Climate change risk impact on financial markets

Climate change risk is now at the forefront of the debate on key risk factors that are likely to affect the world’s economy for years to come. At the Chicago Fed, my colleagues and I are developing a new framework for assessing the impact of climate change on the global financial markets, with particular emphasis on financial instruments that are exchange traded and cleared. As we prepare to release our new framework, I reflect on developments so far.

Climate change risk poses an existential threat to the way society is currently organised. I can think of three characteristics that make climate change unlike other types of risk. First, the increase in frequency and severity of natural disasters, such as hurricanes and flooding. Second, the compounded impact of small, incremental changes that reach tipping point over time, such as sea levels rising and threatening waterfront communities. Finally, the aggregate impact of climate change evolving in a nonlinear fashion. As a result, historical data sets alone are not sufficient to make accurate predictions of future climate change scenarios; careful modelling and analysis are required.

The debate over climate change has evolved over time:

Establishing climate change risk types: 

Early on, the Bank of England focused on the impact of climate change risk (physical risk, transition risk, liability risk) over the economy as a whole.

Disclosures:

There was also an early focus on disclosures as a way to scope out the risk already existing in the economy and determine how it could affect each market participant. In the US in 2010, the Securities and Exchange Commission (SEC) issued guidance indicating that existing disclosure requirements applicable to US public companies apply to climate change matters. In 2015 the Financial Stability Board launched the Task Force on Climate-Related Financial Disclosures (TCFD).  The TCFD is composed of 32 members representing a variety of perspectives: large banks, asset managers, insurance companies, non-financial companies, pension funds and consulting companies. The TCFD organised its recommendations around four key areas, tailored to reflect the way in which many organisations operate: governance, strategy, risk management, and metrics and targets. The purpose of this disclosure framework is to provide a foundation to enable market participants to assess and price the risk and reward balance in the context of climate change.

A conversation is now emerging about the impact of climate change risk on financial markets:

In May 2020 the European Central Bank (ECB) launched a public consultation on its “Guide on climate-related and environmental risks”. The Guide sets out key principles for assessing the potential impact of climate change on financial institutions in Europe. In June 2020 the Network for Greening the Financial System, a group of 66 central banks and 13 observers, published a set of climate scenarios for assessing the potential impact of climate change risk on the economy and the financial system. In September 2020, the Institute of International Finance sponsored the Taskforce on Scaling Voluntary Carbon Markets, an initiative aimed at creating and promoting the rapid growth of a voluntary market for trading carbon emission credits, as a way to create a set of market-led incentives to help meeting the Paris Climate Agreement target to limit global warming to below 2°C and to pursue efforts to limit it to 1.5°C. This initiative is led by private sector representatives, with public sector representatives acting in a consultative capacity.

Also in September 2020, the Climate-Related Market Risk Subcommittee of the Commodity Futures Trading Commission’s (CFTC’s) Market Risk Advisory Committee released a report titled “Managing Climate Risk in the U.S. Financial System”. The scope of the report is quite wide, assessing the impact of climate change risk on the US financial sector. The CFTC report sets out a number of recommendations. One key recommendation is that the United States should establish a price on carbon.

The assumption is that the financial markets do not accurately price the climate impact, or “carbon price” of the companies that issue bonds and stocks. If a more accurate methodology for assessing climate impact is developed, for instance by scaling a market for carbon emissions, then the financial markets will be able to allocate in a more accurate and efficient manner the risk and the cost of polluting. In this context, accurate disclosure of climate change risk practices by market participants takes on a new relevance, as it is now a tool that the market can use to price a company’s carbon footprint. This in turn would create incentives to change behaviour, reduce carbon emissions and rein in climate change, to the extent that irreversible damage can be avoided or ameliorated.

Risk managers in the exchange and clearing world are thinking actively about the issue of climate change, but a framework has yet to emerge to assess the impact of climate change risk on the market risk, credit risk, operational risk and liquidity risk affecting exchange traded products and those who trade and clear them. We hope that our upcoming publications will help advance the conversation on these important topics, and ultimately contribute to managing a risk that affects our legacy to future generations. 

Opinions expressed in this article are those of the author(s) and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.