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CFTC report: climate change poses existential threat to financial system
Last September, the Commodity Futures Trading Commission issued a report, outlining the serious climate risk facing the US financial system. As fires rage across North America, and the world struggles with the multi-systemic ongoing threat from the COVID-19 pandemic, the report is highly relevant to our moment.
The lead takeaway was a stark alarm call:
Climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.
By examining climate-related risks and impacts, and their steadily rising costs, along with available policies and incentive structures, the report determined that financial markets are not prepared to weather a storm of compounding climate costs, in their current state.
This is partly the result of incentives more aligned with negative externalities (generating pollution) than with climate resilience.
It is also partly the result of a general underappreciation of both the pervasive costs of climate-disrupting pollution and the value inherent in building resilience across entire supply chains and economies.
Four major findings stand out:
Without a targeted, explicit price on carbon emissions, “financial markets will operate suboptimally,” with capital helping to exacerbate both risk and cost, while failing to invest in more efficient systems and solutions.
The cascading effect of systemic, sub-systemic, and market-reaction shocks—where prices, values, and ratings, become highly volatile, as other metrics of economic health and wellbeing fail or become too unstable to be of use—could undermine otherwise stable institutions and investments.
“[E]xisting legislation already provides U.S. financial regulators with wide-ranging and flexible authorities that could be used to start addressing financial climate-related risk now,” so more can (and should) be done to structure markets for the climate challenge.
“Insufficient data and analytical tools to measure and manage climate-related financial risks remain a critical constraint.”
The report also found that the climate-related risk is pervasive—now, in the present. The challenge is put in straightforward terms:
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 significant 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.
In other words:
The entire economy is at risk, and today’s standard options for securing and expanding wealth will no longer work, if too much cost piles up.
We need the right price signals to steer markets toward a smarter allocation of resources and protective measures—to avoid cascading risks and compounding costs—and we need a shared understanding of risk and resilience, with complex, integrated, and reliable data systems to provide clear insights about the value of avoiding climate cost and risk.
Demand is already growing, and will likely continue to increase, for significantly more substantial, more frequent, and more reliable data regarding climate risk and resilience. The more data that is produced, the more precision can be achieved in cross-referencing data sets, critical common standards, and actual performance of investments and institutions.
Historically, efficiency or high performance meant producing returns on investment, even if that meant simply pushing problematic costs onto others. Now, those externalities are becoming unbearable to the market itself, as too many kinds of value creation are being degraded. That means measurable market performance will, in the future, have to align with actual good outcomes, beyond the bottom line.
Geophysical climate impacts will disrupt supply chains. This is already happening, and the CFTC report notes that preparedness and resilience may depend on actors outside one's own operations—in the wider supply chain.
Food systems are gravely at risk. Storms, floods, drought, and wildfires, are high-visibility threats, but ecosystem degradation, biodiversity loss, and supply chain disruption also put food production at risk.
Finance is vulnerable to finance-driven climate risk—ripple effects that undermine the viability of investments, operations, and regional economies, when response to major impacts is suboptimal.
Institutional support is not guaranteed to arrive. Climate disruption is less like a heavy rain and more like a prolonged tidal surge; the devastation deepens and then deepens further—adding cost, delaying recovery and degrading institutional agility. Building science-informed fiscal resilience is vital to ensure financial systems are able to respond to complex, compounding climate-related shocks.
It’s not that profit must be abandoned in exchange for service to the greater good. Instead, the CFTC report Managing Climate Risk in the U.S. Financial System details the evidence that profits will simply be harder to come by for those that fail to plan, innovate, and perform against increasingly detailed and data-driven climate resilience metrics.
The report highlights the need for more complex, science-driven scenario planning. For instance:
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, financial 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.
The U.S. is not alone in facing these threats.
The compounding nature of threats to planetary systems means costly or irreversible damage far away can become a major financial risk at home.
The U.S. should, therefore, significantly step up its leadership in steering the world toward a more evidence-based, compound-risk informed, climate-aligned way of doing business. Such global leadership would provide added opportunities for limiting both climate-related risk and cost to the U.S. economy and financial system.
The report makes a number of detailed recommendations at the end of each chapter (53 total). We highlight four here:
Pricing pollution — 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)
Regulation — All relevant federal financial regulatory agencies should incorporate climate-related risks into their mandates and develop a strategy for integrating these risks in their work, including into their existing monitoring and oversight functions. (Recommendation 4.1)
Disclosure — Material climate risks must be disclosed under existing law, and climate risk disclosure should cover material risks for various time horizons. To address investor concerns around ambiguity on when climate change rises to the threshold of materiality, financial regulators should clarify the definition of materiality for disclosing medium- and longterm climate risks, including through quantitative and qualitative factors, as appropriate. (Recommendation 7.2)
Innovation — Financial regulators should establish climate finance labs or regulatory sandboxes to enhance the development of innovative climate risk tools as well as financial products and services that directly integrate climate risk into new or existing instruments. (Recommendation 8.3)
Climate risk and resilience will define both competitiveness and value.
The report explores the viability of various kinds of financial instruments and traded commodities, along with emerging market forces related specifically to climate risk and resilience. Risk is a threat, and an area of already-observed accumulating cost; resilience is an opportunity, and provides clear, structured means of enhancing short-term competitive advantage and long-term value.
It is clear the financial sector needs a new common taxonomy, detailing areas of risk, modes of risk avoidance, quality of performance both in relation to geophysical challenges and financial market challenges, and that can provide meaningful means of multidirectional assessment (from inside a given company, from outside observers and market actors, and from specialized climate resilience analysts and science translation experts).
We take the liberty of referring to this entire multifaceted, multisystem challenge as the quest for resilience intelligence. As we read this report, the takeaways are clear:
All actors must prepare for rigorous measuring of the resilience value of mainstream finance.
Regulators have a duty to ensure values are not artificially inflated by leaving out such information—even as common taxonomies emerge.
New data systems must be informed by Earth systems science, and able to detail the real-world living value of investments for people facing these kinds of threats and impacts.
The result of acting on this guidance will be a more secure and prosperous future for finance, and for the wider economy.
Read the full report here.
NOTE: On the very day the CFTC released this report, more than 300 fires were burning across several western states, and skies were turned an otherworldly shade of orange, darkening almost completely around mid-day, due to thick wildfire smoke blanketing the region.
Learn more about how building resilience by coordinating policy, data, and finance, can enhance the prospects for future prosperity at ReinventingProsperity.org