FIA panel focuses on seminal CFTC climate change report and industry responses to growing perils

By Brad Rosen, J.D.

As climate change is increasingly being recognized as a source of major risk to financial stability, the financial industry finds itself at crossroads as it responds to both regulatory demands and investor pressures to provide instruments reflecting environmental concerns and demands from regulators to improve the reporting of the climate change related financial risks. A group of derivatives leaders engaged in a far-ranging discussion of these topics in a panel titled Managing the Risk of Climate Change: The Role of Markets, at the FIA’s recent Expo-V Conference 2020, a virtual event in light of the ongoing COVID-19 pandemic.

Setting the stage. In her opening remarks, panel moderator Athena Eastwood, a partner at the law firm Willkie Farr & Gallagher, observed that there has been a lot of recent attention on the dangers climate risk may impose on the financial system, noting that central banks have been increasingly vocal that a series of disruptive weather events could lead to the next systemic financial crisis. She also pointed to the emerging private sector trend of enhanced scrutiny of investment portfolios for carbon intensity, corporate commitments to reduce carbon emissions, as well as agricultural and energy market participants’ commitment to reducing carbon their footprints.

Additionally, Eastwood highlighted the CFTC’s recently released seminal report titled Managing Climate Risk in the U.S. Financial System, which was issued by a subcommittee of the CFTC’s Market Risk Advisory Committee (MRAC). That paper contained 53 actionable recommendations to mitigate the risks to financial markets posed by climate change. Eastwood, a subcommittee member, also pointed to the FIA’s policy paper How Derivative Markets are Helping the World Fight Climate Change, which focuses on the products and platforms that can help the world transition to a low carbon future. That paper was meant to compliment the CFTC’s report, and both works informed the panel’s discussion of how financial market players are currently involved in fighting climate change, as well as potential public-private partnerships to build a more sustainable economic future.

Key takeaways from the CFTC report. In his remarks, CFTC Commissioner Rostin Behnam, the MRAC sponsor and the driving force behind the agency’s efforts in the climate change arena, noted that the subcommittee’s diverse composition consists of representatives from the banking, agricultural, energy, and insurance industries, as well as institutional investors, data providers, environmentalists, and academia. He commended the subcommittee’s inspired work to reach consensus and approve the report 34-0.

Additionally, Behnam underscored the report’s number one recommendation to put a price on carbon but noted that it was the only one of the 53 recommendations that could not be implemented by a federal agency. The commissioner also pointed to one crucial statement contained at the report’s beginning which provides, "Climate change poses a systemic risk to the US financial system and its ability to support the economy."Behnam then reflected upon the large number of weather events in the recent past, including west coast wildfires and gulf coast storms, and noted it is incumbent on all of us to start thinking about how these subsystemic shocks to regional economies can lead to larger systemic shocks to the financial system. Some other key takeaways in the report, according to Behnam, include:

• Disclosures. The report contains a comprehensive discussion on disclosures, a tough area to reach consensus noted the commissioner. The report also highlights the need for getting more information, better information, and more transparent information from investor and regulatory perspectives.
• Stress testing. The report recommends that stress testing be conducted under various climate scenarios, and consideration should be given to how to use existing frameworks by prudential regulators and market regulators. The report concludes that stress testing of financial institutions will lead to better preparation in the event of a climate emergency.
• Harmonization. The report stresses the need to work together both domestically and internationally with other regulators. Behnam noted this is an iterative process and that climate change is not linear in terms of the risks that it poses. He also pointed to the need for market participants to leverage each other’s resources to address risks on a global basis.
• Data. The report points to the need to better sift through and share data, and think about what data can tell us to better mitigate climate risks. Additionally, agreeing upon taxonomies is essential as data and information is increasingly shared with various counterparts.

In response to an audience question, Behnam indicated that he had not spoken to the incoming Biden administration, but that the president-elect’s team has put out public documents on climate change. In fact, the Biden team recently announced that it would look to issue an executive order early on requiring public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains.

Climate derivatives grow as the policy tool of choice. Daniel Scarbrough, the president of IncubEx Inc., an incubator for exchange traded products with a focus on environmental markets, observed that market-based solutions have a proven track record of success and are increasingly the policy tool of choice to solve environmental challenges. In support of this assertion, Scarbrough pointed to some of the following metrics:

• Roughly 3 billion tons of carbon emissions are currently regulated under compliance trading regimes versus global emissions of over 40 billion tons. Thus, there is a long way to go in this space.
• 29 states and the District of Columbia have renewable portfolio standards.
• Total global environmental open interest has increased over four times from 650,000 contracts in 2009 to over 3 million currently.
• U.S. open interest has grown dramatically from 100,000 contracts to 1 million contracts currently.

Scarborough also noted that he has seen increased hybridization between the compliance and voluntary credit markets over time. He has also observed voluntary products being adopted for mandatory programs, a development he sees as promising.

Financial institutions commit to carbon neutrality. William McCoy, a managing director at Morgan Stanley, described a number of commitments his firm has made towards a carbon neutral future. These include:

• In 2017, Morgan Stanley announced its commitment to attain carbon neutrality for its global operations by 2022 and sourcing 100 percent of its global energy needs through renewable energy sources and using carbon offsets for remaining emissions.
• In 2018, the firm announced its commitment to provide $250 billion in low carbon financing by 2030. Thus far, $80 billion has been mobilized towards that goal, including the support of clients with clean tech financing and sustainable bonds issuance.
• In September 2020, Morgan Stanley announced a commitment to achieve net zero financed emissions by 2050. Net zero financed emissions refers to the aggregate emissions attributed to those firms that are receiving financing from the company.

McCoy also indicated that more investors and fund managers are adopting sustainable investment strategies and are demanding ESG products. He also noted there is evidence that ESG oriented equities and taxable bonds outperformed their market benchmarks in the first half of 2020. McCoy also observed that market participants are using ESG derivatives as part of overall ESG strategies as noted in the FIA’s policy paper.

Clearing and climate. Pauline Engelberts, a chief operations officer with ABN AMRO Clearing Bank, noted that her institution is in ongoing dialogue with clients, regulators, and exchanges, and engages the whole value chain with regard to climate change related risks. In particular, she noted that ABN AMRO screens companies based on carbon intensity, and is piloting a sustainability dashboard with its clients to identify ESG biases and impacts and to promote engagement on the issue. Engelberts acknowledged the difficulties associated with a lack of standardization and harmonization with respect to climate-related metrics. "We would welcome standardization but aren’t going to wait around for it and miss the boat," she stated.

Concluding thoughts. Towards the end of the panel session, Commissioner Behnam recalled the observations of a leading thinker in the climate space after the issuance of the CFTC’s report who noted: "we missed the housing crisis that lead to the financial crisis; we missed the COVID-19 pandemic crisis; let’s not miss the climate crisis." Behnam urged industry players to pool their intelligence, innovation, and the entrepreneurial spirit of the derivatives market that has existed for decades, and work together to solve the climate problem.