Climate advocates and risk management experts give their two cents on the mission of the CFTC’s climate-related market risk subcommittee
Last year, the Commodity Futures Trading Commission (CFTC) became the first US regulatory agency to set up a group dedicated to identifying and managing the climate risks threatening the financial system.
Hotshots from the fields of sustainable finance, conservation, insurance, data and academia were selected to fill the climate-related market risk subcommittee, under the chairmanship of Bob Litterman — Goldman Sachs alum, climate risk specialist and founding partner of hedge fund Kepos Capital.
The group has an unenviable task: laying the foundations of a climate risk management framework in a country whose government has actively downplayed the reality of climate change, when it’s admitted it’s a reality at all.
So, they did what smart people do: they asked for help. In April, the subcommittee sought public input on how to go about identifying and examining climate risks.
The call for aid was answered by experts from industry trade groups, US senators, climatetech vendors and more — over 40 in total.
Though they represented different interests and approached the challenges facing the subcommittee from varied backgrounds, many of the comment letters identified the same series of ‘must-haves’ for effective climate risk management and oversight in the US.
These were: access to high-quality climate change data, the disclosure of climate-related risks, a taxonomy of the climate risk attributes of different investments, stress testing of financial institutions and an overhaul of prudential requirements for commodity derivatives participants.
There were a handful of more ‘out there’ ideas floated, too. Steve Suppan at the Institute for Agriculture and Trade Policy, for example, wrote that the CFTC should establish a “Climate Change Financial Regulatory Lab” that would, among other things, host a “platform for machine learning about climate change and for beta testing climate change related financial products”.
Gray Schweitzer, meanwhile, wrote that the subcommittee could bring “an important voice to the discussion of Bitcoin mining and the associated energy consumption”, noting how production of the popular digital asset “requires energy usage on par with certain sovereign nations”.
However most respondents stuck to the five core topics above, and it’s these we’ll delve into below.
You can’t control what you don’t understand. That’s why many commenters stressed that a future climate risk management regime has to rest on a foundation of accessible, useful and high-quality data.
“We cannot regulate that which we cannot reliably measure, nor can claims of progress be meaningfully evaluated unless we understand what progress entails,” wrote members of the Global Financial Markets Center at Duke Law.
Some argued that market participants should be encouraged to share their in-house climate-related data with one another to increase the depth and breadth of the information available to all.
Sophia Chowdhury, of Baringa Partners, wrote: “With the falling cost of collecting and storing data and improvements in computing powers and storage, more businesses can integrate their data collection strategies with IoT [Internet of Things] technology. Similar to how institutions share operational risk data in ORX, market participants’ can establish a central agency for anonymizing and sharing data.”
Others volunteered their own measurement systems and databases to help the subcommittee along. Ivan Frishberg, writing on behalf of the Partnership for Carbon Accounting Financials, a group of banks that have implemented open-source methodologies to measure and disclose their financed carbon outputs, said that the group’s emissions database could be used as one measure of climate-related risks.
Similarly, the CDP, formerly the Carbon Disclosure Project, urged the CFTC to draw on its own treasure trove of information. The non-profit presides over a climate change disclosure platform of some 2,500 public companies, with annually-updated data on the scope 1, 2, and 3 emissions produced by all.
Climate data is no good locked up in the dark. That’s why commenters also urged the subcommittee to make firms disclose their climate-related risks for investors, regulators, and the public to see.
US Senator Elizabeth Warren has consistently pushed the Securities and Exchange Commission (SEC), on the need to impose mandatory climate risk disclosures on issuers, and she extended her campaign to the CFTC by writing how it was “critical” the subcommittee “recommends robust climate disclosure.”
Several advocates went further, say these should become a regulatory requirement. “Financial regulators must use their existing authorities to mandate that financial institutions disclose their exposure to climate risk, their direct level of greenhouse gas emissions, as well as the emissions of the assets they finance,” wrote Emma Guttman-Slater, policy advocacy and field building director at Beneficial State Foundation.
As for what form these disclosures should take, there was little in the way of prescription. However, Claire Healy, of climate change think tank E3G, made a powerful case for the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
She wrote: “The TCFD’s eleven recommended disclosures and underlying principles would be the most useful, universally and internationally accepted framework for the disclosure of financial and market risks related to climate change. Implementing the TCFD recommendations can deliver the quality of climate-related financial information that will enhance and contribute to the assessment of climate-related financial and market risks.”
Climate risk data and disclosures offer little more than a heap of dry numbers unless they are put to work, however.
One argument made be several respondents is that the CFTC subcommittee should use data on greenhouse gas emissions by firms and third parties to develop a taxonomy of climate-related risks. This would enable firms to differentiate between climate-friendly and environmentally-harmful activities and investments.
“A universal ‘common language’ is needed,” wrote Cameron Prell of XCHG, a commodities data and technology company. A taxonomy would teach investors “how to identify, digest, and harness climate-related financial risk factors to drive investment decision making in a carbon-constrained world.”
Stacy Swann, founder of consultancy Climate Finance Advisors, recommended the subcommittee consider the “green taxonomy” produced by the European Union’s Technical Expert Group on Sustainable Finance as one model to emulate, but also argued it should explore a “brown taxonomy” of climate-harming activities “which might provide more clarity and transparency for investors around those … investments expected to lose value over time in the context of a low-carbon economic transition.”
Subjecting market participants to rigorous climate stress tests was another core recommendation, the assumption being that if it’s made clear to firms what their exposure to runaway global heating looks like, they’ll be incentivised to reduce it.
“Stress tests on climate risk could help to identify potential shortfalls in firms’ ability to withstand shocks, and force them, where necessary, to change course,” wrote David Clarke, head of policy at Positive Money, an advocacy group for sustainable finance.
Salman Banaei, Americas head of regulatory affairs at IHS Markit, recommended the subcommittee study the Bank of England’s planned climate stress tests and use them to help sketch out scenario analyses of its own.
Banaei further explained that useful climate simulations need to have tightly-defined scenario variables and employ appropriate models, warning against the use of ones that cannot assign “defensible values” to their outputs.
“We emphasize the value of using transparent models. This will enable continuous improvement of the models as our understanding of climate risk and its impacts evolve,” he wrote.
Public models, such as the Integrated Global System Modeling Framework developed by the Massachusetts Institute of Technology, should be preferred over firm-specific ones as they can produce comparable results, he added.
Some respondents also argued that changes to the existing prudential framework could do much to reduce climate-related financial risks, and that the subcommittee should press the CFTC to use its existing powers to make these alterations.
For example, capital and margin standards for futures, swaps, and other financial instruments in the CFTC’s ambit could be made more onerous for those transactions that contribute to climate change and increase climate-related risks.
Tyson Slocum, writing on behalf of Public Citizen, a progressive advocacy group and think tank, explained: “Climate change represents a material market risk that should be incorporated along with operational, market, credit, counterparty and other existing risk variables that prudential regulators presently evaluate.”
He recommended that the CFTC factor climate risk into the risk-weightings used to set capital requirements for exposures to fossil fuel-related businesses, which should be updated frequently as scientific and economic understanding of climate risk evolves.
Graham Steele, staff director, Corporations and Society Initiative at the Stanford Graduate School of business, argued that even tougher measures may be justified.
“Regulations could be applied at the individual transaction level, or at the aggregate portfolio level … Depending upon the impact of these mechanisms, regulators might also consider more robust interventions, such as impose portfolio limits on financial institutions based upon aggregate financing or carbon emissions.”
Anne Perrault, of the Georgetown Climate Center but writing in a personal capacity, also outlined the risks to central counterparties (CCPs) if margin and capital standards weren’t updated to factor in climate risk.
“Key risk management processes and measures, including those required by CCPs, do not adequately reflect these risks. One result could be an increased number of clearing member defaults, with threats of contagious losses in the financial system. At the very least, challenges short of defaults within the futures trading system could increase uncertainty about exchange integrity,” she wrote.
Respondents to the subcommittee’s request for comment have given Litterman and his team plenty to digest. The group is slated to produce a report full of recommendations on climate-related risks to its ‘host’ body — the Market Risk Advisory Committee — in June.
No doubt many of the recommendations provided by commenters will find their way into this document, which is eagerly awaited by climate risk advocates, other US regulatory agencies and the CFTC alike.