A new warning bell for Wall Street, as wildfires rage out West

Climate change has forced its way into the headlines in the past week, as record-setting wildfires rage on the U.S. West Coast, burning millions of acres, forcing tens of thousands to evacuate and blanketing the region in smoke that has now reached all the way across the continent. Even as Louisiana was still reeling from Hurricane Laura, Hurricane Sally made landfall on the Alabama-Florida border this week, delivering a deluge of "historic" rainfall as it moved onshore. At present, up to 30 inches have already fallen in several areas, with combined surge and rainfall causing flooding across the Eastern Gulf Coast and moving inland.

So it seems particularly timely that a federal advisory committee to the a key U.S. financial regulator released a report last week outlining the impact climate change could have on the country’s financial system. The message to Wall Street and financial regulators is stark: climate change poses serious risks that, if ignored, will undermine the financial system’s ability to support the American economy.

This new report, Managing Climate Risk in the U.S. Financial System, is the first of its kind to be released under the auspices of a U.S. financial regulator. It was written and unanimously approved by 34 experts representing banks, asset managers, agribusiness, the oil and gas sector, academia and environmental organizations. (I was one of the authors.)

What makes the report particularly newsworthy is that it connects the dots between climate change and the risk to the financial system.

Other reports have clearly documented the economic damages from climate change. The science has improved tremendously over the past decade, to the point where we can clearly link severe weather events like hurricanes, wildfires, floods, and drought to a warming planet. Just two weeks ago, for example, Datu published a report commissioned by Environmental Defense Fund that calculated $1.75 trillion in damages from severe weather events since the 1980s. But how do we know those economic damages translate into risk to financial institutions?

The new CFTC report provides the answer.

What’s in the report

One of the most powerful sections of the report describes how financial losses from storms, floods, rising sea level and wildfires can undermine core components of the financial system. For example, climate disasters could cause prolonged disruptions to critical operations of financial market utilities that could "paralyze" the markets they serve. The report cites 2012’s Superstorm Sandy, which flooded a bank vault and damaged or destroyed 1.7 million stock and bond certificates. The company couldn’t even assess the damage for two weeks until pumps could clear the vault of water.

There’s also a sobering list of assets that bear the greatest climate risk, including mortgage-backed securities, REITs, utility debt, insurance equities and bonds. The list of industries at greatest risk reads like a synopsis of the American economy: agriculture, airlines, automobile manufacturers, hospitality, power generation, and concrete and steel. Financial advisors, state pension managers and anyone who actively manages their own retirement portfolio should print Table 3.1 and pin it next to their computer screen.

At the macro — or "systemic" — level, the report discusses how climate impacts could conceivably contribute to a financial crisis by propagating throughout the economy and undermining the value of financial assets, as previously hidden risks are suddenly taken into account.

Perhaps more important, however, is the report’s careful look at what it calls "sub-systemic" shocks. After all, the U.S. is a large and diversified economy, which also makes it resilient. But as the report points out, smaller financial institutions are also at risk: community banks in hurricane-prone areas that hold commercial real estate mortgages, for example, or agricultural credit institutions that would be hard hit by drought.

In other words, this isn’t just about big banks on Wall Street: this is about everyday transactions on Main Street: the home mortgages, commercial real estate loans, farm credit and small business loans that underpin the U.S. economy — and that depend on a stable financial system.

What we don’t know

How likely are those risks? The scary answer is: We don’t know. The report shows a range of scenarios for how climate change could threaten the U.S. financial system, but we don’t know when or how those scenarios could occur — because we are not requiring businesses and financial institutions to assess, measure, manage and disclose those risks.

New research from the Brookings Institution, aptly titled “Flying Blind,” makes the same point: investors don’t know the actual climate risks to their portfolios. Members of the financial community who ignore climate change — whether they are banks, investors or regulators — do so at their own peril.

That’s precisely why measuring and managing climate risk should be an essential part of the actions regulators take to protect the financial system. The report calls on Congress and regulators to take concrete steps to manage that risk, ranging from a price on carbon to including incorporating climate risk into corporate risk management and taking steps to ensure better data availability and climate risk scenarios.

Two recommendations stand out in particular:

• First, regulators should require companies to more fully and transparently disclose climate risks. EDF was instrumental in getting the Securities and Exchange Commission to publish guidance on climate risk disclosure a decade ago. But as the report makes clear, too many companies are effectively ignoring that guidance. Regulators should beef up those requirements, making it clear that climate risks amount to material risks that firms are required to disclose — and ensure that they comply.
• Second, the report calls on regulators to make clear that managers of retirement and pension plans are entirely right to take climate risk into account alongside "traditional" financial factors. That’s critical, since only a few weeks ago the Trump administration issued a proposed regulation that would prohibit retirement and pension plans from considering climate risk — despite overwhelming opposition from the investment community.

Anyone who’s been paying attention knows that climate change poses risks to human health and the economy. This report is a warning that climate change also threatens the fluid and stable performance of our financial system. As we transition toward a more responsible and sustainable net-zero emission economy, we must also be aware of and manage for the real risks that two centuries of unchecked climate emissions have created.

Register here for a keynote address by Commissioner Rostin Behnam of Commodity Futures Trading Commission during Climate Week NYC 2020. The Commissioner will share key findings from the recent report: Managing Climate Risk in the U.S. Financial System.