Senators urge CFTC subcommittee to consider climate-related financial risks and carbon pricing

By Brad Rosen, J.D.

Senators Sheldon Whitehouse (D-RI) and Brian Schatz (D-Hawaii) have issued a pair of letters to Bob Litterman, the chairman of the Climate-Related Market Risk Subcommittee of the CFTC’s Market Risk Advisory Committee (MRAC). In those letters, the Senators argue that climate risk standards and carbon pricing be specifically included in a soon to be issued report by the subcommittee.

Litterman, a founding partner at Kepos Capital, has chaired the subcommittee since it was established in June 2019. At that time, the subcommittee became the first body associated with a federal financial regulator charged to formally examine the risks that climate change poses to financial stability. At an MRAC meeting in December 2019, Litterman reported that the subcommittee was looking to issue its report in June 2020 and that it would provide practical steps that could be taken to address the financial risks associated with climate change.

Financial regulators should play a larger role in addressing climate risks. One of the comment letters addressed the sweeping financial risks associated with climate and the need for federal financial regulators to play a bigger role in guarding the financial system from those risks. The senators implored, “Our regulators must develop standards for climate-related scenario analysis, stress testing, governance requirements, and disclosures, and they must incorporate those standards into their core market risk assessments and supervisory practices.” They also observed that “[T]he CFTC’s peers are allowing systemic risk to build in our financial system, even as their counterparts around the world are taking steps to identify climate financial risks.”  The senators also emphasized the need for standards for a range of climate-related financial factors.

The senators noted some of the shortcomings in the financial sector with respect addressing climate related risks as follows:

• public companies are not adequately disclosing to investors how climate risks will impact their business activities, supply chains, assets, and financial planning;
• banks are not incorporating climate change into their core risk management practices, preferring to silo climate responsibilities within corporate sustainability divisions;
• asset managers are screening for climate risks only in niche ESG funds, if at all; and
• financial regulators have no standardized tools for assessing climate financial risks at the institutions they supervise, and there is no effort underway to assess how the financial system as a whole might handle those risks. 

The senators also noted the economic and financial impact of the COVID-19 pandemic, which they asserted “demonstrate the disruption that can occur when markets underestimate risks that are well known and highly probable, but are poorly understood and inaccurately priced.” They added, “We cannot make the same mistake with climate change.”

The urgent need for carbon pricing. The other letter issued by the senators stressed the urgent need for the market to reflect the massive costs of carbon pollution by instituting an economy-wide price on carbon emissions. In support of this position, the senators noted:

• The International Monetary Fund (IMF) estimated that total annual direct and indirect subsidies for fossil fuels in the U.S. are north of $600 billion, the vast majority of which stems from the failure to price negative externalities caused by fossil fuel combustion;
• the failure to price fossil fuels to reflect their true total costs results in an exceptionally large misallocation of capital;
• fossil fuel projects that would not be viable if carbon were accurately priced move forward, while carbon reduction and removal technologies that would be viable with a carbon price suffer from underinvestment;
• numerous financial experts have warned that the overinvestment in fossil fuels will lead to stranded fossil fuel assets and a “carbon bubble” that may present systemic risks to the economy; and
• large scale continued combustion of fossil fuels will make climate change worse by increasing the physical risks of climate change, which will include rising sea levels, severe weather, and systemic risks to the economy. 

The senators contended that carbon pricing can correct the noted market defects and lead to the efficient allocation of capital, the reduction of the risks of a “carbon bubble” in the financial markets, and thereby drive needed reductions in greenhouse gas emissions so as to avoid the worst effects of climate change.

A word about the MRAC and the upcoming report. The MRAC advises the CFTC on matters relating to evolving market structures and movement of risk across clearinghouses, exchanges, intermediaries, market makers and end-users.  The MRAC examines systemic issues that threaten the stability of the derivatives markets and other financial markets, and makes recommendations on how to improve market structure and mitigate risk. Commissioner Rostin Behnam serves as the committee’s sponsor. The Climate-Related Market Risk Subcommittee’s report will be provided to the MRAC with the objective of identifying and analyzing climate-related financial and economic risks.