CFTC: Climate change could significantly impact financial markets

Among the risks to the economy from climate change are the disruption of financial markets, and the Commodity Futures Trading Commission (CFTC) has a list of steps that market regulators and legislators should take to safeguard them.

“The central message of this report is that U.S. financial regulators must recognize that climate change poses serious emerging risks to the U.S. financial system, and they should move urgently and decisively to measure, understand and address these risks,” the report says in one of its first paragraphs. 

Many of the recommendations are standard boilerplate for dealing with climate change, such as imposition of a carbon tax or requiring improved disclosure of corporate risks to climate-related factors.

But the CFTC’s mandate is the regulation of financial markets, not climate policy. Given that, the report seeks to forecast how financial markets could be impacted by climate change. It also provides several recommendations on the use of market forces to bring about changes in climate-impacting behavior or risk mitigation.

While most discussions of the impacts of climate change tend to focus on physical effects — temperature, drought vs. floods, etc. — the CFTC report talks about the impact on financial markets and how climate change could disrupt them. The CFTC describes a cascading series of events: “disorderly price adjustments in various asset classes, with possible spillovers into different parts of the financial system.” What follows then could be “potential disruption” of the operations of financial markets. 

For example, while derivatives may have a negative connotation in some discussions, the CFTC openly calls for more use of them. There are “green” markets already, such as trading in the price of carbon. But a derivatives market would allow participants to trade less tangible products that all might fall under the category of climate risk or climate incentives.

That move doesn’t just need to be in the form of new contracts. The report says that current derivative exchanges “could address climate and sustainability issues by incorporating sustainability elements into existing contracts and by developing new derivatives contracts to hedge climate-change risks.”

It isn’t all up to commodity exchanges either. “Some (over-the-counter) swap contracts have been modified to embed new sustainability incentive mechanisms,” the report says. As an example, the report said that an interest rate swap (another word for derivative) has included a “pre-agreed sustainability performance target.” What that does is allow a counterparty’s payment to be reduced if those targets are reached. 

“If expanded across derivatives, this mechanism could provide market participants with a financial incentive for improved environmental performance,” the report says. 

But it isn’t easy. For example, the report notes some easy switches in commodity contracts in the past, such as changes in sulfur specifications in oil contracts. But where standards aren’t as clear, changes can get tricky.

Specifically, what are the standards that a market needs to follow to be considered improving its sustainability? “Market participants may be reluctant to support sustainability specifications because of a lack of verifiable climate-related standards and concerns that sustainability specifications may reduce the liquidity of the product,” the report says. It adds that private sector participants can and should be part of the effort to create those standards. 

Concerns about sustainability and the corporate role in it have generally fallen under the umbrella of ESG — environmental, social and governance — standards. Companies now find themselves judged on their adherence to ESG principles and some investors take notice.

But one problem the report brings out is that precisely what constitutes good ESG stewardship can be difficult to define. 

There is “insufficient data” to measure climate risks, the report says. “Public data will enable market participants to, among other things, compare publicly available disclosure information and sustainability-benchmark financial products,” it says. 

“The process of combating climate change itself — which demands a large-scale transition to a net-zero emissions economy — will pose risks to the financial system if markets and market participants prove unable to adapt to rapid changes in policy, technology and market preferences,” the report says. Specifically, climate risks may “exacerbate financial system vulnerability that have little to do with climate change, such as historically high levels of corporate leverage.”

And while climate change may be something considered well into the future, the fallout from the pandemic with “stressed balance sheets” can “undermine the resilience of the financial system to future shocks.”

While climate change shocks may be thought of something that hits large institutions, the report warns that smaller companies and entities could kick off a series of “sub-systemic shocks” that are “those that affect financial markets or institutions in a particular sector, asset class or region of the country but without threatening the stability of the financial system as a whole.” 

The types of companies that the report says would get hit by that are smaller and might be the type of firms that are tied in with trucking and transportation: community banks, agricultural banks or local insurance markets, “leaving small businesses, farmers and households without access to critical financial services.”

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