2015b; Clark et al., 2015; Khan, et al., 2016).
Insufficient Investment Opportunities
A second barrier to sustainable investment is the shortage of climate-related investment
opportunities relative to investor demand. Demand for sustainable investments is large
and growing. Coalitions of asset owners, asset managers, and other nancial institutions
are expressing interest and support for sustainable investment. For example, the U.N.
Principles for Responsible Investment (PRI) includes more than 3,000 investor signatories
with more than $100 trillion in assets under management. However, expressions of support
have not translated into the necessary capital ows.
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In addition, a growing number of asset owners, including endowments and pension funds,
are committing to transitioning their investment portfolios to net-zero emissions by 2050—a
goal consistent with a maximum temperature rise of 1.5 degrees Celsius above pre-industrial
temperatures and in alignment with the Paris Agreement. The Paris Agreement has
increasingly motivated U.S. and global companies and investors to voluntarily commit
to reducing their carbon footprints, and some rms have pledged to achieve net-zero or
net-negative emissions. Recently, Harvard University and Stanford University, which manage
two of the ve largest university endowments globally, committed to net-zero portfolios
(HMC, 2020; Stanford, 2020).
The market for products widely considered to be “green” or “sustainable” is rapidly
expanding but remains small relative to institutional investors’ needs. A growing number
of opportunities are focused on integrating climate risk and investing in the transition, but
many of the opportunities have been within private markets, including venture capital,
private equity and infrastructure. Public equity and debt markets are signicantly larger
and more liquid but offer far fewer sustainable investment opportunities.
With respect to debt, even though global green bond issuance hit a record $255 billion in
2019, it was not nearly enough to satisfy investor demand, particularly once emerging market
risk and other constraints were considered (Chestney, 2020). Similarly, investors have few
options for sustainable U.S. corporate debt exchange-traded funds (ETFs). Among the
largest global asset management rms, only a few U.S.-domiciled ETFs with any measure of
sustainability focus are currently available. A variety of factors are driving these limitations.
The lack of sufcient scale is even more clear in equity markets, as is the gulf between
Europe and the United States. In Europe and elsewhere, investors are shifting increasing
portions of their portfolios to “green” or “sustainable” assets. For example, as of March
2020, total sustainable European fund (open-end funds and ETFs) assets reached a
record of more than $680 billion (Morningstar, 2020). By comparison, sustainable U.S.
fund (open-end funds and ETFs) assets totaled nearly $120 billion (Morningstar, 2020). In
the rst quarter of 2020, $45.6 billion globally owed into ESG funds, with 72.4% of ESG
inows in Europe relative to 22.8% in the United States, and this occurred in the context
of an outow of $384.7 billion for the overall fund universe (Morningstar). These trends
suggest that U.S. demand for these products may be weaker relative to European demand
for a variety of reasons, including the lack of proper incentives.
Concerns About “Greenwashing”
A third barrier holding back sustainable investment may be concerns about potential
“greenwashing.” Some investors lack condence that “sustainable” or ESG-labeled products
are as green as they claim to be. These concerns form the partial basis for a current SEC
Request for Comment about the naming of funds and investment companies (SEC, 2020).
The absence of widely accepted, consistent denitions and standards for climate risk data in
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
106
general, and sustainable investing in particular, may be hindering market development. It is
difcult for investors to understand what labels such as “ESG,” “sustainable,” “green,”
“low-carbon,” or “net-zero” actually mean and to compare products that carry the same label.
Today, nancial products may be identied as sustainable or green, based on the proprietary
research of the provider. Investors looking for consistency in labeling can rely on private
certication entities, but with potential implications for cost and comparability. Private
certications are limited to a comparatively narrow range of sectors and asset classes.
Their advantage is that they likely incorporate emerging intelligence and expertise on
climate risks, uncertainties, and opportunities. Their disadvantage is that comparability
may be difcult.
Credible data is the foundation of any nancial product’s sustainability credentials. It can
be attained from emerging public source and proprietary data providers, as well as from
corporate disclosure and reporting. The goal is consistent and comparable information.
A lack of available climate risk data is hindering the development of sustainable investment
products, including derivatives based on ESG or sustainable assets. For example, certain
carbon indices are designed to screen for companies based on their carbon intensities or
environmental performance. But to build datasets like that, clearly demarcated methodologies
and denitions are needed to ensure the integrity of nancial products such as over-the-
counter (OTC) and listed derivatives with ESG and, more specically, carbon-related
underliers. Clear denitions and methodologies are also necessary for central counterparties
to adequately assess and manage risks associated with listed ESG contracts.
Policy Uncertainty
One of the most critical factors holding back sustainable investment is policy uncertainty.
The lack of carbon pricing and uncertainty about climate policy more generally create
enormous nancial risk and make long-term investments in energy, infrastructure and other
sectors difcult to effectively value. This difculty reduces the ow of capital to renewable
energy and other existing low-carbon technologies, and to new technological innovations
needed across nearly every sector. Technological innovation, from initial research through
pre-pilot, pilot and initial commercialization, is an area of particular market failure, given
the long time horizon to commercialization, the capital intensity of many sectors, and the
risk aversion of market participants.
While the absence of climate policies impedes sustainable investment, so too do various
existing policies. One example is regulation of nancial products that U.S. companies
may offer to their employees through retirement plans. The Employee Retirement Income
Security Act of 1974 (ERISA) and the rules adopted under it by the U.S. Department of
Labor (DOL) govern the management of retirement and pension plans. ERISA articulates
duciary responsibilities that companies must follow in retirement plan offerings. Elements of
this regulation may be chilling the offering of sustainable products in U.S. retirement plans.
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Guidance issued by the DOL in 2018 and recently proposed amendments to ERISA rules
limit how managers of ERISA assets may consider ESG benets (DOL, 2018; DOL, 2020).
Because of misperceptions about risk-return, ERISA plan sponsors and managers also
may believe they could risk violating their duciary duties if they integrate sustainability
factors into their investment approach.
Catalyzing Structural Change and Market Innovation
Addressing barriers and building an ecosystem that supports sustainable nance will require
structural shifts. The ultimate goal is that all investment products and services internalize
climate risks and opportunities in a manner that drives dynamic competition and mitigates
GHG emissions. Effectively pricing carbon is the best way to recognize the inherent risk-
return prole of sustainable investments and would signicantly expand the market for
them. However, gaps remain, and policymakers have an important role to play in reducing
barriers and harnessing the innovative capacity of markets.
Fiscal Policy
Beyond carbon pricing, a wide range of complementary policies can mitigate climate risk
and advance the transition to a net-zero emissions future. The U.S. government’s scal
authority—its capacity to spend, borrow, and structure the tax code—can signicantly
increase the scale of investment in sustainable projects. To be sure, trillions of dollars are
needed for the transition, and there are limits to how much the government can do on
its own. Additionally, constant changes in the direction of scal policy can sustain policy
uncertainty. Fiscal policy nevertheless can advance the transition in many ways. Project
standards can be designed to minimize “greenwashing,” for example. Fiscal policy can
support the many co-benets of the transition, including job creation and the promotion
of equity for historically marginalized communities. Additionally, it can drive continued
innovation by funding basic scientic research and the deployment of mature technologies.
Fiscal policy includes economic stimulus, disaster relief, and infrastructure, all of which have
implications for climate risk. The direction of public investment could increase or decrease
climate risk across the nancial system. The ongoing response to the COVID-19 global
economic crisis has included urgently needed economic stimulus. Future spending offers
possibilities for reducing the structural barriers holding back the transition to a net-zero
emissions future, while simultaneously supporting the economy. Policymakers’ ambition
should be to enhance the economy’s long-term potential, including by managing climate
risk, not to maintain the status quo.
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Catalyzing Private Capital
Government spending can be structured to more directly address market failures and
structural barriers that impede private sector capital ows. These efforts can harness the
power and innovation of the nancial system to efciently drive capital toward the net-zero
transition. These programs can increase total investment by leveraging private sector
dollars alongside public sector dollars. These efforts can help expand the scale of both
investor demand and the supply of quality investment opportunities, improve risk-return by
stimulating the integration and pricing of climate risk, and aid in denition standardization
to alleviate “greenwashing” concerns.
Several successful government programs focus on de-risking certain investments and
attracting private capital—effectively expanding the universe of investable green assets.
The U.S. Department of Energy (DOE), U.S. Department of Agriculture (USDA), and U.S.
Department of Transportation (DOT) have the authority to encourage clean energy and
resilience through the loans and loan guarantees they deploy to a range of large-scale
infrastructure projects. As of year-end 2019, the DOE Loan Programs Ofce (LPO) had
$44 billion in available loan and loan guarantee authority to support advanced vehicle
manufacturing; advanced nuclear; advanced fossil energy (for example, CCUS); renewable
energy and energy efciency; and tribally-owned energy projects (DOE, 2020). Entities
such as the Advanced Research Projects Agency-Energy (ARPA-E) provide capital and
support to advance innovations that are still too nascent for private sector investment.
ARPA-E funding typically averages $500,000 to $10 million. It has provided $2.3 billion
since 2009 to 850 projects, many of which led to patents, new companies, or partnerships
with other government agencies; 20 percent of the projects went on to raise $3.2 billion
in private sector funding (ARPA-E, 2020). These credit enhancements and co-investments
attract private sector funds.
Green banks at the state and municipal level have directly addressed a range of barriers and
opportunities. Green banks can mitigate barriers of scale by aggregating small transactions
and supporting the development of new products. They can foster investor trust by
participating in classication guidance and leading the initial development of new markets.
They can also help address concerns about nancial returns by de-risking investments and
familiarizing investors with new markets. Ultimately, many of these programs are focused
on attracting private sector capital to increase total funding.
For example, the New York Green Bank (NYGB) is a state-sponsored specialized nancial
entity that collaborates with the private sector to accelerate and expand sustainable
investment. NYGB invests with the goal of unlocking signicantly more private capital.
Examples include warehousing and aggregation facilities, term loans, credit enhancements,
and construction nance. As of the rst quarter of 2020, NYGB had invested nearly
$960 million in energy efciency, solar, sustainable transportation, and fuel cell projects.
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NYGB is targeting a ratio of total project investment to NYGB funds of 8-to-1. Its goal is
to eventually generate $8 billion in investment from its $1 billion of capital. So far, the bank
has mobilized $2.6 billion (NYGB, 2020).
Existing authorities could be leveraged and expanded into a more unied program, perhaps
under a federal umbrella, that could coordinate a wide range of government programs and
provide an increase in institutional capital to maximize their impact. Potential tools could
include those that are already actively used, such as lending and credit enhancements.
The federal umbrella could also facilitate the initial capitalization of state and local green
banks and other state climate initiatives.
Supportive Regulatory Policy
Regulators have long supported innovation in the markets they oversee. They could do the
same for sustainable investments. Regulation, for example around permitting and federal
leasing, can stimulate capital ows. Financial regulators have sought to facilitate nancial
technology (ntech) innovation and at the same time tried to ensure their policies keep pace
with the ever-changing nancial services industry. By the same token, ntech innovators
need a detailed understanding of regulation to pursue their work successfully.
Financial regulators support innovation through regulatory labs or sandboxes. A lab serves as
forum for rms to engage with regulators. They help regulators adapt their regulatory frame-
works to innovation and help market participants navigate regulation. Sandboxes go further
by creating a formal structure for innovators to develop and test new products and services,
with regulatory oversight and support. Labs and sandboxes can also drive innovation via
accelerators, grants and competitions providing awards in specic areas. Labs and sandboxes
established by domestic and foreign regulators currently focus on ntech innovation in general.
For example, the CFTC established LabCFTC with the aim of—“facilitating market-enhancing
FinTech innovation, informing policy, and ensuring that the agency has the regulatory and
technological tools and understanding to keep pace with changing markets” (CFTC, 2019).
A similar approach could be used to drive market innovation for climate-related nancial
products. Climate-related nancial innovation, including climate data platforms and climate
ntech solutions, is crucial for managing climate risk and driving the transition to a net-zero
emissions future. A climate nance lab or sandbox could enhance emerging innovations
relating to climate risk data and analysis and facilitate the development of innovative
nancial products.
In addition, labs and sandboxes, as well as catalytic funding programs, can facilitate access
to data and expertise. By improving the availability and consistency of data, government
programs can reduce private sector risk aversion to creating new or modied nancial
products and services (Keenan, 2019). Improved data integration and access would
encourage the development of new climate-related technologies and products, particularly
the emerging efforts to use nature-based solutions for physical climate resilience and
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adaptation investments. Some programs to integrate and communicate data already exist,
such as the U.S. Department of Energy’s Energy Investment Center, which was established
to share the technical expertise of the Department’s National Laboratories with investors.
Finally, the clarication of existing rules could help unlock sustainable investment. As noted,
regulatory concerns may discourage ERISA plan sponsors and managers from integrating
climate-related factors into their investment approach. Similar concerns arise in other
situations where there is duciary duty. They include the potential misperception of risk-return,
worry about violating unclear standards (including those caused by conicts or changes in
regulatory guidance), and potential liability for the underperformance of investments being
attributed to their sustainability features.
Clarication is necessary to conrm the appropriateness of making investment decisions
using climate-related factors—and more broadly, ESG factors that impact-risk return.
Because climate-related factors may affect nancial performance, they should be considered
by duciaries to the same extent as “traditional” nancial factors—such as valuation,
protability ratios, and management strength. Regulatory efforts must not discourage the
consideration of these factors, and instead should encourage their consideration. Climate risk
and opportunities, as well as broader sustainability and ESG factors, need to be considered
as part of the analysis of nancial fundamentals and the normal investment process.
Innovation in Derivatives Markets
For more than 25 years, derivatives have been used to hedge climate-related risks. The
need for new products likely will grow. Various OTC and exchange-traded climate-related
derivatives currently are used by agricultural, energy and metals market participants, as well
as nancial entities. These instruments include traditional weather derivatives, electricity
futures, and relatively new instruments, such as ESG futures and carbon derivatives based
on equity indices. Broadly speaking, derivatives can address climate-related risk through
adjusting existing instruments and by providing new instruments.
To advance the market for climate-related derivatives, regulators should consider appropriate
and targeted exemptions from their rules when needed to facilitate coordination with other
regulators and promote market development. For example, the CFTC classied environmental
commodities as non-nancial commodities, thus allowing them to be purchased and sold
pursuant to excluded spot and forward contracts. This paved the way for primary regulation
by the agencies designing the underlying market—the Environmental Protection Agency
for Renewable Fuel Standards (RFS) markets and state agencies for existing Renewable
Portfolio Standards (RPS) and carbon markets.
The CFTC provided guidance to these primary regulators based on its experience as a
market regulator. For example, in its
Report on the Oversight of Existing and Prospective
Carbon Markets
, the CFTC encouraged broad and open market participation and emphasized
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that “rules and trading systems should be designed to encourage market liquidity, facilitate
price discovery and allow those directly and indirectly impacted by the regulation of carbon
emissions to efciently hedge associated risks” (CFTC, 2011, p. 50). Appropriate oversight
of primary and secondary markets could be revisited “if or when Congress considers Federal
market-based options for reducing greenhouse gas (GHG) emissions” (CFTC, 2011, p. 52).
Reducing Exposure to Climate-Related Risks within Existing Instruments
Businesses and consumers are increasingly focused on the environmental impact of the
commodities they produce and consume. As a result, businesses often desire greater
oversight and understanding of their supply chains to ensure that the commodities meet
certain sustainability denitions and standards. This trend will likely impact not only
commodity spot markets, but also the corresponding derivative markets.
As a result, commodity derivatives exchanges may seek to incorporate sustainability- and
climate-related elements into existing contracts. As environmental standards evolve, futures
contracts will need to be modied to replicate changes to the physical market. Consider,
for example, the recent transition from high-sulfur fuel oil (HSFO) to low-sulfur fuel oil
(LSFO) to comply with the terms of the United Nation’s International Maritime Organizations
2020 international agreement. Or the metals industry, where the London Bullion Market
Association (LMBA) introduced a Responsible Sourcing program for precious metals that
aims to protect the integrity of the global supply chain for the wholesale precious metals
markets. In conjunction with these physical market changes, all COMEX physically delivered
gold futures contracts were modied to ensure compliance with LBMA Responsible Gold
Guidance, which formalizes and consolidates standards of due diligence among all LBMA
Good Delivery Reners. Agricultural suppliers are increasingly asked to deliver “greener”
commodities with specied environmental traits, such as low-methane rice, the standards
could become incorporated into existing product specications.
However, there are various challenges to modifying these exchange-listed contracts. Some
market participants may be reluctant to support sustainability specications because of a
lack of veriable climate-related standards and concerns that sustainability specications
may reduce the liquidity of the product (World Federation of Exchanges, 2019). Commodity
exchanges should work closely with the industry and the CFTC to anticipate future product
changes inuenced by climate risk so that contracts related to them can be traded effectively.
Private sector players can also help establish trust and transparency for climate-related
standards and guidelines as existing products are modied to incorporate sustainability
elements. This is like the role price reporting agencies currently play in some commodity
markets and can help advance price transparency in derivatives markets.
Modications to existing products are not limited to derivatives traded on commodity
derivative exchanges. More recently, some OTC swap contracts have been modied
to embed new sustainability incentive mechanisms. Appearing rst in an OTC interest
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swap in August 2019, and then in October 2019 in a foreign exchange forward swaps,
this mechanism consists of reducing one counterparty’s payment in the event it achieves
some pre-agreed sustainability performance target. If expanded across derivatives, this
mechanism could provide market participants with a nancial incentive for improved
environmental performance.
Providing New Derivatives Products to Hedge Climate-Related Risks
To serve the long-term need for price discovery and risk mitigation, the derivatives industry
must provide new, innovative products focused on climate risk. However, there is no
comprehensive and comparable set of metrics for climate-related risks, and the ability to
accurately quantify climate risks is critically important for nancial functions ranging from
assessing lending risk, to pricing derivatives, and, ultimately, to constructing sustainable
nance products. Derivatives products can only be developed if climate-related data is
transparent, reliable and trusted by market participants. If that happens, new-product
innovation would likely span multiple asset classes as data becomes more available.
Weather derivatives, or index insurance, have for decades provided customized solutions
to address low risk, high probability weather-related events. To date, most exchange-listed
weather futures and options are based on weather indexes that aggregate both catastrophic
and non-catastrophic data. While these products can help manage localized exposure to
weather-related risk, they do not address the broader impact of climate risk. It has been
very challenging to develop liquidity in weather derivatives because liquidity providers
have no associated risk layoff. Since exchange-traded weather derivatives do not meet
reporting thresholds, commodity exchanges have not reported position data for weather
derivatives or indexed weather derivatives products to the CFTC.
Extreme weather events, shifting demand patterns, and new technology for renewable
power generation, will require the continued development of new products, data, and
related technology to improve the ability of electricity market participants to measure and
manage their risk. Electricity prices can be extremely volatile, posing challenges for smaller
market participants, who often offer renewable energy. Volatility is greater in the intra-day,
and short-dated markets where there are few instruments to mitigate risk. Greater volatility
results in higher prices for end-use customers. Also, the inability to effectively hedge makes
it more difcult for renewable generation to receive funding. Typically, renewable energy
providers’ sell long-term Purchase Power Agreements (approximately for 10 years), but
do not often hedge their operational capacity even one day in advance. Hedging solutions
currently available to smaller market participants are prohibitively expensive and lack the
detail necessary to provide effective risk management. Lastly, as an increasingly large
portion of power generation derives from renewable sources, new futures contracts
could be developed to manage risks around wind and solar power generation, as well as
transmission and storage, including via managing intermittent generation, congestion risk,
and Renewable Energy Certicates markets.
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In addition, as demand increases for nancial products to manage climate risk, derivatives
exchanges likely will seek to develop products where investor interest is high. In 2019,
$20.6 billion owed into ESG funds, four times more than during the previous period (Hale,
2020). ESG ETF and Index futures have seen increased volumes and open interest. To
attract a broader set of market participants, these new ESG-related futures contracts will
need to develop deeper liquidity. The successful adoption of these derivatives products
also depends on the continued growth of ESG funds and the decline of their costs.
The development of new derivative products focused on measurable climate-related events
such as sea level rise, extreme rainfall events, and natural disasters should appeal to a
broad set of market participants. Reliable and trustworthy data sources that help measure
environmental attributes and characteristics throughout the physical commodity supply
chain will be needed to underpin these new derivatives contracts. Private sector companies
are nding new ways to collect, process, and transfer decision-useful lifecycle datasets
to differentiate their products on the basis of their climate impacts and reveal the market
value or risks associated with asset-level environmental attributes.
Innovation in Other Financial Markets
While derivatives are a risk-focused product, a wide range of other innovative nancial
products also can help isolate and manage risk, including climate risk, and thereby drive
capital to sustainable investment opportunities. Broadly, these instruments can be grouped
into two categories: (i) new instruments to direct capital to climate-related opportunities;
and (ii) increased exposure to climate-related opportunities within existing instruments.
New Instruments to Direct Capital to Climate-Related Opportunities
A wide range of nancial products directly provide funding to sustainable or transition
projects. These instruments can expand capital ows by leveraging improved data and by
increasing investor awareness of the return potential for ESG. These instruments provide
capital at the corporate or project level.
Many innovative nancial structures aim to increase demand from the deep pools of
institutional capital. As we saw above, green bonds are widely used due to their relative
simplicity. However, more green bonds are needed. While the green bond label can apply
to a variety of debt instruments, most have been based on corporate credit and cash
ows. In addition, the cost of issuance and the lack of market rewards for issuing remain
barriers to the issuance of green bonds. The green bond market has spurred offshoots,
including sustainability bonds and Sustainable Development Goal (SDG) bonds, which
cover a wider range of eligible projects. More recently, transition bonds have been issued
to fund projects that reduce carbon emissions, typically along a pathway compatible with
the goals of the Paris Agreement.
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Financial products can directly deploy investors’ capital to green assets. This includes
venture capital, private equity and infrastructure investments supporting the development
and deployment of climate-related technologies. It also includes traditional insurance
products for new technologies such as CCUS.
Securitization allows for tranches of risk, attracting new capital and recycling existing capital
to continue private sector sustainable investment. In addition to securitization of green
assets, innovation in securitization could help with difcult local stranded asset problems,
including how to retire older highly polluting power plants without excessively burdening
ratepayers. In a regulated utility securitization, utilities issue bonds that are paid back
through a discrete customer charge. Customers benet because the utility is renancing
the unrecovered value of the plant being retired at a lower cost than if the utility issued
stock. Credit agencies generally view the mechanism positively because the utility recovers
its investment and generates cash for other purposes. Securitization, by isolating and
allocating climate risk to investors willing to accept it, may prove to be critically important
for nancing the transition.
Increasing Exposure to Climate-Related Opportunities
within Existing Instruments
A nascent but growing range of innovative products prices physical and transition risk
within existing instruments. Insurance is an example of a sector with signicant advances
in integrating climate risk. As the availability of data increases, a range of new nancial
products, including insurance and insurance linked securities (ILS), are being developed
to integrate the benets of adaptation and resilience activities.
Catastrophe bonds are an innovative security that transfers the catastrophic risk of extreme
events, including climate-attributed weather events, to the capital markets. Recently,
catastrophe bonds have evolved to account for the changing nature of physical risk. In 2015,
the quasi-public National Railroad Passenger Corporation (Amtrak) issued $275 million of
catastrophe bonds to cover storm surge, wind damage and earthquakes. It was one of
several catastrophe bonds issued after Superstorm Sandy struck in 2012, causing $1 billion
of damage to Amtrak tunnels. In the future, the pricing of catastrophe bonds could potentially
account for resilience and climate adaptation that might reduce physical risks.
Sustainability-linked loans, revolving credit facilities, letters of credit, and guarantees are
emerging which adjust their interest rate to correlate with performance toward achieving
sustainability targets. There are new insurance products whose pricing and underwriting
reect the potentially stronger cash ows and valuations of “green” buildings (CDI and
UC Berkeley CLEE, 2018). Nature-based solutions can provide unique value. They include
property insurance that can take into account the benets of ecological forestry for reducing
the risk of severe wildres or the benets of coral reefs, mangroves or salt marshes for
reducing the risk of coastal ooding (The Nature Conservancy, 2019).
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Recommendations
Effective and well-functioning markets should allocate capital efciently to net-zero
emissions investments, spur innovation, and create and preserve quality jobs in a growing
net-zero economy. These recommendations seek to meet these goals by improving
the functioning of markets by reducing structural barriers and catalyzing private sector
innovation. In undertaking these efforts, consideration should be paid to the distributional
and equity impacts on low-to-moderate income households and marginalized communities.
In addition, efforts should aim to facilitate an orderly transition, where possible, avoiding
adding nancial strain on already stressed sectors, including agricultural producers and
commercial and industrial companies, among others.
Recommendation 8.1: The United States should consider integration of climate risk into scal
policy, particularly for economic stimulus activities covering infrastructure, disaster relief,
or other federal rebuilding. Current and ongoing scal policy decisions have implications
for climate risk across the nancial system.
Recommendation 8.2: The United States should consolidate and expand government efforts,
including loan authorities and co-investment programs, that are focused on addressing
market failures by catalyzing private sector climate-related investment. This effort could
centralize existing clean energy and climate resilience loan authorities and co-investment
programs into a coordinated federal umbrella.
Recommendation 8.3: Financial regulators should establish climate nance labs or regulatory
sandboxes to enhance the development of innovative climate risk tools as well as nancial
products and services that directly integrate climate risk into new or existing instruments.
Recommendation 8.4: The United States and nancial regulators should review relevant
laws, regulations and codes and provide any necessary clarity to conrm the appropriateness
of making investment decisions using climate-related factors in retirement and pension
plans covered by ERISA, as well as non-ERISA managed situations where there is duciary
duty. This should clarify that climate-related factors—as well as ESG factors that impact
risk-return more broadly—may be considered to the same extent as “traditional” nancial
factors, without creating additional burdens.
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Recommendation 8.5: The CFTC should pursue the following activities to further catalyze
climate nance market development:
●
Survey market participants about their use of climate-related derivatives, the adequacy
of product availability and market infrastructure, and the availability of data to incorporate
climate impacts into existing and new instruments.
●
Consider appropriate and targeted exemptions where needed to help facilitate
coordination with other regulators and promote market development.
●
Support the study and adoption of alternative execution methods, such as block
trading, auction style markets, or incentive programs, to attract liquidity providers to
make climate-related markets.
●
Coordinate with other regulators to support the development of a robust ecosystem
of climate-related risk management products.
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As this report was being nalized, governments around the world were working assiduously
to contain the spread of COVID-19. Along with other major economies, the U.S. economy
was suffering from simultaneous demand and supply shocks, the result of the synchronized
shutdown of many parts of the economy. Unemployment had surged to post-Depression
highs, and the economy was contracting at a record rate. Many households and businesses
were suffering from falling income and wealth, as well as deteriorating creditworthiness.
Stress in nancial markets subsided only after the Federal Reserve launched interventions of
unprecedented scale and scope, and Congress approved historically large scal measures
to assist businesses and households. While the “great shutdown” to contain the virus led
to a signicant drop in global greenhouse gas emissions, the decline was temporary and
not expected to fundamentally change the overall course of global emissions.
The pandemic is relevant to this report because its legacy will likely be prolonged scal
deterioration, stressed business balance sheets, and depleted household wealth. In this
context of heightened nancial fragility, managing climate-related risk becomes even more
important and urgent.
This report has argued that the physical impacts of climate change are already affecting
the United States, and over time, will likely touch virtually every sector and region of the
country. Depending on the evolution of policy, technology, and consumer preferences, the
transition to net-zero emissions may also impact many segments of the economy. Both
physical and transition risks could give rise to systemic and sub-systemic nancial shocks,
potentially causing unprecedented disruption in the proper functioning of nancial markets
and institutions. Sub-systemic shocks to particular sectors or regions could reduce access
to nancial services by marginalized communities and people already underserved by the
nancial system. Climate impacts may also magnify or exacerbate existing, non-climate-
related vulnerabilities in the nancial system, with potentially serious consequences for
market stability.
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Conclusion
CONCLUSION
A nancial system that is better able to measure and manage these risks will be better
positioned to absorb and recover from climate-related shocks, as well as to help investors
and entrepreneurs seize opportunities that arise from the transition to net-zero emissions.
That will be especially signicant in the post-COVID period, when the weakened economy
and nancial system will be especially vulnerable to any additional disruption. Given the
uncertain timing of physical and transition risks, it is imperative that this process begin now.
As this report has mentioned repeatedly, policies essential to decisively address climate
change lie beyond the purview of nancial regulators. Those policies include, rst and
foremost, effective mechanisms to price carbon appropriately. Financial regulators and
other market participants can insistently point to the need to “get incentives right,” and
they can warn about the consequences of failing to act. But, ultimately, these critical policies
must come from Congress, coupled with an international framework that can facilitate
synchronized reductions in greenhouse gas emissions across countries.
However, that does not mean nancial regulators have little to do while an adequate carbon-
pricing regime emerges. Quite the contrary. This report has argued that nancial regulators
should actively promote, and in some cases require, better understanding, quantication,
disclosure, and management of climate-related risks by nancial institutions, large dealers,
investors, asset owners and managers, and other market participants. They should also
work to preserve the proper functioning of markets in the face of low-probability but
high-impact risks. As this report has noted, regulators already enjoy wide latitude, on the
basis of existing authorities, to advance these objectives.
To be sure, the road ahead will not be straight. The evolution of climate change and its
impacts is highly uncertain. Also, as these pages have described, climate-related data,
models, and scenario planning, remain in an incipient stage. Therefore, the process of
strengthening climate risk management will be inherently experimental and demand constant
learning and innovation. Persistent evaluation, consultation, and course-correction will be
par for the course.
While this report has been addressed to nancial regulators, nancial market participants
also have a critical role. In this context, nancial regulators can help by encouraging and
facilitating innovation in nancial rms’ risk management. This includes innovations in
scenario planning, improvements in environmental, social, and governance (ESG) data,
and better methodologies for measuring climate-related nancial risk.
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At the same time, regulators can help promote the role of nancial markets as providers
of solutions to climate-related problems. A good example is the derivatives market, which
thanks in part to regulatory changes, has evolved from a magnier of nancial shockwaves
during the 2008 Global Financial Crisis to a source of risk-management instruments that
can help preserve nancial stability. Innovations in the derivatives market may also help
market participants manage climate-related risks and maximize climate-related opportunities
in the future. Importantly, nancial innovation will result not only in products for managing
risk, but also for promoting the ow of capital toward net-zero-emission, climate-resilient
technologies and investments.
A theme that has run through this report is that the United States is not alone in confronting
this challenge. Financial regulators around the world, including from many of the leading
economies; multilateral organizations; and groups of investors and major nancial institutions
have joined this mission. Together, they are generating a plethora of initiatives and tools
to safeguard nancial stability in the face of climate risk. However, the United States
remains, at best, a reluctant participant in these efforts, and in some cases, it is absent.
Without the full involvement of the largest economy and home to the world’s largest capital
markets, international efforts will surely fall short. As this report has argued, the United
States should fully participate in these forums and help lead the way.
Finally, in a report such as this, it is important to recall the ultimate objective. Financial
stability is not an end it itself—it is a means to protect the assets of millions of Americans
and to ensure that the nancial system continues to support their goals and aspirations
through an efcient and sustainable allocation of capital. In a world confronting climate
change, it is imperative that the nancial system continue to serve this purpose and, where
possible, to advance the solutions needed to meet the climate challenge.
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CONCLUSION
Chapter 1
Recommendation 1: 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.
Chapter 4
Market participants and the regulatory community, in the United States and abroad, are
in the early stages of understanding and experimenting with how best to monitor and
manage climate risk. Given the considerable complexities and data challenges involved,
regulators and market participants should adopt pragmatic approaches that stress continuous
monitoring, experimentation, and learning. Regulatory approaches in this area are evolving
and should remain open to renement, especially as the understanding of climate risk
continues to advance and new data and tools become available.
At the same time, regulators should establish a clear framework with appropriate
milestones. This is what nancial regulators are already doing in some jurisdictions and is
consistent with recommendations of nancial regulatory bodies (Bank of England, 2019;
Bank for International Settlements, 2020; NGFS, 2020). As explained above, in general,
regulators have sufcient authority to start tackling climate risk immediately. The following
recommendations provide, in our view, a good starting point.
123
List of Recommendations
LIST OF RECOMMENDATIONS
Systemic Risk Oversight
Recommendation 4.1: All relevant federal nancial 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. Regulators should
further develop internal capacity on climate-related risk measurement and management,
including through their strategic planning, organizational structure, and additional resourcing.
Recommendation 4.2: The Financial Stability Oversight Council (FSOC), of which the
Commodity Futures Trading Commission (CFTC) is a voting member, should undertake
the following:
●
As part of its mandate to monitor and identify emerging threats to nancial stability,
incorporate climate-related nancial risks into its existing oversight function, including
its annual reports and other reporting to Congress;
●
Encourage and coordinate, across the Council’s member agencies, the sharing of best
practices concerning the monitoring and management of climate-related risks, the
building of relevant institutional capacity, the integration of climate-related risks into
the risk monitoring function of the agencies and into nancial supervision and regula-
tory frameworks, and the potential for second-order impacts, such as the migration
of nancial activity from one part of the nancial system to another; and
●
Task the Ofce of Financial Research with developing a long-term program of research
on climate-related risks to the nancial system, paying close to the potential intercon-
nectivity and spillovers of climate-related risks across the nancial system; monitoring
relevant developments; and developing tools that regulators can use for the monitoring
and management of climate-related risks.
Recommendation 4.3: Research arms of federal nancial regulators should undertake
research on the nancial implications of climate-related risks. This research program
should cover the potential for and implications of climate-related “sub-systemic” shocks
to nancial markets and institutions in particular sectors and regions of the United States,
including, for example, agricultural and community banks and nancial institutions serving
low-to-moderate income or marginalized communities. Research should also include the
impact of climate risk on nancial system assets and liabilities, including by sensitivity of
specic sectors to climate change, geographic location, and tenor. In doing so, regulators
should identify data gaps and approaches to address these shortcomings. Regulators
should develop assessments of the magnitude of the impact of climate on these assets
and liabilities, for example through scenario analysis.
Recommendation 4.4: Relevant federal regulators should assess the exposure and
implications of climate-related risks for the portfolios and balance sheets of the government-
sponsored enterprises (GSEs) and strongly encourage the GSEs to adopt and implement
strategies to monitor and manage those risks.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
124
Recommendation 4.5: The Federal Insurance Ofce, in collaboration with state insurance
regulators, should undertake an assessment of the insurance sector’s systemic vulnerability
to climate-related impacts and report the ndings to the FSOC. FIO should also evaluate
the adequacy of state insurance regulators’ oversight of climate-related risks.
Recommendation 4.6: Federal nancial regulators should actively engage their interna-
tional counterparts to exchange information and draw lessons on emerging good practice
regarding the monitoring and management of climate-related nancial risks. U.S. regula-
tors should join, as full members, groups convened for this purpose, including the Central
Banks and Supervisors Network for Greening the Financial System (NGFS), the Coalition
of Finance Ministers for Climate Action, and the Sustainable Insurance Forum (SIF). The
United States should also engage actively to ensure that climate risk is on the agenda
of Group of Seven (G7) and Group of Twenty (G20) meetings and bodies, including the
Financial Stability Board (FSB) and related committees and working groups. The Federal
Reserve already participates in the Basel Committee on Banking Supervision’s climate
task force, and the Securities and Exchange Commission participates in the International
Organization of Securities Commissions’ (IOSCO) sustainable nance network.
Risk Management
Recommendation 4.7: Financial supervisors should require bank and nonbank nancial rms
to address climate-related nancial risks through their existing risk management frameworks
in a way that is appropriately governed by corporate management. That includes embedding
climate risk monitoring and management into the rms’ governance frameworks, including
by means of clearly dened oversight responsibilities in the board of directors.
Recommendation 4.8: Working closely with nancial institutions, regulators should
undertake—as well as assist nancial institutions to undertake on their own—pilot climate
risk stress testing as is being undertaken in other jurisdictions and as recommended by the
NGFS. This will enable stakeholders to better understand institutions’ exposure to climate-
related physical and transition risks, as well as to explore climate-related opportunities.
The pilot program should include the testing of balance sheets against a common set of
scenarios (elaborated on in Chapter 6 and Recommendation 6.6), covering how nancial
institutions might respond to climate-related risks and opportunities over specied time
horizons. This climate risk stress testing pilot program should include institutions such as
agricultural, community banks, and non-systemically important regional banks.
Recommendation 4.9: Regulators should closely monitor international experience with
climate risk stress testing of banks and insurers and apply relevant lessons to the U.S.
context. U.S. regulators should engage in international forums, such as the NGFS, to
ensure that climate risk stress testing conducted in the United States is comparable to
similar exercises in other jurisdictions and avoid duplicative exercises for institutions with
a multi-jurisdictional footprint.
125
LIST OF RECOMMENDATIONS
Recommendation 4.10: Financial authorities should consider integrating climate risk into
their balance sheet management and asset purchases, particularly relating to corporate
and municipal debt.
Recommendation 4.11: The CFTC should:
●
Undertake a program of research aimed at understanding how climate-related risks are
impacting and could impact markets and market participants under CFTC oversight,
including central counterparties, futures commission merchants, and speculative traders
and funds; the research program should also cover how the CFTC’s capabilities and
supervisory role may need to adapt to fulll its mandate in light of climate change and
identify relevant gaps in the CFTC’s regulatory and supervisory framework;
●
Drawing on the conclusions of the research program above, review the extent to
which existing CFTC rules are adequate to monitor and manage climate-related risks.
For example, CFTC should review the extent to which rules for non-centrally cleared
over-the-counter derivatives (NCD) are appropriate for monitoring and managing
climate-related risks. It should also review rules related to capital and margin require-
ments of futures commission merchants and swap dealers, as well as initial margin
and default fund rules, risk management rules, and capital requirements pertaining to
central counterparties;
●
Expand its own central counterparty stress testing to cover the operational continuity
and organizational resilience of central counterparties, including organizational resilience
of operations, contingency planning, and engineering resilience for facilities exposed
to climate-related physical risks. Where central counterparties and market infrastruc-
ture are not within the CFTC’s direct supervisory remit, the supervision of physical
risks should be addressed by the relevant FSOC member in a consistent fashion; and
●
As better understanding emerges of the risk-transmission pathways and of where
the material climate risks lie, consider expanding the CFTC’s risk management rules
and related quarterly risk exposure reports to cover material climate-related risks.
Recommendation 4.12: State insurance regulators and insurance regulators’ supervisory
colleges, which are convened by regulators where an insurer or its subsidiaries or afliates
operate in multiple jurisdictions, 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; and
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
126
●
To facilitate the risk assessment mentioned in the point above, insurance regulators
should conduct, or require insurance companies to conduct, climate risk stress tests
and scenario analyses to evaluate potential nancial exposure to both the physical
and transition impacts of climate change; state insurance regulators should provide
the scenarios, assumptions, and parameters for the stress testing exercise.
Recommendation 4.13: Regulators should require insurers to integrate consideration of
climate risks into insurers’ Enterprise Risk Management (ERM) and Own Risk Solvency
Assessments (ORSA) processes.
Recommendation 4.14: Regulators should require credit rating agencies to disclose the
extent to which their ratings take into account climate risk, including for issuers of corporate,
municipal, and sovereign debt. This should include a disclosure of applicable methodologies
for those credit rating products that consider climate risk.
Financial Market Utilities
Recommendation 4.15: Federal regulators should ensure that risk management standards
governing the operations related to the payment, clearing, and settlement activities of
FMUs incorporate measures to monitor and manage physical climate risks. The CFTC,
in its capacity as an FSOC member, should recommend that the Council oversee and
coordinate this process as it pertains to FMUs designated as systemically important.
Recommendation 4.16: The CFTC should review the extent to which nancial market
infrastructure—including but not limited to systemically important FMUs for which it is the
primary regulator—is resilient against losses that could arise through the physical impacts
of climate change.
Chapter 5
Recommendation 5.1: Financial regulators, in coordination with the private sector, should
support the availability of consistent, comparable, and reliable climate risk data and analysis
to advance the effective measurement and management of climate risk.
●
Regulators and nancial institutions should support the range of platforms for climate
data and analysis, including improving public access to governmental data and expertise
that can enable climate risk management. They should also support new and existing
open source platforms, as well as proprietary efforts to develop new climate risk
datasets and tools that leverage innovative technologies.
127
LIST OF RECOMMENDATIONS
Recommendation 5.2: Financial regulators, in coordination with the private sector, should
support the development of U.S.-appropriate standardized and consistent classication
systems or taxonomies for physical and transition risks, exposure, sensitivity, vulnerability,
adaptation, and resilience, spanning asset classes and sectors, in order to dene core
terms supporting the comparison of climate risk data and associated nancial products
and services.
●
To develop this guidance, the United States should study the establishment of a Stan-
dards Developing Organization (SDO) composed of public and private sector members.
●
Recognizing that this guidance will be specic to the United States, this effort should
include international engagement in order to ensure coordination across global
denitions to the extent practicable.
Recommendation 5.3: Financial regulators should proactively encourage capacity building
for climate risk management. This should be consistent with the education and training
practices supported by agencies in implementing the Sarbanes-Oxley Act of 2002. It should
align with and aid in meeting regulator expectations around embedding climate risk in
governance frameworks.
Chapter 6
Scenarios and Scenario Analysis
Climate scenario analysis should focus on potential material impacts to the institution’s
nancial portfolio, whether loans, derivatives, or investments. In this context, the following
guidelines should be useful:
Recommendation 6.1: Analyze more than one warming path. Various long-term paths for
climate change exist and can be used for scenario analysis. Three common scenarios are
(i) Paris-aligned (for example, consistent with limiting temperatures well below 2 degrees
Celsius above pre-industrial levels), (ii) current trajectory and (iii) in-between (for example,
late policy adoption with a more abrupt and disruptive response). Each will produce different
impacts on institutional portfolios and provide insights that will help to more effectively
manage risk, particularly bookends of best- and worst-case scenarios. Scenarios should
include both shorter- and longer-horizon paths as appropriate.
Recommendation 6.2: Analyze disruptive policy. It is particularly important to analyze a
scenario involving a major policy disruption. Transition scenarios have wide implications
across the economy, industries, and markets. Unanticipated policies can abruptly strand
long-lived capital assets or induce rapid reallocation of capital across sectors and industries.
Increasing physical impacts may increase the risks of a disorderly transition as res, oods, and
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
128
hurricanes, and the attendant shifts in public sentiment, force governments into unanticipated
policy responses. Scenarios are therefore especially relevant for risk management.
Recommendation 6.3: Analyze both broad and specic impacts. Scenarios should capture
the breadth of impacts but with a focus on materiality, covering a global perspective but
enabling regional, country, and sectoral analysis appropriate to the rm’s business.
Recommendation 6.4: Map macroeconomic and nancial impacts. Scenarios should take
into account macroeconomic and nancial outcomes since these are likely to be most
material to nancial institutions. Coming up with additional temperature scenarios, for
example, is less important than providing some common guidance on potential transmission
mechanisms and implications for macroeconomic and nancial factors.
Recommendation 6.5: Account for adaptation actions to the extent feasible. Tackling
climate change necessarily involves myriad adjustments by a range of actors. Modeling
the effects of such adaptation actions on portfolios is complex but may become more
feasible with future technology and scenario modeling development.
Policymakers and Regulators
Recommendation 6.6: Prescribe a consistent and common set of broad climate risk
scenarios, guidelines, and assumptions and mandate assessment against these scenarios,
as described in Chapter 4. Regulators, in consultation with industry participants, external
experts, and other stakeholders, should develop and prescribe a consistent set of broadly
applicable scenarios, guidelines, and assumptions and require institutions to assess their
exposure to those scenarios. Climate scenarios should be both plausible and relevant,
all the while informed by climate science. Regulators should require a range of climate
scenarios, including scenarios covering severe but plausible outcomes. Key assumptions
(including policy pathways) and limitations should be transparent. Scenarios, assumptions,
and guidelines should be updated as relevant factors are better understood and as policy and
technology evolve. There should be a recognition that climate risk will manifest differently
across various parts of the nancial system.
Recommendation 6.7: Provide analytical discretion, to the extent practicable, as long as
regulatory needs for consistency and comparability are met. Given the many unknowns
and complexities inherent in modeling the economy, climate change science, and policy,
regulated entities will need some discretion in how they perform their analysis based on
the prescribed scenario. On the other hand, regulators need consistent approaches across
rms so they can ensure risks are responsibly analyzed and reported. Investors would
benet from better comparability across scenario-related disclosures. To achieve a balance
across these needs, regulators, in consultation with the rms they regulate, should specify
key assumptions, scope, and the outputs they expect. As long as regulators’ prescribed
expectations are satised, regulators should allow nancial institutions to provide additional
context and analysis informed by the nature and complexity of their business.
129
LIST OF RECOMMENDATIONS
Recommendation 6.8: Encourage domestic and global coordination across regulators to
provide a coherent approach. This is an overarching theme of this report and especially
applicable to the use of scenarios for risk management. Requiring entirely different stress
scenario exercises from institutions operating under different jurisdictions would be costly
while generating uncertain value. Harmonizing requirements and prioritizing practical, actionable
exercises where feasible would be useful. The high costs associated with multiple regulatory
regimes is a lesson of post-nancial crisis regulation that can be applied now to climate risk.
Recommendation 6.9: Focus on materiality and risk management. Climate risks can
manifest in many different ways. Institutions should focus on what matters for them and
what decisions need to be made given their specic exposures and vulnerabilities. Such
an approach facilitates effective risk management by laying out plausible ways climate
risk-related nancial losses could occur.
Recommendation 6.10: Ensure a mechanism for ongoing renement and improvement. As
science, data, tools, conditions, and policy change, it is important for regulatory guidelines
to evolve as well. Data in particular is evolving rapidly. Creating a mechanism for regular
updating, rather than relying on ad hoc adjustments, would be benecial to ensure effective
and pragmatic oversight. As regulators better understand the material risks in the system
and their spillover effects across industries and markets, a mechanism for ongoing learning
and timely renement from these lessons learned will ensure they are most effectively
managing risk across the system.
Capabilities and Applications
Given the uncertain nature of how the climate will evolve and the limited ability to rely on
historical data and back-testing, robust scenario analysis calls for a new set of capabilities
that combines statistical, nancial, and environmental knowledge.
Recommendation 6.11: Tailor analysis to specic exposures. How an institution analyzes
scenarios should be determined based on the unique nature of its portfolio. Not every
scenario will be material to an institution’s portfolio, depending on its largest asset
concentrations, longest-dated assets, and highest potential sensitivities.
Recommendation 6.12: Use results to upgrade risk management capabilities. Regulators
and risk managers can use insights coming from scenario analyses to strengthen and
augment existing institutional risk management. Each institution should determine how
to do so within its own framework but could include climate-related limits, adjustment to
underwriting processes, client engagement, and climate risk appetite.
Recommendation 6.13: Beware of false precision. Scenario analysis can provide great
value in understanding a range of potential outcomes (particularly between worst and
best cases) and in identifying concentrations and relative sensitivities in a portfolio. But
results, especially quantitative ones, will be illustrative, not precise, and so should be used
accordingly in risk management decisions.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
130
Risk Managers
Recommendation 6.14: Risk managers should develop in-house capabilities, as relevant
and in line with best practices, to analyze climate scenarios, understand the key underlying
assumptions, and recognize the limitations.
Recommendation 6.15: Firms and institutions should consider additional climate scenarios,
guidelines and assumptions tailored to their specic needs and vulnerabilities, in addition to
those provided by policymakers and regulators, to enhance internal risk management and
decision-making. This can focus on generating decision-useful information for identifying
and managing climate risk given their specic exposures and vulnerabilities.
Recommendation 6.16: The scope, depth, and complexity of the analyses performed by
institutions should be proportionate to the materiality of the impact measured.
Chapter 7
In developing and implementing the recommendations below, nancial regulators and the
entities they oversee should consult with stakeholders, including investors, businesses,
global peers, and other market intermediaries to create a U.S. climate disclosure regime.
They also should closely coordinate with international bodies and foreign regulators to
ensure the U.S. regime is aligned internationally. Because the understanding of climate
risk remains at an early stage, any regulatory approach to climate-related disclosure should
evolve in line with emerging best practices. Regulators should continually monitor the
state of corporate climate disclosures, evolving clarity on the nancial impacts of climate
change and emerging best practices. This will allow regulators to continually monitor the
quality of the information disclosed in a sophisticated manner, and issue supplemental
guidance or begin rulemaking where needed to reect emerging best practice and market
needs. A mandatory, standardized disclosure framework for material climate risks, including
guidance about what should be disclosed that is closely aligned with developing international
consensus, would improve the utility and cost-effectiveness of disclosures.
Financial Market Regulators
Recommendation 7.1: All nancial regulators should consider the following principles for
effective disclosure, which are mainly derived from principles developed by the Task Force
on Climate-related Financial Disclosures, when developing rules on climate risk disclosure,
implementing existing rules or guidance, or seeking public comment on actions they should take:
●
Disclosures should represent relevant information.
●
Disclosures should be specic and complete.
●
Disclosures should be clear, balanced, and understandable.
131
LIST OF RECOMMENDATIONS
●
Disclosures should be consistent over time.
●
Disclosures should be comparable among companies within a sector, industry,
or portfolio.
●
Disclosures should be reliable, veriable, and objective.
●
Disclosures should be based on current consensus science (and updated as the
science evolves) and the best available projections regarding climate change impacts.
●
Disclosures should be provided on a timely basis.
Recommendation 7.2: 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, nancial regulators should clarify the denition of materiality for disclosing
medium- and long-term climate risks, including through quantitative and qualitative factors,
as appropriate. Financial lings should include disclosure of any material nancial risks
from climate change in a consistent but non-boilerplate manner, as well as a qualitative
description of how rms assess and monitor for potential changes in climate risks that
may become material.
Recommendation 7.3: Regulators should consider additional, appropriate avenues for rms
to disclose other substantive climate risks that do not pass the materiality threshold over
various time horizons outside of their lings. Regulators should consider that a growing
number of companies are creating greenhouse gas reduction targets and strategies out to
the year 2035 or 2050, and targeted disclosure related to these items may be appropriate
to facilitate robust efforts toward this positive trend.
Recommendation 7.4: Recognizing the costs associated with collecting, assessing and
disclosing climate risk information, nancial regulators should consider whether smaller
companies could be provided a longer period of time to provide their initial disclosures,
and the specic disclosures required of those companies could be different and less
burdensome than those required of larger issuers.
Recommendation 7.5: In light of global advancements in the past 10 years in understanding
and disclosing climate risks, regulators should review and update the SEC’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
. Such an update could incorporate advice on:
●
Information that is needed from all companies in order to enable nancial regulators to
assess the systemic risks posed by climate change. Federal nancial market regulators
should work closely with prudential regulators to develop these rules.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
132
●
Industry-specic climate risk information. Rules should build from existing standards
that provide industry-specic climate disclosure recommendations, for example,
those developed by the TCFD, SASB, CDSB, the Physical Risks of Climate Change
(P-ROCC) framework, and the Global Real Estate Sustainability Benchmark (GRESB)
standards for real estate and infrastructure. Because these standards are already
sophisticated, regulators do not need to create their own standards or metrics from
scratch. Regulators should encourage stakeholders to partner with these standard-
setting bodies to further develop, standardize, implement, and validate these metrics
over time. Regulators should also acknowledge, in any rulemaking, that climate
disclosure standards continue to evolve, and it could provide issuers exibility, where
appropriate, to adopt these evolving standards.
●
Governance, risk management and scenario planning information that demonstrates
how well companies are situated for a clean energy transition. Federal nancial market
regulators should work closely with prudential regulators to develop these rules.
Scenario planning disclosure is discussed in Chapter 6. Regarding governance and
risk management disclosure, regulators should consider the TCFD’s recommendations
and the Committee of Sponsoring Organizations of the Treadway Commission/World
Business Council for Sustainable Development (COSO/WBCSD) guidance, applying
enterprise risk management to environmental, social and governance-related risks.
Recommendation 7.6: 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, nancial regulators should require their disclosure, to
the extent they are material.
Recommendation 7.7: Regarding derivatives, nancial regulators should examine the
extent to which climate impacts are addressed in disclosures required of the entities they
regulate and consider guidance and rulemaking if disclosure improvements are needed.
This could include, for example, swap dealers registered with the CFTC, risk management
rules that govern risk identication approaches; Quarterly Risk Exposure Reports, and
business conduct rules that govern disclosure of material information to counterparties
prior to entering into a swap.
Accounting Standards Regulators
Recommendation 7.8: Once climate risk disclosure standards are well advanced, accounting
standards regulators should undertake a mapping exercise of the applicability of accounting
standards to climate-related disclosure and subsequently issue guidance on disclosure,
as appropriate. This would provide U.S. companies greater clarity about how climate risks
may be integrated into nancial statements.
133
LIST OF RECOMMENDATIONS
Recommendation 7.9: The United States should direct the Federal Accounting Standards
Advisory Board (FASAB) to study and pilot the development of climate-related federal
accounting standards, disclosure procedures and practices for U.S. government
departments, agencies and administrative units.
Municipal Securities Regulators
Recommendation 7.10: Municipal securities regulators should provide improved tools on
the EMMA website to search for climate-related disclosure in municipal bond lings, similar
to that provided for publicly traded companies, to allow better assessments of potential
climate risk exposure in such assets and how they are being addressed.
Recommendation 7.11: Municipal securities regulators and the federal nancial market
regulator overseeing them should examine the quality of climate-related disclosures in
municipal bonds’ ofcial statements and continuing disclosures, and whether the disclosure
provided is adequate for market participants to assess any underlying climate risk exposure.
If disclosure is found to be decient, they should issue a public statement calling on key
stakeholders to improve disclosure, including municipalities, municipal advisers, and banks.
Recommendation 7.12: Municipal securities regulators and federal nancial market and
prudential regulators should study how risks facing municipalities differ from—and could in
some cases be more impactful than—risks facing issuers and explore options to enhance
disclosure on these issues. Some municipalities already disclose information, as part of
their bond issuances, about oods, storms, dam safety, droughts, wildres, sea level
rise, and risk mitigation efforts, and further study could demonstrate that such disclosure
should be enhanced.
Chapter 8
Effective and well-functioning markets should allocate capital efciently to net-zero
emissions investments, spur innovation, and create and preserve quality jobs in a growing
net-zero economy. These recommendations seek to meet these goals by improving
the functioning of markets by reducing structural barriers and catalyzing private sector
innovation. In undertaking these efforts, consideration should be paid to the distributional
and equity impacts on low-to-moderate income households and marginalized communities.
In addition, efforts should aim to facilitate an orderly transition, where possible, avoiding
adding nancial strain on already stressed sectors, including agricultural producers and
commercial and industrial companies, among others.
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
134
Recommendation 8.1: The United States should consider integration of climate risk into scal
policy, particularly for economic stimulus activities covering infrastructure, disaster relief,
or other federal rebuilding. Current and ongoing scal policy decisions have implications
for climate risk across the nancial system.
Recommendation 8.2: The United States should consolidate and expand government efforts,
including loan authorities and co-investment programs, that are focused on addressing
market failures by catalyzing private sector climate-related investment. This effort could
centralize existing clean energy and climate resilience loan authorities and co-investment
programs into a coordinated federal umbrella.
Recommendation 8.3: Financial regulators should establish climate nance labs or regulatory
sandboxes to enhance the development of innovative climate risk tools as well as nancial
products and services that directly integrate climate risk into new or existing instruments.
Recommendation 8.4: The United States and nancial regulators should review relevant
laws, regulations and codes and provide any necessary clarity to conrm 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 duciary duty. This should clarify that climate-related
factors—as well as ESG factors that impact risk-return more broadly—may be considered
to the same extent as “traditional” nancial factors, without creating additional burdens.
Recommendation 8.5: The CFTC should pursue the following activities to further catalyze
climate nance market development:
●
Survey market participants about their use of climate-related derivatives, the adequacy
of product availability and market infrastructure, and the availability of data to incorporate
climate impacts into existing and new instruments.
●
Consider appropriate and targeted exemptions where needed to help facilitate
coordination with other regulators and promote market development.
●
Support the study and adoption of alternative execution methods, such as block
trading, auction style markets, or incentive programs, to attract liquidity providers to
make climate-related markets.
●
Coordinate with other regulators to support the development of a robust ecosystem
of climate-related risk management products.
135
LIST OF RECOMMENDATIONS
Foreword
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fossil fuel subsidies remain large: an update based on
country-level estimates.
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WP/Issues/2019/05/02/Global-Fossil-Fuel-Subsidies-
Remain-Large-An-Update-Based-on-Country-Level-
Estimates-46509
Pei, S., Kandula, S., & Shaman, J. (2020).
Differential
Effects of Intervention Timing on COVID-19 Spread in
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Chapter 1
Bank for International Settlements (BIS)(2020).
Climate-
related Financial Risks: a Survey on Current Initiatives
.
Basel, CH.: Bank of International Settlements, Basel
Committee on Banking Supervision. Retrieved from
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Brainard, L. (2019, November 8th).
Why Climate Change
Matters for Monetary Policy and Financial Stability
.
Remarks at "The Economics of Climate Change"
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Carney, M. (2019). Remarks Given during the U.N.
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MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
156
157
REFERENCES
Appendix Table 1: Sample of Multi-Sector Efforts to Increase Climate Data Availability
Initiative Mission Website
Aqueduct Aqueduct maps water risks such as floods,
droughts, and stress, using open-source,
peer reviewed data.
https://www.wri.org/aqueduct
Climate Data
Online (CDO)
Maintained by the National Oceanic and
Atmospheric Administration (NOAA) National
Centers for Environmental Information, the
CDO provides free access to NOAA's archive
of weather and climate data.
https://www.ncdc.noaa.gov/
cdo-web/
Climate
Explorer
The Climate Explorer provides graphs
and maps of historical and projected
climate variables for counties across
the United States.
https://crt-climate-explorer.
nemac.org/
ClimateWatch ClimateWatch provides open data sets,
visualizations and customized analyses
to support stakeholders.
https://www.climatewatchdata.org/
Food and
Agriculture
Organization
of the United
Nations (FAO)
FAO maintains a variety of data centers
including FAOSTAT which provides food
and agriculture statistics (including crop,
livestock and forestry sub-sectors) for
over 245 countries and territories and the
Food and Agriculture Microdata Catalogue
(FAM) which provides access to micro
data sets collected through farm and
household surveys.
http://www.fao.org/statistics/en/
(continued on next page)
159
APPENDIX
Appendix
Appendix Table 1: Sample of Multi-Sector Efforts to Increase Climate Data Availability
Initiative Mission Website
Future of
Sustainable
Data Alliance
(FSDA)
FSDA works to identify and accelerate the
reliable, actionable ESG data and related
technology that is needed for improved
investor decision-making.
http://solutions.refinitiv.com/
futureofsustainabledata
GeoAsset
Project
GeoAsset is a public goods endeavor
focused on making accurate, comparable,
and comprehensive asset-level data tied
to ownership publicly available across all
major sectors and geographies.
https://spatialfinanceinitiative.com/
geoasset-project/
Global Energy
Monitor (GEM)
GEM organizes the production of
asset-level data sets for fossil fuel sectors.
https://globalenergymonitor.org
U.S. EPA
Greenhouse
Gas Reporting
Program
(GHGRP)
GHGRP requires reporting of emissions
data from 8,000 facilities covering large
GHG emissions sources, fuel and industrial
gas supplies, and CO
2
injection sites in the
United States. The Facility Level Information
on GreenHouse gases Tool (FLIGHT)
leverages the GHGRP data into a visual
tool to quickly filter data in a variety of ways,
including by facility, industry, location, or gas.
https://www.epa.gov/ghgreporting
Oasis Hub Oasis Hub is an aggregator for catastrophe,
extreme weather and environmental risk
data, tools and services, as well as provider
of data set enhancement, development and
data aggregation services.
https://oasishub.co
OS-Climate OS-Climate aims to aggregate the best
available data, modeling, and computing and
data science worldwide into an AI-enhanced
physical-economic model that functions
like an operating system, enabling powerful
applications for climate-integrated investing.
https://www.os-climate.org
(continued on next page)
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
160
(continued)
Appendix Table 1: Sample of Multi-Sector Efforts to Increase Climate Data Availability
Initiative Mission Website
Power Explorer Power Explorer aims to serve as the most
comprehensive source for understanding the
world's power systems and their impacts on
development and environmental challenges.
http://powerexplorer.org
U.S. Climate
Resilience
Toolkit
(USCRT)
USCRT serves as multi-sector platform for
case studies, data sets, digital tools, and
other resources for a variety of domestic
stakeholders.
https://toolkit.climate.gov/
World Bank
Sovereign ESG
Data Portal
Data platform that provides country-level
sustainability performance information
to increase transparency and support
investment aligned with sustainable
development.
https://databank.worldbank.org/
source/environment-social-and-
governance-(esg)-data
161
APPENDIX
(continued)
The CFTC seeks to ensure that all of its advisory committee and subcommittee memberships are fairly balanced.
To that end, the selection of the Climate-Related Market Risk Subcommittee members was consistent with the
MRAC Federal Advisory Committee Act Charter and Membership Balance Plan. The Subcommittee members
were selected to ensure that the subcommittee’s membership consists of a wide range of perspectives and
interests, including representation from industry, public interest groups, and academia.
Name Entity Representing Position Title
Robert ‘Bob’ Litterman
(Chairman)
Kepos Capital Chairman of the Risk Committee
and Founding Partner
Clark E. Anderson Morgan Stanley Managing Director
Nathaniel Bullard BloombergNEF Chief Content Ofcer
Ben Caldecott Special Government
Employee
Director, Oxford Sustainable Finance
Programme & Associate Professor Smith
School of Enterprise and the Environment,
University of Oxford
Martina L. Cheung S&P Global President, S&P Global Market Intelligence
John T. Colas Marsh & McLennan
Companies
Vice Chairman, Oliver Wyman Financial
Services America
Robert Coviello Bunge Senior Vice President, Sustainability and
Government Affairs
Peter W. Davidson Aligned Climate Capital Co-Founder and Chief Executive Ofcer
Continued on next page
163
MEMBERS OF THE CLIMATE-RELATED MARKET RISK SUBCOMMITTEE
Members of the Climate-Related
Market Risk Subcommittee
Name Entity Representing Position Title
Jeffrey S. Dukes Special Government
Employee
Director, Purdue Climate Change Research
Center; Professor of Forestry and Natural
Resources; Professor of Biological Sciences;
Belcher Chair for Environmental Sustainability
Hervé P. Duteil BNP Paribas Chief Sustainability Ofcer
Athena Eastwood Dairy Farmers of America Outside Counsel
Eliza H. Eubank Citigroup Managing Director and Global Head of
Environmental and Social Risk Management
Naty Figueroa BP Global Environmental Products Commercial
Manager
Christopher J. Goolgasian Wellington Management Managing Director; Director, Climate Research;
and Portfolio Manager
John Hartmann Cargill Global Sustainability Lead, Cargill Agricultural
Supply Chain and Global Edible Oils
Dave Jones The Nature Conservancy Senior Director of Environmental Risk
Jesse M. Keenan
(Editor)
Special Government
Employee
Associate Professor of Real Estate,
School of Architecture, Tulane University
Nathaniel Keohane Environmental
Defense Fund
Senior Vice President for Climate
Mindy Lubber Ceres Chief Executive Ofcer and President
Divya Mankikar CalPERS Investment Manager
Leonardo Martinez-Diaz
(Editor)
World Resources
Institute
Global Director of the Sustainable Finance
Center
Sara Menker Gro Intelligence Founder and Chief Executive Ofcer
Stephen Moch
(Associate Editor)
Special Government
Employee
Graduate Student, Harvard Business
School & Harvard Kennedy School
Continued on next page
MANAGING CLIMATE RISK IN THE U.S. FINANCIAL SYSTEM
164
Name Entity Representing Position Title
Adrienne Monley Vanguard Head of Investment Stewardship, Americas
Adele Morris Special Government
Employee
Senior Fellow and Policy Director,
Climate and Energy Economics Project,
The Brookings Institution
David Parham Sustainability Accounting
Standards Board
Director of Research – Projects
Daniel R. Paul ConocoPhillips Commercial Manager of Risk, Regulatory Affairs,
Market Analysis & Business Development
Rene Ramos JPMorgan Chase Executive Director, Climate Risk Executive,
Global Environment and Social Risk
Management
Armin Sandhoevel Allianz Global Investors Chief Investment Ofcer, Infrastructure Equity
Truman Semans OS-Climate Founder and Chief Executive Ofcer
Betty Simkins Special Government
Employee
Professor of Finance and Williams Chair; Head,
Department of Finance, Spears School of
Business, Oklahoma State University
Johannes Stroebel Special Government
Employee
David S. Loeb Professor of Finance and the
Boxer Faculty Fellow at the New York University
Stern School of Business
David S. Vogel Voloridge Investment
Management
Founder and Chief Executive Ofcer
Julie Winkler CME Group Chief Commercial Ofcer
165
MEMBERS OF THE CLIMATE-RELATED MARKET RISK SUBCOMMITTEE
The recommended citation for this publication is:
Climate-Related Market Risk Subcommittee (2020).
Managing Climate Risk in the U.S. Financial System.
Washington, D.C.: U.S. Commodity Futures Trading
Commission, Market Risk Advisory Committee.
