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US Commodity Futures Trading Commission sets eyes on climate risk with new unit

18 March 2021 Amena Saiyid

The US agency charged with regulating the derivatives market is turning more of its attention to the risk posed by climate threats, as more companies transition to low-carbon solutions.

The US Commodity Futures Trading Commission (CFTC) announced 17 March the creation of a "Climate Risk Unit" that would play a "vital role" in developing new financial products and solutions that will build a financial system that is resilient to shocks caused by climate-fueled impacts.

Specifically, this newly created unit, with staff from across the agency, would ensure that any new financial products and markets in the climate and broader environment, social and governance (ESG) arena "fairly facilitate hedging, price discovery, market transparency and capital allocation."

Derivative markets, which help the global economy manage risk, play a vital role in discovering prices for everything "from a barrel of crude oil to a megawatt of solar energy to a tonne of CO2, helping businesses" while helping policymakers understand the true costs of climate change," according to the Futures Industry Association (FIA), a global organization for the futures, options, and centrally cleared derivatives markets.

With more than $30 trillion now flowing into ESG investments, the FIA said, "there is clearly demand for these types of products."

The CFTC's announcement comes a day after Allison Herren Lee, the acting chair of the US Securities and Exchange Commission, solicited public comment on its efforts to improve how publicly traded companies report risk posed by climate and ESG issues.

The two announcements demonstrate that the Biden administration is taking its government-wide approach to tackling the climate crisis -- which has fueled power and water shortages, damaged properties, and ramped up insurance premiums among other things -- to heart.

"Climate change poses a major threat to US financial stability, and I believe we must move urgently and assertively in utilizing our wide-ranging and flexible authorities to address emerging risks," Acting CFTC Chairman Rostin Behnam, said in a statement accompanying the agency action.

Front lines

He said the CFTC's unique mission focused on risk mitigation and price discovery puts the agency on the "front lines" of this effort.

As part of its charge, the newly created unit will reach out to exchanges, clearinghouses, industry groups, and market participants to discuss new and emerging risks pertaining to climate change and how such risks are being addressed, or ought to be addressed, in "a fair and equitable manner."

The unit also will coordinate national and international efforts to write consistent standards, disclosures, and practices as well as efforts to develop relevant and reliable climate-related market risk data, the agency said.

Alexandra Thornton, senior director for tax policy at the Center for American Progress (CAP), said the CFTC's action is "truly good news" and represents a key part of the all-of-government approach to move the US economy toward the goal of reducing net greenhouse gas emissions to zero.

Align with ESG trends

Most analysts and former CFTC regulators tracking climate finance developments said the CFTC's action was a direct response to the dramatic increase in ESG and climate-related investments.

Given the Biden administration's focus on climate, this new structure to align CFTC internal resources "makes complete sense," Scott O'Malia, chief executive officer of the International Swaps and Derivatives Association, wrote in a March 18 email to IHS Markit.

"The demand for green investments is growing rapidly, and CFTC-regulated entities can play an important role in providing financial solutions to help deploy the trillions of dollars in risk capital required to transform our economy," O' Malia, a former CFTC commissioner, added.

Likewise, Cornerstone, an energy policy advisory group, noted that the CFTC decision to set up a climate risk unit is "certainly in line with the broader trend we are seeing across all markets and sectors" as climate risk and overall ESG factors are increasingly being folded into investment and transactional decisions, and financial tools continue to grow to keep up with demand.

Behnam's announcement builds on his prior actions to identify challenges to managing climate-fueled risks to US financial markets. In 2019, he set up the agency's Climate-Related Market Risk Subcommittee, which was charged with looking at how to manage climate risk in US financial markets.

That committee issued a report in September 2020 that concluded that climate change does pose a risk to all aspects of the US economy, and thereby its markets.

"The process of combating climate change itself -- which demands a large-scale transition to a net-zero emissions economy -- will pose risks to the financial system if markets and market participants prove unable to adapt to rapid changes in policy, technology, and consumer preferences. Financial system stress, in turn, may further exacerbate disruptions in economic activity, for example, by limiting the availability of credit or reducing access to certain financial products, such as hedging instruments and insurance," the report concluded.

Derivatives a part of solution

The FIA reviewed the need for derivatives markets to be part of the global climate solution in a September 2020 report, titled, "How derivatives markets are helping the world fight climate change."

Through the use of futures, options and other derivatives, the FIA emphasized, "companies are able to absorb currency fluctuations, allow energy companies to mitigate short-term price volatility so they can invest in future infrastructure, and let farmers grow their crops without worrying that global trade disruptions might drive them to ruin."

The paper cited several examples of climate-driven innovations in the derivatives markets, including the CME Group's E-mini S&P 500 ESG Index futures, a new risk management tool that was released in 2019 to align a growing number of global institutional investors and asset managers with ESG principles. CME Group is the world's largest derivatives exchange.

The FIA also pointed to the futures market that has built around the Regional Greenhouse Gas Initiative (RGGI) in the US that enables electric utilities across Northeastern and Mid-Atlantic states to trade carbon allowances under a "hard" emissions cap. The RGGI futures market, which was built and operated by the Intercontinental Exchange, has helped provide price discovery and liquidity, the report said.

CAP's Thornton agreed, saying climate change poses risks to the entire financial system, of which derivatives are a major part.

"Since derivatives exist on virtually every kind of asset, the cascading consequences of a climate shock are real and directly related to the mission of the CFTC to mitigate risk and promote appropriate price discovery," she said.

The US saw with the 2008 financial crisis that derivatives can be used to offload risks to others, Thornton said, adding "as the US and the world transition as quickly as possible to a low-carbon economy, some assets, especially those related to oil and gas production, will lose value with ripple effects in the derivatives markets. That is just one example."

Posted 18 March 2021 by Amena Saiyid, Senior Climate & Energy Research Analyst, IHS Markit

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