Courtesy of Graham Steele
Today, the Senate Select Committee on the Climate Crisis has convened a hearing about the potential financial risks from climate change. This hearing is the culmination of years of expert warnings about the risks of a growing carbon bubble that, like other asset bubbles, could result in stranded assets and job losses. These voices are warning that this carbon bubble, if left unchecked, will lead to a new global financial crisis, as the subprime mortgage bubble did a dozen years ago; only this time, the global economic losses caused by climate change could reach $23 trillion—three or four times the scale of the 2008 crisis. If these warnings are to be believed, climate change poses a significant risk to the stability of the financial system.
Dire warnings notwithstanding, business appears to largely be proceeding as usual, ignoring many of the potential risks and seeking to eke out any remaining profits before the bubble bursts. This response is understandable for corporations seeking to maximize profits and share prices. It is perhaps more alarming that, despite a growing international consensus, United States regulators lag their international counterparts in working through the financial risks associated with climate change and fashioning an approach to mitigating such risks, essentially arguing that it is outside of their core regulatory mandate. The one Federal agency that has identified the financial risks of climate change – while avoiding that terminology – has merely said that the risks “bear monitoring.”
Because most thought leadership has come from abroad, scholarship on climate financial risk to date largely comes in an international context, without regard to U.S.-specific legal authorities. To contribute to the U.S. understanding, I have posted a new draft article that attempts to fill this gap by offering an analysis of climate-driven financial risk though the U.S. financial regulatory framework established in the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010 following the global financial crisis. In addition to this legal analysis, the article also attempts to further the policy conversation by proposing financial regulations, based upon existing U.S. legal authorities, that would force more accurate pricing of the risks created by large financial institutions’ financing of climate change-causing activities.
Climate Risk as a Systemically Risky Financial Activity
The concept of “systemic risk” does not have a single legal definition, but it can be summarized as the “impairment of financial intermediation or of financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy.” The regulators serving on the Financial Stability Oversight Council (FSOC) have established a list of roughly six criteria to be applied when evaluating whether a financial activity “could amplify potential risks to U.S. financial stability.” While some initial arguments have been made about the basic physical and transition risks from climate change, using the FSOC’s framework, as I lay out below, it becomes clear that the financing of the drivers of climate change – primarily fossil fuels and commodities that drive deforestation – are systemically risky activities.
Credit risk affects lending businesses, causing loan defaults, lost income, and severely discounted asset write-downs. Climate examples include the bankruptcy of the California utility Pacific Gas and Electric that has been described as the “first climate change bankruptcy,” or the fact that three of the top five U.S. coal firms have filed for bankruptcy since 2011. Climate change can impact both the creditworthiness of a borrower and the value of collateral securing a loan, leading to both a higher likelihood of default as well as greater losses in the event of default.
Leverage, including from derivatives
Excessive borrowing can lead to greater defaults and losses. The four largest U.S. bank derivatives dealers are currently exposed to $929 billion in notional value of commodity swaps contracts, which are sensitive to climate conditions, and the vast majority of which are traded over-the-counter without the risk mitigating effects of centralized clearing. The energy industry also derives significant funding from products like leveraged loans and collateralized loan obligations, which often have low credit ratings and trade in less liquid markets.
Liquidity or maturity mismatch
Climate change could exacerbate the mismatch between assets and liabilities in a variety of ways. A critical mass of banks simultaneously seeking to exit short-duration loans on the basis of potential or actual climate exposure would likely impair certain lending markets and related assets. Thirty-year mortgages are long-term assets paired with property and casualty insurance policies that are renewed every year, creating duration mismatch; a sudden repricing of, or failure to renew, homeowner insurance policies could have implications for borrowers’ ability to repay their loans, leading to delinquencies or defaults, or affect the value of current or future mortgage assets in particularly climate-exposed areas.
Counterparty risk or interconnectedness
Climate financial risk is not isolated to a specific financial sector or market. Climate risk is a particularly significant source of potential contagion because a deeply interconnected financial system is layered on top of interconnected economic sectors, which are then layered atop interconnected earth systems. The interdependencies between the sectors and systems that are exposed to the climate, such as energy, water, and agriculture, and those less directly exposed to climate, like the financial sector, “can lead to complex behaviors and outcomes that are difficult to predict.”
Transparency or opacity
Information gaps lead to panics and runs, particularly in the absence of shock-absorbing prudential regulations. The corporate sector’s climate disclosure efforts to date have largely been driven by social responsibility and sustainability, rather than focused on financial risk management. In addition, the most polluting industries largely already comply with disclosure best practices, proving the insufficiency of such measures.
Market disruptions can lead to asset devaluations and the market dynamic known as a “fire sale,” where market participants simultaneously seek to monetize assets that are declining in value, leading to further devaluation. The potential culmination of this risk would be a “climate Minsky moment,” wherein “wholesale reassessment of prospects could destabilise markets, spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions,” making it “difficult for banks to manage their exposures to carbon-intensive investments” while “simultaneously, increasing losses and potentially also causing liquidity issues.” As we learned earlier this week with the collapse of the price of oil, climate-sensitive markets can be affected by a variety of factors—some expected, others less so.
A final factor in the evaluation of systemic risk is whether an activity is highly concentrated or significant and widespread. In the case of climate risks, both are true. Climate risk is highly concentrated in the largest U.S. financial institutions, which are major financiers of the industries driving climate change through lending, underwriting, investing, or some combination of these activities. From 2016-2018, six of the eight largest U.S. bank holding companies loaned, underwrote, or otherwise financed over $700 billion to fossil fuel companies. As of 2016, large insurers reported $528 billion in fossil fuel related investments. These investments would, on a standalone basis, be the second-largest U.S. life insurer by assets. And one report estimates, conservatively, that the “Big Three” asset managers hold at least $287 billion in fossil fuel investments.
In addition to the concentration of climate risks in the most systemic U.S. financial institutions, climate change has a widespread, and global, reach. Consider the concept of “telecoupling,” that there are “connections between geographically separate biomes and economic activities.” There is mounting evidence that reaching climate tipping points in one region increases the likelihood of reaching them in others. This is relevant to climate finance, because financial investments and decisions have “cross-continental social and ecological effects.” In this context, the risks of climate “are not constrained by borders” and “affect economic systems which can transmit and amplify their effects across borders.”
Importantly, the proper conceptual framework for mitigating potential threats to financial stability is not to wait for these risks to come to fruition. Instead, we must preemptively inquire about a range of prospective crisis scenarios, and seek to anticipate how such scenarios might be prevented. This is analogous to the “precautionary principle,” that “you act urgently to prevent ruin.”
The Dodd-Frank Act as a Framework for Regulating Climate Risk
The Dodd-Frank Act was intended to both prevent “recurrence of the same problems” that gave rise to the financial crisis, but also to create a “new regulatory framework that can respond to the challenges of a 21st century marketplace.” There should be little doubt that, although it is analogous in many ways to past financial crises, climate change presents the very type of new challenge that Dodd-Frank was intended to address. That is why the significant discretionary authorities established under the Dodd-Frank Act can be deployed by federal financial regulators to mitigate the financial risks of climate change that threaten the stability of the financial system.
The first source of macroprudential regulation in the Dodd-Frank Act is the FSOC, the multi-agency council tasked with identifying emerging systemic risks and providing for their comprehensive regulation. FSOC has the authority to designate a nonbank financial company, known as a systemically important financial institution (SIFI), to be supervised by the Federal Reserve and subject to enhanced regulation if the “nature, scope, size, scale, concentration, interconnectedness, or mix of the activities … could pose a threat to the financial stability of the United States,” based upon a set of factors.
The second source of macroprudential regulation is section 165 of the Dodd-Frank Act, which requires the Federal Reserve to craft “enhanced prudential standards” for the largest bank holding companies and any designated nonbank SIFIs. Section 165 authorizes the Federal Reserve to establish prudential standards in order to “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions[.]”
To fully address the systemic risks of climate change, insurance companies and asset managers would be designated as non-bank SIFIs by the FSOC, on the basis that their mix of activities, in this case their financing of climate change-driving industries, pose a threat to the financial stability of the United States. (Others have argued persuasively about why designation is the appropriate way to deal with certain entities and activities, especially insurance.) Those nonbank SIFIs, and the largest U.S. bank holding companies that are already regulated and supervised by the Federal Reserve, would then be subject to a suite of regulations by the Federal Reserve under section 165 to mitigate climate financial risk. Such prudential regulations – including stress testing, risk-based capital requirements, margin or collateral requirements for securities and derivatives transactions, and so on – would be tailored to address climate change-causing activities and climate-driven events on the basis of their potential risks to financial stability.
It is important to view the forgoing regulations, known as “macroprudential” regulations, as the first step in climate risk mitigation. In addition to addressing the role of financial institutions in creating climate risk, policy makers must also make the financial system more resilient to the effects of climate change. However, recalibrating the potential risks of assets, communities, and entire geographic regions that are most vulnerable to climate change raises important issues of socioeconomic and racial equity and inclusion. Any such measures would need to be part of a more comprehensive investment plan that ensures the most vulnerable communities are being made more climate resilient. Creating a comprehensive climate program should not, however, prevent near-term action by U.S. financial regulators to address the risks from investments and activities that play the most significant role in driving climate change.