Hurricane Delta’s landfall in Louisiana last week marked the tenth named storm to hit the United States this year, breaking the record set in 1916. Records, of the ignominious sort, have also been set on the West Coast. California has experienced six of its twenty largest wildfires this year, and on August 16th, Death Valley in Southern California recorded the earth’s hottest temperature, ever, of 130 degrees Fahrenheit.
An objective review of the evidence reveals that extreme weather events are compounding in the United States due to man-made climate change, and the physical consequences on public health, agriculture, residential property, and public infrastructure are becoming increasingly apparent. What is less obvious are the complex downstream consequences that climate change will have on financial markets and economic stability.
In June 2019, the Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission established the “Climate-Related Market Risk Subcommittee” (“the Subcommittee”), whose mandate was to identify and examine downstream financial and market risks of climate change. In September 2020, the Subcommittee released a comprehensive report that urged the financial community to prepare for climate-related risk management challenges, warning that “climate change poses a major risk to the stability of the U.S. financial system and its ability to sustain the American economy.” The report highlights that the physical and transition risks associated with climate change could cause disorderly price adjustments in various asset classes and disrupt the proper functioning of financial markets. Further, the process of combating climate change itself, which will require the large-scale transition to a net-zero emission economy, the implementation of carbon prices, technological innovations, and the adaptation of carbon-focused supply chains and infrastructure, “will pose risks to the financial system if markets and market participants prove unable to adapt” to the rapid changes.
The central message of the Subcommittee’s report is that U.S. financial regulators must “move urgently and decisively to measure, understand, and address” the physical and transition risks associated with climate change. The report acknowledges that one of the most pressing concerns when it comes to climate change is the vacuum of information regarding climate-related risks—as noted by the Subcommittee, a “major concern for regulators is what [they] do not know.”
Under current U.S. regulation, there are few incentives for firms, both private and public, to disclose thorough, accurate, and decision-useful climate related information. As a result, firms are not sufficiently measuring and disclosing their impact on climate change and extreme weather events, nor are they measuring and disclosing the impact of climate change and extreme weather events on their operations. The Task Force on Climate-Related Financial Disclosures (“TCFD”) found that the lack of climate-related disclosure requirements creates massive problems for financial market participants, as they lack the necessary information to understand the financial impact of climate change on their investments. As noted by SEC Commissioner Allen Herren Lee, over 90% of U.S. equities by market capitalization may be exposed to material financial impacts from climate change. Under the current regulatory framework, which lacks robust climate-related disclosure standards, investors are left with insufficient information to assess the “individual risks that firms face and the macroprudential risks across the financial system.”
The Subcommittee report comes at a time when stakeholders are recognizing the dangers of poor climate disclosures, and are calling upon U.S. regulators to incorporate climate-risk into their frameworks. In July 2020, a group of over 40 investors representing nearly $1 trillion in assets sent letters to the OCC, the FDIC, the SEC, the CFTC, the FIO, the FHFA, the FSOC, and various state insurance regulators, calling on the agencies to implement a “range of actions to explicitly integrate climate change” across their mandates to protect the economy from any further climate-related disruptive shocks. In a June 2020 report, sustainability nonprofit Ceres urged U.S. financial regulators to “recognize and act on climate change as a systemic risk” in order to protect the stability and competitiveness of the U.S. economy. As noted in the Ceres report, the mandate of financial regulators is to “maintain financial market stability, foster capital growth and competitiveness, protect consumers and investors and ensure market efficiency and integrity. Climate risk is relevant to each of these considerations.”
Investors have been calling on the SEC to implement robust climate-related disclosure requirements. In 2016, the SEC issued a Concept Release seeking comments on the topic of mandatory climate related disclosures. The SEC acknowledged that many investors believe that “the Commission’s current rules do not adequately address the risks associated with climate change.” The majority of investors who submitted comments expressed their desire for improvements in sustainability disclosure requirements. Many of the commenters indicated that, under current standards, climate risk disclosure is “inconsistent, difficult to find, and often not comparable and lacking in context.” The comments highlighted that the lack of effective comparability makes it extremely difficult for investors to make confident capital allocations. According to former SEC chairwoman Mary Schapiro, the comments received in response to the 2016 concept release indicate that “the market is asking for more sustainability information, particularly climate-related financial disclosure.” The 2020 Ceres report also pressed the SEC to “issue rules mandating corporate climate risk disclosure,” and to issue guidance “encouraging credit raters to provide more disclosure on how climate risk factors are factored in ratings decisions.” BlackRock founder and CEO Larry Fink has also highlighted the need for improved climate disclosures, stating that “all investors, along with regulators, insurers, and the public, need a clearer picture of how companies are managing sustainability-related questions.” And Julie Gorte, senior vice president for sustainable investing at Impax Asset Management, has urged the SEC to require companies to disclose the location of all of their physical assets to allow investors to “gauge the risks facing those facilities from wildfires, hurricanes or flooding.”
Despite this mounting pressure from investors, the SEC failed to enhance climate-risk disclosure requirements in its recent amendment to Regulation S-K. Commissioners Allison Herren Lee and Caroline Crenshaw dissented, citing the SEC’s failure to address climate change despite the “unprecedented and massive campaign to obtain voluntary climate-related disclosures from companies.” Commissioner Crenshaw warned that the SEC’s failure “address climate change risk continues to hamper the efficient sorting and comparison of modern companies.” Commissioner Lee, who issued a statement in January 2020 calling on the SEC to stop ignoring the “challenge of disclosure around climate change risk” and to “begin the difficult process of confronting it,” also criticized the SEC for staying silent on the critical topic of climate change, noting that “it has never been more clear that investors need information regarding … how their assets and business models are exposed to climate risk.”
Stakeholders have also called on the Federal Reserve to recognize its “responsibility to act on the climate crisis,” and to “immediately consider whether decisions being made right now could inadvertently exacerbate the climate crisis.” The 2020 Ceres report recommends that the central bank “work with the SEC and other agencies to require banks to assess and disclose climate risks, including carbon emissions from their lending and investment activities.” The report urges the Federal Reserve to integrate climate change into its prudential supervision mandate to ensure that systemically important firms address climate change as a part of their risk management processes. Ceres also recommends that the Federal Reserve follow the lead of European supervisors in mandating climate stress tests for financial institutions and defining scenarios, time horizons and modeling approaches that should be used.
The Federal Reserve has also been asked to assess its own role in the growing climate crisis. In July 2020, a group of 69 organizations, including Amazon Watch and GreenPeace USA, wrote to the central bank expressing their concern “over the failure of the Board of Governors of the Federal Reserve System to fulfill its responsibility to serve the public interest and promote financial stability due to its investment in the fossil fuel sector,” claiming that the Federal Reserve “has utterly failed to account for climate risk” in its asset purchases.
When describing the Federal Reserve’s role in managing the financial impacts of climate change in the United States, Chairman Jerome Powell has stated that the principle responsibility and leadership in that area lies with the “many other agencies of the federal government,” declaring that the overall American response has to “come from elected officials, and not the Fed.” Currently, there are “minimal to no regulations in place for U.S. banks to measure or even acknowledge their impact on climate change and extreme weather events.” According to former Federal Reserve governor and Deputy Secretary of the Treasury Sarah Bloom Raskin, the Federal Reserve has fallen well-behind its “counterparts in other countries, which have already begun imposing stress tests for climate change as well as other steps.” As noted by the Subcommittee report, while international financial regulators have “launched important initiatives to tackle the challenge,” the United States is “noticeably absent” in many of the “international initiatives, working groups, task forces, coalitions, and other efforts” that have emerged to facilitate collaborative solutions and accelerate learning and information exchange. Notably, the U.S. central bank is a not a member of the Network for Greening the Financial System (“NGFS”), an international organization established to help strengthen the “global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development.” The NGFS now includes 65 members, including the central banks of Mexico, Canada, China, Germany, and most European countries. In May 2020, U.S. Representatives Sean Casten and Mike Levin led a letter signed by 41 of their House colleagues calling on the Federal Reserve to join the NGFS as an active member.
Finally, in August 2020, Representative Mike Levin and Senator Brian Schatz sent a letter to Treasury Secretary Steven Mnuchin, urging him to respond to the serious threat climate change poses to financial markets. The letter calls on Secretary Mnuchin to use his statutory responsibility as Chair of the Financial Stability Oversight Council (“FSOC”) to “respond to emerging threats to the stability of the United States Financial System,” noting that the FSOC’s failure to address climate-related risks has left the “the financial system and economy vulnerable” to a severe crisis.
In the absence of regulatory action, numerous private organizations have set standards to help firms disclose climate-related information. The TCFD, the Sustainability Accounting Standards Board, the Global Reporting Initiative, the Principles for Responsible Investment, the Partnership for Carbon Accounting Financials, and CDP have all developed standards and systems that are used by firms to identify, measure, and disclose climate-related information. However, in the absence of a mandatory and standard framework, the proliferation of multiple voluntary disclosure standards allows firms to omit unfavorable information, and creates a situation where firms disclose climate-related information according to different methods and metrics.
The Subcommittee report makes clear that climate change poses major risks to the US financial system, and that the downstream consequences of climate change could devastate the American economy. Absent regulatory action that ensures the disclosure of thorough, decision-useful, and comparable climate-related information, firms, investors, and stakeholders remain ill-equipped to adapt to the consequences of climate change.
Lee Reiners is the Executive Director of the Global Financial Markets Center at Duke Law
Charlie Wowk is a J.D. candidate at Duke Law and a research assistant at the Global Financial Markets Center
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