The effects of climate change and the transition to a low-carbon economy present emerging climate-related financial risks. Across industries, companies face physical risks (such as more frequent extreme weather events that can damage assets, disrupt operations, and increase costs) and transitional risks (such as shifts in policy, regulations, or market or social forces that can affect business operations and create stresses to financial institutions or sectors).
To address these risks, the Commodity Futures Trading Commission (CFTC)1 is seeking public feedback on "all aspects of climate-related financial risk as it may pertain to the derivatives markets, underlying commodities markets, registered entities, registrants, and other market participants." Given the broad sweep of the CFTC's request, any entities with insights about direct or indirect climate-related risks and impacts should be weighing in. This includes market participants in the energy, agriculture, and insurance sectors, as well as all those interested in the purchase or sale of carbon or other climate-related products.
The comment period runs until October 7, 2022.
Climate change poses major risk to the U.S. financial system
Climate change poses complex and systemic risks for the U.S. financial system. Climate-related physical and transitional risks will create market volatility, disruptions of historical price correlations, and challenges to existing risk management assumptions.
In May 2021, President Biden signed Executive Order 14030 on Climate-Related Financial Risk, which outlines a whole-of-government strategy to mitigating those risks. Executive Order 14030 recognized that the failure of financial institutions to appropriately and adequately account for the effects of climate change threatens the competitiveness of U.S. companies and markets.
In response to Executive Order 14030, the U.S. Department of the Treasury's Financial Stability Oversight Council issued the Climate-Related Financial Risk Report (FSOC Report) in October 2021 with thirty-five recommendations for the FSOC and its member agencies to: (1) build capacity and expand efforts to address climate-related financial risks; (2) fill climate-related data and methodological gaps; (3) enhance public climate-related disclosures; and (4) assess and mitigate climate-related risks that could threaten the stability of the financial system. A key recommendation of the FSOC's report was that member agencies, consistent with their legal authority, "expand their respective capacities to define, identify, measure, monitor, assess, and report on climate-related financial risks and their effects on financial stability."
CFTC requests comments on climate-related financial risk
As part of its effort to act on the FSOC Report's findings, the CFTC issued a Request for Information on Climate-Related Financial Risk (RFI) that was published on June 8, 2022 in the Federal Register. The RFI seeks comments on how climate-related financial risk2 may affect any of its registered entities or other market participants, and the soundness of the derivatives markets. This includes assessing how registrants and registered entities may need to adapt their risk management frameworks, as well as how market participants may need to adapt their dealing, trading, and advisory businesses in the derivatives markets. The CFTC is also seeking comment on how market participants use the derivative markets to hedge and speculate on various aspects of physical and transition risk, and how those practices may evolve in the future.
In addition to any general input, the CFTC is interested in responses to specific questions listed in the RFI pertaining to data, scenario analysis and stress testing, risk management, disclosure, product innovation, voluntary carbon markets, digital assets, financially vulnerable communities, and public-private partnerships and engagement. The CFTC may use this information to issue new or amend existing guidance, interpretations, policy statements, and regulations, or take other potential agency action.
The CFTC extended the public comment period to October 7, 2022.
Broad scope and potentially sweeping implications
The broad scope of the RFI, and that it may serve as the basis for similar requests from other government agencies, suggests that future CFTC policies and regulations may have profound impacts across several industries. For example, the RFI stands to impact the burgeoning number of companies making net zero pledges. As interest grows in carbon offset or sustainability products, so do concerns related to transparency, credibility, and greenwashing. The information received in response to the RFI will provide the foundation for addressing these issues.
Illustrating potential agency actions, the RFI poses several specific questions, ranging from climate risk stress tests to customer protections. The breadth and depth of the questions posed show that the CFTC, at the very least, is considering taking action on the following fronts:
Voluntary Carbon Markets. Questions about voluntary carbon markets (VCM) include whether enhanced CFTC oversight is warranted to enhance integrity, transparency, fairness, and liquidity of VCMs and, as necessary, root out potential fraud and manipulation.3 The fact that the CFTC requests specific feedback on a framework for registering VCM participants suggests that a new registration requirement is in the works.
Digital Assets. The RFI probes whether and to what extent digital asset markets,4 including Bitcoin and other cryptocurrencies, and such activities as mining, are creating climate-related financial risk for derivatives markets and CFTC-regulated entities and whether the CFTC should address such risk. These questions suggest that the CFTC will be examining the risks and benefits of digital assets through the lens of climate risk, as it continues to grapple with how to design an effective regulatory framework of digital assets.
Disclosures. The CFTC is considering the development of specific climate-related financial disclosures and that such disclosures might include greenhouse gas emissions. It remains unclear how much overlap there would be between the Securities and Exchange Commission's (SEC) proposed disclosure rule and the CFTC's proposed disclosures, and whether they would create overlapping or duplicative requirements for entities registered with both the CFTC and SEC.
Particularly because of the broad sweep of the RFI, any proposed regulation that follows will almost certainly be challenged under the major question doctrine used by the Supreme Court in West Virginia v. EPA to overturn EPA's Clean Power Plan. In other words, the CFTC will need to point to clear statutory authority for any regulatory action it takes based on the responses to the RFI.
Conclusion
CFTC regulation has the potential to enhance market integrity. It also has the potential to impose considerable costs associated with new regulatory burdens and to deter market entrance. New regulation may also sweep new entities into a registration or disclosure framework. The CFTC has broad fraud and manipulation authority over not just registered entities, but also traders and sellers of commodities, and its examination of climate risks may also lead to a broader examination of commodity users. For these reasons, participants in insurance, agriculture, energy, weather, carbon, and other climate-impacted commodities, futures and options markets, as well as all entities regulated by the CFTC, should consider submitting comments on this RFI.
FOOTNOTES
1 The CFTC regulates the commodity derivatives markets and has fraud and manipulation enforcement authority over underlying commodity markets. Commodities are defined broadly by the CFTC and can include physical and intangible commodities (e.g., cattle, soybeans, cryptocurrency, oil, gold, weather, water, carbon offsets, etc.), with limited exceptions.
2 Per the RFI, climate-related financial risk includes credit risks, market risks, counterparty risks, and other financial and operational risks.
3 CFTC Chairman Rostin Behnam has pointed out that carbon offsets are the underlying commodity to several CFTC-regulated futures products.
4 A digital asset is defined as anything that can be stored and transmitted electronically, and has associated ownership or use rights. This broad definition includes virtual currencies, like Bitcoin, as well as smart contracts, digital photographs, and computer storage space, among other things. Per the CFTC, depending on structure and use, digital assets may be considered a commodity, swap, or other derivative.