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Financial Reforms Can Promote Climate Actions

The commodities markets are double-edged swords in the battle against climate change. Until now, many commodities have been a huge part of the problem, but a new report shows how they can become part of the solution.

Fossil fuels have clearly contributed to global warming, but agricultural commodities such as palm oil, soybeans and livestock are major contributors, especially when produced in forests that have been slashed and burned. In a new report, federal regulators in the United States are recommending sweeping reforms on finance and production.

According to the authors, financial regulators, business leaders, and legislators around the world understand the urgency of global warming and climate change. The missing link, however, has been in the climate-related financial markets. Until the financial world stops subsidizing pollution, deforestation and inefficiency, climate action won’t reach critical mass fast enough.

reforestation and global warming and climate change nature-based solution

To speed up the process, the United States and other nations must establish a price on carbon.

It must be fair, but it must include all industries, and it must be effective in reducing emissions consistent with the Paris Agreement. This is the single most important step to manage climate risk through the appropriate allocation of capital.

That stark warning is the conclusion of a new report from the federal regulators in the United States. Managing Climate Risk In The U.S. Financial System is a new Report of the Climate-Related Market Risk Subcommittee, Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission. The powerful report will make it impossible for financial markets to ignore climate risks much longer. Embracing solutions, however, will not come fast enough.

According to the report, fair incentives encourage the efficient allocation of capital. Unfortunately, when it comes to financing climate risks, they are urgent and they are missing. Until this flaw is fixed, capital will flow in the wrong direction. This report reflects agreement around a set of fundamental principles beyond pricing carbon, such as the need for collaboration with international efforts to address climate-related financial market risk.

Agriculture, for example, is directly dependent on weather and uniquely exposed to weather risk. While farmers have coped with weather variability since the advent of agriculture, these changes have already begun to affect agriculture in the United States and globally and will continue to do so in proportion to the amount of warming experienced over the coming decades and centuries. There is a general consensus that crop yields are likely to decline unless improvements in agricultural technology can keep pace with weather-related stress, including drought, floods and extreme temperatures.

The 1930s saw the beginning of federal support of agricultural risk management in the United States. Today, the Federal Crop Insurance Program (FCIP), managed by the USDA Risk Management Agency, is one of the most common tools that farmers use to manage weather risk. While the weather on any given day may be difficult to predict beyond a few weeks, the range of what is possible and what is likely have been remarkably consistent throughout most of the history of the United States. American agriculture has been mostly stable for about 250 years.

Evidence has accumulated in recent years, however, that long-term temperature averages are shifting with the buildup of greenhouse gases in the atmosphere. In addition to average temperature, shifts in seasonal patterns of temperature, precipitation, and other variables have been observed. While weather consistent with the long-term historical record will continue to occur, some forms of weather that had previously been rare or extreme are projected to become increasingly likely, while other forms increasingly rare.

Programs that help farmers manage risk are a major component of the federal government’s support to rural America. Changes to this risk—and thus to the government’s fiscal exposure—are expected as weather averages and extremes change over the coming decades.

In the United States, the government implements a number of programs that help mitigate risk in agriculture, with expenditures on these programs of approximately $120 billion over the past decade. The largest program is the Federal Crop Insurance Program (FCIP), which insures participating farmers against adverse production or market conditions. Under the FCIP, the Federal Government pays a portion of farmers’ premiums; these premium subsidies represent FCIP’s costs to the Government. Much depends on the severity of future warming.

The cost of administering the FCIP rises in years with adverse weather events, such as droughts, when insurance claims outpace premiums paid for insurance coverage. Premiums are adjusted over time based on recent claim payout histories. As the frequency of adverse weather events changes, so do premiums. Climate change could affect the Federal Government’s fiscal exposure from the FCIP as premiums and subsidies adjust with changing growing conditions. Adverse weather could make yields more variable from year to year, causing losses to happen more frequently. Commodity prices could become more variable if adverse weather events affect large proportions of farmland at the same time, also increasing the frequency of crop insurance losses. Finally, declining supply could raise average commodity prices, causing increased payouts when losses occur, and therefore also raising premiums and subsidies.

On average, climate models project declining average corn and soybean yields, while changes to winter wheat are modest and variable (winter wheat is not exposed to summer heat). Losses are generally largest in the southern United States and in dry-land production. This is consistent with the known vulnerability of corn and soybean yields to extreme heat, which is projected to increase across all climate scenarios. Differing levels of production will affect prices for crops.

“The members of the Commodity Futures Trading Commission’s (CFTC) Climate-Related Market Risk Subcommittee and I recognize that the financial community must prepare for climate-related risk management challenges,” said Bob Litterman, Chairman of the CFTC. “The smooth functioning of the financial markets is crucial to economic prosperity generally, and in particular to facilitating the flow of capital toward mitigating and adapting to climate change. My focus on climate risk began when I left Goldman Sachs. Like many others, I was concerned that society is not adequately addressing the risks created by climate change. The root cause of climate change is the increase in greenhouse gas (GHG) emissions from humans. As an economist and risk professional, it has long been obvious to me that the risks created by climate change must be addressed by the creation of appropriate incentives to reduce carbon emissions. There is uncertainty about the precise policy levers and tools that will be used to mitigate climate risk, and the innovations that will be required to do so. However, at this moment, what is very clear is that the risks created from climate change are increasing rapidly, economic incentives are misdirected, and immediate action across the global financial system is required.”

According to Litterman, a fundamental flaw in the economic system lies at the heart of the climate change problem—the lack of appropriate incentives to reduce GHG emissions. No discussion of climate-related financial risk management can begin without focusing on this market failure. Financial markets do an amazing job of allocating capital in the direction of the incentives that they are given. Appropriate incentives arise in these markets primarily from the prices that balance supply and demand for capital.

reforestation and climate change

According to the report, when negative influences exist, as is the case with the risks and costs imposed by GHG emissions, there is a role for government to ensure that those externalities are reflected in prices. Unfortunately, that is not happening; emissions remain mispriced and capital is flowing in the wrong direction. In fact, on average, global public policies strongly subsidize carbon emissions from fossil fuel consumption—the International Monetary Fund (IMF) estimated $5.2 trillion (6.5 percent of gross domestic product) in 2017 alone (Coady, et al., 2019). Given the lack of appropriate incentives to reduce emissions, the inevitable responses in economic behavior are directly responsible for the current rapidly accelerating increase in climate risk. The primary obstacle is political inertia. While there is an ongoing debate about the right price for emissions, what we do know is that inaction creates a large and growing liability. It is very possible that each ton of carbon dioxide put into the atmosphere today will have to be removed and sequestered at some future date to stabilize the world’s climate, an expensive process that is not currently feasible and thus a substantial liability that this generation is creating for future generations.

Because the future is very uncertain, society today should err on the side of caution.

In the context of pricing climate risk, that implies imposing a higher price than what models used to calculate the social cost of carbon currently suggest. Prudent risk management calls for immediately implementing carbon pricing globally to quickly reduce GHG emissions and to try to get the planet to net-zero emissions as soon as possible while ensuring that the costs are shared equitably across society and that the distributional impacts are not regressive. Policies should respond to new information over time, and it is very likely that we will need to go beyond net-zero and pull greenhouse gases out of the atmosphere.

Building A Climate-Resilient Financial System Requires Reform

How should financial markets and regulators respond in the face of this enormous market failure? Nearly everyone in the financial markets understands several fundamental principles of risk management. The first is that you must think about worst-case scenarios. Of course, only rarely is there a well-defined worst case. In the financial community, we generally use the expression “extreme, but plausible” to communicate a common-sense understanding of this type of risk scenario. In this report, we explore a variety of risks, including those that are extreme but plausible, which challenge the stability of the U.S. financial system.

Second, it is well understood that the purpose of risk management is to recognize risks and to warn when they are not being priced appropriately. Markets are in equilibrium when assets reflect not only the expected outcome, but when investors are paid an appropriate premium for the risks that they take. In the case of climate risk, neither the expected impacts—nor the potential for extremely bad outcomes—is being priced appropriately.

Third, time is of the essence. Given enough time, virtually any problem can be addressed. But in risk management, time is a scarce resource. When time runs out, risk can turn into catastrophe. With climate change, we do not know precisely when the planet’s climatic system will be pushed past catastrophic tipping points, beyond which financial (and other) consequences would become non-linear. Indeed, some scientists argue that there are thresholds which are very close or may have already been crossed. This uncertainty about thresholds is a powerful reason not to delay.

Finally, in financial markets we often distinguish between risk and uncertainty. Risk generally refers to a model-based statistical measure of a probabilistic distribution, such as volatility or Value-At-Risk (VaR). But we recognize that the real world does not behave according to a model. Our models give us measures of risk, but what we manage in the financial markets is the broader concept of uncertainty, the full potential of bad outcomes when our models are wrong. Similarly, with respect to climate change, the consequences are highly uncertain. After all, this is the first time we have performed this planetary experiment. This uncertainty means that in managing climate risk we must err on the side of caution if we are to maintain the relative stability and proper functioning of our market economies. Unlike most financial risks, climate risk has unique characteristics, such as the extended time horizon over which damages are expected to occur, which make it more difficult to measure and manage. For the financial risk management of climate change to succeed, we need to be able to understand how physical climate impacts and the transition to a sustainable economy will affect the valuations of financial instruments.

Investors and financial markets are poised to deliver the low-carbon capital and infrastructure that our global economy requires to address climate risk. We know what we need to do and how to do it. We are impatiently waiting for the appropriate incentives and other policies to reduce emissions to be instituted through legislation. Only then will the awesome power of the financial system be able to address at scale this existential threat.

Over the past decade, most global leaders recognize the urgency of the challenge and they have embraced the need to better manage climate-related financial and market risks. Many countries have adopted legislation, guidance, and other initiatives to advance this goal. In addition, many international initiatives, working groups, task forces, coalitions, and other efforts have emerged to facilitate collaborative solutions and accelerate learning and information exchange. The United States has been involved in, and has even led, some of these international efforts; but it is noticeably absent in others. As the world’s largest economy and second-largest emitter of GHGs, the United States must engage in—and lead—these initiatives.

Finally, it is worth noting two interrelated challenges. One is safeguarding the soundness and stability of the financial system in the face of climate change. The main goal is to responsibly manage climate risk, while protecting the system’s ability to serve the American public, support economic activity and entrepreneurship, and safeguard the assets of millions of savers, retirees, institutions, and businesses. The second challenge involves helping the financial system facilitate the transition to a low-carbon, climate-resilient economy. Central to this challenge is identifying ways financial markets and institutions can channel more capital toward sustainable investments and net-zero-emission activities, including low-carbon and renewable energy, energy efficiency, other net-zero or low-carbon technologies for transportation, industry and agriculture, and resilience against climate impacts. “Net-zero” refers to activities or investments that seek a net neutral balance between GHG emissions produced and removed from the atmosphere.

“I see what is already happening—entire regions burned by increasing wildfires, larger storms, more frequent floods, ecosystems under mounting stress, major health impacts, and climate refugees,” Litterman said. “I worry about the future my four grandchildren will likely experience in the coming decades, along with the rest of their generation. Our decisions today will have a major impact on the quality of their lives. Those of us who see the danger, recognize the required path forward, and understand the urgency of taking action must muster the courage and clarity of vision to do what is required now to get us on that path.”

In a report such as this, it is important to remember that financial stability is not an end in itself—it is a means to protect the assets of millions of Americans and to ensure that the financial system continues to support their goals and aspirations through an efficient and sustainable allocation of capital. In a world confronting climate change, the financial system must be part of the solution.

To be fair, this conversation must include the topic of deforestation. Deforestation is responsible for about 20 percent of carbon emissions. Deforestation also impairs the planet’s ability to absorb carbon. Rainforests, in particular, are the lungs of the earth. Unfortunately, most deforestation today is done to clear rainforests and convert them into palm plantations, soybean plantations and pastures for cattle. These are all commodities that are causing permanent damage to entire ecosystems, not to mention the planet. These production practices must stop immediately and financial reforms can make an immediate difference in the Amazon, Africa and Southeast Asia. Reforms can’t come fast enough for the sake of biodiversity, climate and humanity.

Read The Full CFTC Report on Climate Change

deforestation and global warming

Sacred Seedlings is a global initiative to support forest conservationreforestationurban forestrycarbon capture, sustainable agriculture and wildlife conservation. Sustainable land management is critical to the survival of entire ecosystems. Sacred Seedlings is a charitable division of Crossbow Communications.

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Author: Gary Chandler

Gary Chandler is the founder and Executive Director of Sacred Seedlings.