The adoption of the Paris Agreement in December 2015 was a landmark moment for both global cooperation and recognition of the urgency of addressing climate change. Despite the many disagreements between countries, 196 nations came together at the Conference of Parties (COP) 21 to commit to limit global warming below 2o Celsius.
In the 5 years since the adoption of the accord, progress among nations has been asymmetric and insufficient, with material progress in the European Union, China, and Canada while other nations have prioritized national interests over climate action. Over the same 5 years, globally, investor activism has strengthened and much of the world has progressed on ESG and climate related financial regulation.
With a mandate to reestablish itself among global leaders, the Biden administration has signaled that action on climate change is one of its highest policy priorities. As the Biden administration’s stated priorities have yet to manifest as specific policy positions, there is considerable regulatory uncertainty across all industries. Given the progress on climate related regulation among the leaders of climate action, the administration could look to adopt similar approaches taken by regulators outside of the US.
In September of 2020, the Climate-Related Market Risk Subcommittee of the Commodities Futures Trading Commission (CFTC) released a report that provides 53 recommendations to mitigate climate related risks that urges US regulators to measure and address these risks, establish standards for climate related data and calculation methodologies, and integrate climate risk into the broader risk management framework1.
Fulfilling one of the key recommendations in the report, Federal Reserve Chair Jerome Powell announced that the US Federal Reserve would be joining the Network of Supervisors and Central Banks for Greening the Financial System (NGFS) in December 2020. The NGFS, established in 2017, is a group of central banks and regulators focused on the integration of climate risk management into each country’s supervisory and regulatory regimes and on the global coordination and collaboration required to meet the challenge. The actions of the CFTC and Federal Reserve were bolstered as the Biden administration announced its intent to rejoin the Paris Agreement a few hours after the inauguration.
In the near term, we believe that there are three key areas where the Biden administration could quickly make progress on climate related financial regulation: Financial Disclosures, Climate Stress Testing and Green Taxonomies.
Investors have been clamoring for greater transparency into climate related risks and transition plans from corporates. Established by the Financial Stability Board (FSB) in 2017, the Task Force on Climate-Related Financial Disclosure (TCFD) developed voluntary climate-related financial disclosure recommendations. The TCFD developed four widely adoptable core recommendations on climate-related financial disclosures of universal applicability to organizations across sectors and jurisdictions, divided into these topics: governance, strategy, risk management, and metrics and targets. According to the TCFD’s third progress report (Oct. 2020), nearly 60% of the 100 largest global public companies now support the TCFD, report in line with the TCFD recommendations, or both2.
In addition to the TCFD disclosures, firms have started implementing Sustainable Accounting Standards Board (SASB) disclosures, CDP disclosures, and more robust Greenhouse Gas (GHG) accounting frameworks.
Given the need for greater transparency into carbon intensity and climate risk exposures, mandatory disclosures on ESG and climate-related risks could be an early target for US regulators.
The nomination of former CFTC Chairman Gary Gensler, the appointment of acting commissioner Allison Herren Lee, who has served on the American Bar Association’s Committee on Public Company Disclosure and issued a strong dissent on the omission of climate and diversity disclosures from the SEC’s Modernization of Regulation S-K, and the appointment of Senior Policy Advisor Satyam Khanna, who advises the Principles for Responsible Investment, indicate that the Biden administration could make mandatory financial disclosures a priority.
Climate related tests could be another near-term action from the Biden Administration. In Europe, the European Central Bank (ECB) directs institutions with material climate and environmental risks to incorporate physical and transition risks into various stress testing scenarios as part of the Internal Capital Adequacy Assessment Process (ICAAP). The Bank of England will be releasing its stress test scenarios for large banks and insurers in June 2021, after it was forced to delay the initial stress tests due to COVID3.
In the U.S., calls for stress testing directives have been emerging at the both the federal and state level. At the state level, the New York Department of Financial Services (NYDFS) and California Insurance Commission (CIC) have called for stress tests for insurers. In November 2019, the Climate Change Financial Risk Act of 2019 was introduced into committee to direct the Fed to conduct stress tests on large financial institutions to measure their resilience to climate-related financial risks. This act would have required the Fed to establish an advisory group of climate scientists and climate economists to help develop climate change scenarios for the financial stress tests. The CFTC report suggests that existing regulatory frameworks may already support this.
As calls from investors and regulators to quantify systemic and idiosyncratic risks from climate change grow, the U.S. seems likely to adopt a stress testing framework for a range of climate change scenarios similar to the CCAR scenarios defined by the Federal Reserve, as well as guidelines for institutions to define and test firm specific scenarios.
Given the appointments at the SEC, the naming of the Secretary of the Department of Labor to the National Climate Task Force and the proliferation of green finance, green taxonomies could be an early consideration for the Biden administration.
Green taxonomies require asset and investment managers to classify assets with respect to issuer or borrower contribution to mitigating or adapting to the impacts of climate change. Financial institutions can leverage these taxonomies to analyze the impact of their capital markets (financing and investing) activities and align financing policies with these activities to achieve climate impact goals.
To meet the growing demand for ESG and sustainable finance products paired with a mandate to protect investors and minimize “greenwashing”, market regulators in the European Union’s Technical Expert Group (TEG) defined a green taxonomy for the classification of key industrial sectors and economic activities with respect to climate change mitigation or adaptation. This taxonomy is also expected to serve as the framework for upcoming regulatory changes, such as the EU’s Sustainable Finance Disclosures Regulation (SFDR).
In China, the People’s Bank of China (PBOC) issued a two level “green bond catalogue” of activities eligible to be classified under green bonds issues by banks and financial institutions in 2015. A “guiding catalogue for the green industry” was also established in 2016 by several Chinese environmental and financial ministries. It recently backed away from a “Brown” taxonomy, bringing their taxonomy into closer alignment with the EU. The UK could also adopt the EU’s classification framework.
The adoption and alignment of a taxonomy system by the world’s 2nd and 3rd largest economies could lead the US to align to an existing green taxonomy framework. In the US, asset managers could also face competitive pressure to align investment choices with the EU Taxonomy for comparability, allowing asset managers with global operations to scale existing efforts, easing regulatory burden and expediting implementation in the United States.
There is much work that will need to be done to conquer the challenges and to capture the opportunities created by climate change. Globally, ESG and Climate Risk seem likely to remain high on the regulatory agenda for the foreseeable future. In the US, where government response to climate change has lagged behind other nations, looking to the actions of peer nations at the forefront of climate management should provide good indicators of where to get started.
- Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee of the CFTC (2020) ‘Managing Climate Risk in the US Financial System’ https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf
- Task Force on Climate-related Financial Disclosures – 2020 Update https://assets.bbhub.io/company/sites/60/2020/09/2020-TCFD_Status-Report.pdf
- “The Bank of England is restarting the Climate Biennial Exploratory Scenario (CBES)”, Bank of England, November 13th, 2020