Eakinomics: Climate
Change and Financial Stability
This past Wednesday the Commodity Futures Trading Commission (CFTC)
released a report it had commissioned on
climate change and the U.S. financial system. The CFTC had voted unanimously
(which means on a bipartisan basis) to create a Climate-Related Market Risk Subcommittee and
task it with a report covering evaluation and management of
climate-related risks to the financial sector, the effective use of
climate stress tests, and policy recommendations.
The CFTC did not vote to approve the report or endorse
its recommendations (and there were 53 concrete recommendations),
but that is not the important point. The most important point is that the
CFTC chose to investigate the implications of climate change, which means
that it acknowledged the existence and potential importance of climate
change. This represents another important step in reaching a bipartisan
consensus on the scale, scope, and timing of the climate change problem,
as well as appropriate policies to address the issue.
AAF’s Ewelina Czapla and Thomas Wade reviewed the report and
concluded, “the key finding is that 'climate change could pose systemic
risks to the U.S. financial system.' Even a conclusion that climate
change could pose any risk
to the financial system would be dramatic enough, particularly from this
administration. That the report elevates this potential risk to
'systemic,' or having the capacity to collapse an entire industry or the
economy, is a startling indication of the seriousness of the perceived
threat.”
In terms of key insights into the analysis, there are two main points.
The first is that the United States (and, indeed, the globe) needs to
address the problem. The preferred route is to put an economy-wide price
on carbon (e.g., a carbon tax) that is in line with the damage the
emissions are doing. Obviously, this has been an enormous political
challenge in the United States and abroad.
Second, there is a huge gap in data on the scale of the problem, much of
which is unknown and unquantified. The report calls for developing
additional data on the impact of environmental changes on market
participants, instruments, and functioning. The combination of these two
issues means that climate-induced risks will not be appropriately priced
into financial transactions, their manifestation will cause dramatic
financial fluctuations, and the stability of the system will be at risk.
That is a troubling conclusion because the United States will “solve” the
climate problem only as fast as American business is given incentives to
do so, and this indicates that those incentives will not be priced into
financial markets. The conclusion is much deeper than just the financial
sector.
To me, at least, there is a third point that should have been
mentioned in the report. Financial markets will continue to evolve
even as climate change occurs – and perhaps even offer new products as a
result. That means the goal should not be to understand how to prevent
instability of the future financial
system, which would require continuous updating of the nature of the risk
exposures.
The CFTC report is not the final word on anything. But it is an important
sign of recognition that the potential risks to financial markets
posed by climate change represent a pervasive policy challenge.
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