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Climate Risk: The two sides of transition risk

Nov 17, 2020
Why it’s important to diversify our orientation for a more sustainable future

How can climate change affect the financial markets? The U.S. Commodity Futures Trading Commission (CFTC) addresses this question—one that’s on the minds of consumers and financial experts alike—in a new report, Managing Climate Risk in the U.S. Financial System.

Climate change impacts the global economy, supply chains, and valuations of assets. The private sector is poised to do its part to manage climate risk, but it needs the right tools to move each respective industry one step further.

Hosted by Brad Hurley, senior communications consultant at ICF, this conversation with Jesse Keenan, a social scientist at Tulane University and one of the editors of the CFTC’s report, covers topics such as:

  • Transitional risks as society shifts to a net zero carbon strategy.
  • The wide-reaching impacts of a regional event (e.g. wildfires, drought) on multiple commodity markets.
  • How changing consumer preferences amplify uncertainties—and opportunities.
  • Steps regulators can take to prepare for risks related to climate change.
  • Barriers to financial institutions’ ability to measure their climate risk.


Explore insights on how to drive low-emission transitions and build resilience against the effects of climate change.
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Full transcript below:

Brad: Welcome to the "Climate Risk" podcast. I'm your host, Brad Hurley from the consulting firm ICF. On Sept. 9, 2020, the Commodity Futures Trading Commission, an independent agency of the U.S. government, published a report entitled "Managing Climate Risk in the U.S. Financial System." The report concluded that climate change poses major risks to the stability of the U.S. financial system, and it provides 53 specific recommendations for reducing those risks. The report was unanimously approved by the commission's 34-member Climate Risk subcommittee, which includes members from financial, agricultural, and energy markets; the banking and insurance sectors; data and intelligence service providers; the environmental and sustainability public-policy sector; and academia.

To learn more about this report and its findings, we talked with Jesse Keenan, one of the report's editors. Dr. Keenan is an associate professor and social scientist at the School of Architecture at Tulane University, where he leads courses and seminars advancing the interdisciplinary fields of sustainable real estate and urban development. His research focuses on the intersection of climate-change adaptation in the built environment, including aspects of design, engineering, regulation, planning, and financing.

Brad: So, what was the impetus behind the CFTC report? How did climate risk bubble up to the top as an issue for the commission's attention?

Dr. Keenan: The reason that the CFTC decided to take this on is a reflection of several things. One, climate change is an inescapable phenomenon as it relates to its impacts on the global economy, supply chains, valuations of assets, etc. And so, particularly for the CFTC, which deals in futures, options, derivatives—an enormous market far exceeding the size of any equity market—these types of forward-looking behaviors are consistent with the challenges of forward-looking behavior as it associates with understanding climate change. At the same time, it's a present phenomenon. It's a present challenge. Climate change is already with us. So, in that regard, there are several things happening.

One is that, after the Paris Accord, central bankers and financial regulators of economies got together—but for the United States—and created something called the Network for Greening the Financial System. This is a bit of a nebulous thing many people have never heard about, but I would argue it's probably the most consequential body of global governance that there is, as it relates to climate change—in part because they are rewriting the rules of how we think about sustainability: What's green, what's brown, what's the gray area there in terms of assets and levels of performance and their associated impact on climate change in both terms of climate mitigation, reducing greenhouse gases, as well as climate adaptation. It's an enormous effort that's going to shape our global economy.

The United States has not been a part of that but for some minor participation by the State of New York, as well as an emerging observer role for the Federal Reserve Bank of San Francisco. And, of course, just in this year, it was acknowledged that it was very likely that the board of governors of the Federal Reserve would also be joining. But in the past year this has been really brewing in the absence of the United States. So, that's one sort of global top-down component.

Another global component of this has been the Task Force for Climate Financial Disclosure, TCFD, which among many disclosure systems has probably risen to the top in terms of standardization. It’s moved very quickly to engage trillions of dollars of assets or assets under management in a significant component of our global economy. And that standardization is moving quickly, again, in the absence of federal leadership and engagement on many fronts.

The other component of it, I would say, is the groundswell from the bottom-up. Many investors—asset managers—have increasingly been looking for guidance and greater resolution domestically with the United States, and the overt policy disposition of the Trump administration is to stand in the way of allowing greater access to a greater diversity of funds, products, and financial services that is driving sustainable investment, whether that's your 401K or whether that's a pension fund. Where do these fiduciary duties rest?

"We're getting better intelligence about how climate change is shaping and shifting the world, particularly the financial economy."
Dr. Keenan

Another component of this is a concept that I put forward and coined for broader public discourse, which is the idea of the “climate intelligence arms race.” So, in the context of all of these—both top-down and global—we have a tremendous arms race, if you will, to understand and to measure and ultimately lead to disclosure. And we can talk about that, climate phenomena and environmental phenomena as they relate to exposure, sensitivity, adaptive capacity of markets, assets, supply chains, networks, etc. So, we're getting better intelligence about how climate change is shaping and shifting the world, particularly the financial economy.

The confluence of all of these things—the technology, the governance, the demand from consumers—really could not be ignored any further. Commissioner Behnam, one of the commissioners appointed by Trump, took the step to bring this idea to the commission and to empanel a group of experts to proceed with researching—and ultimately producing—what is really the penultimate and first-of-its-kind report from a U.S. financial regulator on fundamentally what does it mean to manage risk in the U.S. financial system.

In many ways, this is an exercise in domesticating global knowledge but also working within the unique American vernacular of things that are unique to our markets and our way of regulation about what we can do to, not just transform the system of regulation, but calibrate it and work within existing modes of regulation. So, there's different transformations that need to happen in terms of investing or a transition to a net-zero economy, but there's much that we can do on the margins that are minor, that are technical, but that really add up and really matter in many ways. And so, we have a lot of very detailed prescriptions and recommendations in this work that get to that level of technical specificity—again, really a first of its kind.

The systematic relationship between climate change and the supply chain

Brad: It's interesting to me that this is coming out of a commission that focuses on futures and derivatives because, I think, to most people, they would think that would really have a more short-term focus than the kind of longer-term focus of climate change. But as you mentioned, this is a here-and-now problem, and I'm wondering if you could give us some examples of ways in which climate change could affect the financial markets that will affect futures and other derivatives, including both the impacts of climate change itself as well as the effects of actions that are aimed at reducing emissions.

Dr. Keenan: So, let me say this, that one of the great benefits or liberties that we had in producing this work was that we were not limited to the regulatory domain of the CFTC. We had liberties to look across a variety of stakeholders and regulatory bodies and agencies. We didn't limit this to the realm of the CFTC. We really looked at everything from the labor department, to the SEC, to the Federal Reserve, to the FDIC, too. We looked at really a broad range of things.

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"Derivatives and futures have been long utilized to hedge environmental risk."
Dr. Keenan

But to your question, first of all, derivatives and futures and the like—and many similar instruments—have been long utilized to hedge environmental risk. And as, again, we get better information about how climate impacts are manifesting—in not just first-order but second- and third-order relationships and impacts as it begins to diffuse within a risk in sub-systematic or systematic ways—we see innovation in these types of products in how they're being utilized in the market. And so, there is innovation there. I think when you look at commodities, food, supply chain—even things like mortgages—where you have a very close nexus between physical risk and its associated impact on accelerated material degradation or depreciation or asset impairment with physical items and goods, it's probably the most clear way that people can draw these connections.

Let me give you an example of how this can work systematically. We can have droughts that impact the Midwest, in terms of cereals and grains production, that increase the necessity to draw out more groundwater, pump more water—which, by the way, has a huge energy cost and eats into your bottom line at the other end of the equation in terms of primary production. But then you start thinking, "What happens when the Mississippi has too low [levels] of water to bring these goods to market, and you can't have sufficient river traffic?" This works the other way too. When you have too much rain and you can't get seeds to the market in the spring. So, you start thinking about it, not just in terms of, "OK, drought's one thing, but how do we think about logistics? How do we think about supply chain?"

A number of years ago, a forest fire took down one of the largest warehouses for hops, and the impact that that has on beer and beer making in the United States. So, you can start seeing the extent to which climate change has impacted, not just primary production, but networks associated with logistics and production that are wide scale. In this, of course, all is manifested in prices that people pay in foods and other goods. There are a lot of impacts. There are a lot of systematic relationships.

You know, if you are a lender or a regional lender who's investing in these markets, you have a fair amount of concentrated risk. For instance, when you have entire assets that are challenged—that may be an entire book of loans to a certain type of a particular market that's geographically concentrated. That may represent a certain measure of risk in its own right. So, measures of stability and underwriting and credit underwriting in the past, in some sectors, they no longer hold true. That world view of a certain stationarity is upended when we think about the dynamic nature of human-environmental conflict in relationships in the face of climate change.

"Transition risk refers to risks related to the transition to a lower-carbon economy, such as risks to the value of investments in coal, oil, and gas, or risks to industries that rely heavily on fossil fuels."

The impact of changing consumer preferences

Brad: And what about the transition risk, so, the effects of a shift toward a net-zero system?

Dr. Keenan: Yeah. Well, let me tell you this. Think about what's going on right now with Boeing. Boeing is really foreseeing a decline in production of aircraft, and this is really the convergence of three risks, right?

It's the convergence of technological risk in how they coded out the 737 Max. So that's a technological risk.

"Technological risk refers to risks caused by the emergence of new technologies that displace older ones and disrupt existing systems. For example, manufacturers of CD players faced technological risk during the emergence of online music streaming."

There's a pandemic risk, which is more or less a natural hazards peril. You can associate that in the environmental terms of a pandemic, also human-caused in a way, managed or mismanaged. So that's impacting air travel.

Then you also have a climate risk with air travel, in the sense that you have change in consumer preferences. People are more cognizant of the carbon footprint of travel. And so that doesn't just impact airlines, particularly when they are being impacted by these other hazards and economic impacts. It impacts things like Boeing, and, of course, Boeing has thousands of contractors, subcontractors, and suppliers throughout the United States and the world that are engaged and very reliant on that flow of capital and production.

So, here we are with such a massive impact in a particular sector. In fact, it's so large, it's shaping our imbalance of trade. That's one example of changing consumer preferences being amplified—or amplifying, rather—the risks and effects from other types of hazards and perils. And that confluence is quite real.

"Market risk from climate change is caused by changes in supply and demand for products and services due to climate change itself or due to efforts to mitigate climate change."

When you look at this—and think about it—you can pick just about any sector, and you can think about how changing consumer preferences are impacting pricing both in positive and negative ways. That's going to drive not just transitional risk, but it's also going to drive opportunities. It's worth reflecting that, a lot of times, we contextualize risk as the sort of primary orientation, and that is uncertainty because risk is probabilistic. But if we often think about the negative consequences of climate, we also have to recognize the positive opportunistic aspects of climate change, where we have an opportunity to get it right—to think in more sustainable—and perhaps you could argue less impactful—terms, or more impactful perhaps if it's social impact. In many ways, we have to diversify our orientation of risk and really understand that there are opportunistic elements here, and that, indeed, transition risk is a way to begin to see both sides of that same coin.

Controlling sub-systemic shocks

Brad: Another issue, another risk that was highlighted in the report was what you call sub-systemic shocks. I'm wondering if you could explain what that means, and which kinds of sectors or communities might be most affected.

Dr. Keenan: Sure. So systematic shocks reflect something that, in many ways, has many different attributes of being arguably controllable—or lacking in its ability to control, or diffuse, or to even fully understand or measure. It reverberates and diffuses risk in ways that are in many ways difficult to understand and to have intelligence around.

And so, we think about things like the October 2008 systematic reverberations associated with credit among global financiers and banking and investment entities. We think of that as reaching a penultimate point of a shock, a moment of credit freeze and squeeze at the same time.

But when you're also thinking about climate change, you have to recognize that there are both spatial and geographic orientations as well as non-spatial orientations to the concentration of capital. A lot of times, we think in terms of global capitalism—that it's non-spatial, right? Obviously, most money and value particularly in things like derivatives are external to any spatial or geographic orientation but for perhaps where people's country of tax election may be. Nonetheless, there's a flip side of that.

And because we generally think of money and financial systems in non-spatial terms, there's also a spatial dimension to it—which is that there are concentrations regionally of capital and at-risk capital that represent sub-systematic risk in the sense that there are, for instance, coastal housing markets and, let's say, regional to local lenders who have mortgages on the books—mortgages or assets that they haven't passed on to the secondary market. It may not just be mortgages. It may also be lines of credit and other debt and investment products in local economies that are at risk from greater inundation events—rain and precipitation inundation events as well sea-level rise—any number of coastal hazards. All of that is going to challenge and impair those assets, and that leads to a certain concentration of risk that indeed may be regional.

But it may be sub-systematic in the sense that it also influences or has impact on, let's say, a scenario where there may have to be greater capital reserves to account for this level of impairment or potential impairment. And that has an impact on reducing capital availability for things like small businesses or manufacturing or other allied components of the economy that are reliant on access to more local or regional sources of capital. So that may not be widely diffused in terms of global capitalism and undermining systematic or globally systematic markets, but it may be sub-systematic to the extent that there is a more resolute, more localized—if not regional—orientation of that concentration of risk.

Building a case for standardization

Brad: OK. That makes sense. So then in terms of financial regulators and financial institutions, what are some of the steps that they should be thinking about taking now to prepare for these risks?

"Legal risk in the context of climate change refers to risks such as litigation for insufficient disclosure of financial risks to investors, or for the failure of organizations to mitigate or adapt to climate change."

Dr. Keenan: Well, regulators are caught in negotiating a very difficult world where the market is increasingly demanding greater action, and greater consistency, and greater recognition of the scale and the scope of the problem. Technology is emergent, but it's not fully there. In many ways, one of the greatest measures of momentum that we have in terms of global financial economies addressing climate change is the translation of measurement science, as well as the management side of this into modes of disclosure that create measures of disclosure and public access and transparency, but also reflects a certain protection of proprietary nature of that information.

And it leads to this question of materiality. What is the material nature of what we need to disclose? And that question is a difficult question that varies by sector, it varies by asset, and it's really at the heart of where we are in terms of thinking about disclosure. But disclosure among other avenues of opportunity and momentum is really critically important because it's at that moment that regulators have something tangible or empirical from which they can base future regulatory ambitions on.

"The question is a bit of a chicken and egg: What comes first, the information about physical and transition risks or does the regulation happen?"
Dr. Keenan

So, the question is a bit of a chicken and egg: What comes first, the information about physical and transition risks or does the regulation happen?

What we call for in a way is greater collaboration between sectors to begin standardizing in standard development that begins to give greater recognition or greater definition and resolution to some really core concepts associated with physical and transition risk, climate risk writ large, as well as basic ideas of sustainability.

What does it mean to invest in sustainability? At what point does an asset cross a threshold Scope 1, 2—and now with greater dialogues, now with Scope 3 emissions? At what point do you cross that threshold and something becomes ostensibly green, right? How do we set those benchmarks? All of this requires a greater dialogue leading towards standardization.

Now, you can move too quickly in terms of standardization, and that can represent its own type of political and transition risk in its own right. But we have to begin that process, and regulators really have to lead by example, of course, but lead in terms of driving that home. And that's an opportunity for the National Academy of Sciences, that's an opportunity for investment banks, global financiers, stakeholders in the financial markets, clearinghouses, being led together with a consortium of particularly U.S. financial regulators so that we can advance this standardization.

But it has to happen in parallel with disclosure, among other things, so that we can have an empirical foundation and a factual basis from which we can rest regulation—or calibrate or advance new regulations. And that's a little bit tricky, right? Because at what point in time do we have a measure of precautionary principle applied to our regulation?

Historically, in the United States, our regulation goes in the other direction. It's not really based on precautionary principles. It's based on science and facts. But there's going to be a lag between climate measurement and the science and how it impacts financial markets. So at what point in time do we shift gears in our global mindset about financial regulation to impose a precautionary set of principles from which we can create some room there—a margin of safety, if you will—to addressing climate risk. There's a lot happening. There's a lot of momentum. But those are the sort of two principled areas of standards development and disclosure that are going to converge in a very productive way.

A private sector ready to lead

Brad: And what are some of the barriers? What are some of the factors that are standing in the way of financial institutions' ability to measure and manage their climate-related financial risks?

Dr. Keenan: Well, one component of this is internal communications and education—and this is a human-capital problem—across the various sectors and participants and regulatory entities and agencies. We just don't have a great recognition of the value or a great recognition of understanding science in very broad terms. We need better education about what is climate change science—how climate change impacts the world that also interacts with other aspects of global change, change in technology, labor force, artificial intelligence, biodiversity loss, inequality. How do these things interact in a rate of change that's hard to keep up with? And, I think, that requires greater education in terms of what is sustainability, what is climate resilience or engineering resilience, disaster resilience, ecological resilience? What is transformative adaptation?

These words and these concepts that people throw around haphazardly actually have precise meaning and precise analytical modes from which we can have more informed decision-making, yet many people are still operating in largely rhetorical terms. So, we need an investment in human capital. We need investment in people to be educated and to have an ongoing dialogue about where science and applied science and social science can help inform decision-making.

"But at the end of the day, we also have to acknowledge that science isn't going to make the decisions for us."
Dr. Keenan

But at the end of the day, we also have to acknowledge that science isn't going to make the decisions for us. Much of what we need to make going forward is laden with judgment and is centered on judgment, and it's ultimately centered on leadership. So, more than anything, what we need is true leadership that balances empiricism, precautionary principles, and a well-informed consensus of industry in the private sector to really lead this and push this forward. And that's what we sorely lack now is leadership on many fronts, but that is certainly a major impediment.

Now, there are certain sectors that may be inclined to impede this progress of what needs to happen, more or less, because of their own transitional risk, their own stranded assets, their own inability to perhaps participate—or even be economically viable—as we transition to a net-zero economy. And they will throw up their own screens of information and misinformation.

"Reputation risk refers to the potential impact of customers’ (and potential customers’) perceptions of a company based on its actions or views with respect to climate change."

Let's not forget that we—at least in the United States and much of the West—are in the middle of a hybrid warfare with Russia, and that climate change is very much part of the war of misinformation. There are millions of bots out there producing misinformation about climate change that indeed shapes public opinion and public perception about what the problems and solutions are. Why would Russia as a nation-state want us, not only fight the hybrid warfare but do so in terms of climate change? They're a major oil producer, right? They have their own vested national security and economic interest in thwarting consensus in global momentum in climate change. So, we really have to think at the level of people and human dimensions of this, the leadership dimensions of this.

"The private sector is largely mobilized in favor of greater certainty and greater political momentum to push this forward,"
Dr. Keenan

I think what we can acknowledge now—and what the CFTC work represents—is that the private sector is ready to go. The private sector is largely mobilized in favor of greater certainty and greater political momentum to push this forward, and that that's critically important where we are now in the current election season [2020]. It also resonates on a global sphere of national security and competitiveness as we face a new and changing world.

Positive momentum heading to a net-zero future

Brad: Are there efforts underway or being planned to implement some of those recommendations? What are the next steps from here?

Dr. Keenan: Well, I'm going to limit this commentary primarily in an entirely domestic sense and really put the onus on Congress here. What you see is that much of this work runs parallel to the ambitions and the thinking, particularly in the Senate, of a number of bills and an ongoing conversation on the Hill, about how the regulatory realm can be calibrated and shifted to address climate risk and, frankly, climate opportunity.

I think it's also part of the fiscal stimulus dialogue, probably not to the extent that one would argue it could or should be—especially when you compare fiscal stimulus in the EU, in the ECB, and elsewhere—and the extent to which they are making really large investments in sustainability. I think, in the United States, that would entirely make sense particularly when you're talking about mobilizing a workforce and a labor force and having them engaged in the process of making these investments. I mean, just take buildings alone, and the impact that we can have on weatherizing and advancing retrofits of buildings for greater energy efficiency.

The PV [photovoltaic] workforce now is many times the size of the coal workforce. What would it mean if we had an investment in housing and sustainable and energy-efficient housing? We could mobilize a very large workforce and train and develop skills and education. So, that's part of it, but probably not where we need to be. But nonetheless, sustainable investment and mobilizing that for a net-zero transition allied with matters of fiscal policy are critically important.

Within the agencies themselves, there is greater recognition of what needs to happen. Many advisory groups and internal dialogues have been churning in the same direction—particularly at the Federal Reserve, which, I think, has been scoping this issue for a number of years and has really come to an understanding, or a greater understanding, of the scope of the problem as well as the potential solutions.

That's probably true in the OCC, in the treasury department, and in many other areas of the government. So, you know, it's going to take years to not just scope the problem but to train people, to educate people to think and begin to see climate impacts as they are diffused systematically, or you could argue sub-systematically. It takes time. And we're at such a nascent stage of the acceleration of climate and climate impact that it's going to take a number of years for this to really hit home.

But we're heading in the right direction. I actually feel quite optimistic that we have the people in place and that we have enough momentum because—in many ways—if there's one thing that is sort of unique to the American model of regulation, it’s that industry can drive and can self-define some measure of its own regulation or a regulatory sphere that works for some but maybe not for all.

And when we think about the context of inequality and other challenges that we face, there's a recognition that public and private stakeholders have to work together if anything to build the political momentum, not for self-regulation but for more finite public regulations that is going to help steer markets.

Let me put this another way in more plain-spoken terms: The SEC comes out and says that we need to have all climate-change impacts or material or whatever, and publicly traded companies that fall under the SEC's jurisdiction start disclosing climate impacts or whatever. But that's already happening on some measure. There's already measures of accountability that the markets are imposing on themselves. Now is it complete? Is it as thorough as it needs to be? Absolutely not. And it's not to mean that that's a substitute for regulation. I don't mean that at all. But I guess where I feel optimistic is that the markets are already beginning to impose this discipline on themselves, and I think that that's a necessary step because it's going to give the regulators the tools to take it to the next step. And that's what we can feel optimistic about.

Brad: Thanks again to Jesse Keenan for talking with us for this podcast. If you're interested in climate risk and would like to learn more, please subscribe to the podcast. You can follow along as we explore this topic in more depth.

Meet the author
  1. Brad Hurley, Senior Communications Consultant, Climate Change + ICF Climate Center Senior Fellow

    Brad is an expert in writing, editing, and public communications on climate change and related topics and has more than 30 years’ experience. View bio