To put it mildly, federal regulatory agencies have not, during this administration, been in the forefront of those calling for bold action on climate change. That makes last week’s report on Managing Climate Risk in the U.S. Financial System especially welcome. The report comes from a subcommittee of the Commodity Futures Trading Commission (CFTC) an independent U.S. regulatory agency responsible for regulating commodity futures, options, and swaps.
The report is not an official policy statement from the executive branch, but the five CFTC commissioners, three Republicans and two Democrats, all appointed by President Trump, voted unanimously to create the subcommittee and subcommittee members voted unanimously to issue the report.
Why is the CFTC putting out a report on climate policy? Isn’t that the job of the Environmental Protection Agency? Well, yes, but the EPA is busy fighting a war against the previous administration’s war on coal, easing regulations on methane leaks, and other urgent business. Besides, there is a direct tie-in to the CFTC’s business: Wildfires, heat waves, sea level rise, and other climate-related phenomena represent a real and present danger for insurance markets, mortgage markets, agricultural commodity markets, and related futures, options and swaps.
The CFTC report does not hesitate place the need for carbon pricing at the very top of its list of recommendations:
The United States should establish a price on carbon. It must be fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement. This is the single most important step to manage climate risk and drive the appropriate allocation of capital.
In that regard, this independent subcommittee takes a far stronger position than those taken by either the Republican or Democratic parties during the current election cycle. The CFTC report is neutral as to whether carbon pricing is implemented via a carbon tax or a cap-and-trade mechanism. Either way, it would be an improvement over the current unacceptable situation:
Without an effective price on carbon, financial markets lack the most efficient incentive mechanism to price climate risks. Therefore, all manner of financial instruments — stocks, bonds, futures, bank loans — do not incorporate those risks in their price. Risk that is not quantified is difficult to manage effectively. Instead, it can build up and eventually cause a disorderly adjustment of prices.
According to a New York Times article, Heath Tarbert, the Republican chairman of the CFTC, is already hedging his support for the subcommittee report. Yes, says Tarbert, climate change poses risks, but it is also important to account for “transition risks” in the form of direct costs of decarbonization and also financial losses to fossil fuel industries if the government enacted a carbon price. But the new report itself is forthright about transition risks. For example, it recognizes that a transition to clean energy will result in “stranded assets,” such as coal-fired power plants that will have to be mothballed. It points out that getting an early start on the transition could reduce the total value of stranded assets by nearly half. On the whole, the report sees the benefits of decisive climate action as far outweighing the costs.
Some of the points made by the CFTC report address concerns raised by progressive as well as conservative opponents of carbon pricing. In particular, critics on both the left and the right are skeptical that if policymakers just put a price on carbon, and then walk away, leaving the rest to the market, nothing will happen. The new report acknowledges the existence of barriers that must be overcome to make a carbon price fully effective in redirecting capital as needed.
One such barrier is a “misperception among investors that sustainable or environmental, social and governance (ESG) investments necessarily have lower returns relative to traditional investment strategies.” If that were true, investments in low-carbon technologies might be inconsistent with managers’ fiduciary duties to seek the highest possible returns on investment. However, the report argues forcefully that empirical evidence does not support the idea that sustainable investments are inherently inferior.
A second barrier is a limited number of investment vehicles compared to the growing number of would-be green investors, including endowments and pension funds. The report discusses ways to encourage the issuance of green bonds and stocks so that the market will not be limited to private investors and venture capitalists.
A third worry is a lack of workable standards for labeling sustainable investments. As a result, some would-be investors are concerned about “greenwashing,” meaning the sale of investments that are not, in fact, as environmentally friendly as their sellers claim them to be. The CFTC report recommends more transparency and tighter labeling standards.
Policy uncertainty is a fourth problem that limits the flow of investment to sustainable projects. The lack of a commitment to a robust, lasting mechanism of carbon pricing is an obvious case in point, but not the only one. Regulations that discourage pension fund managers from investing in ESG vehicles are another, less prominent example.
Beyond regulatory changes, the CFTC report also calls for more vigorous deployment of fiscal policy to support sustainable investment. It points out that public spending could do more to support the many co-benefits of the transition, including job creation and the promotion of equity for historically marginalized communities. Additionally, it can drive continued innovation by funding basic scientific research and the deployment of mature technologies. Examples of fiscal policy with implications for climate risk include economic stimulus, disaster relief, and infrastructure.
In sum, although this report on managing climate risk in the financial system is only advisory, it provides a road map for financial, regulatory, and fiscal action in the event that the November elections produce a political opening for it. Read it, bookmark it, but don’t forget it.