Why the FSOC’s Climate-Related Financial Risk Report Doesn’t Go Far Enough
Remember how the whole world mobilized to find a vaccine to COVID-19 just to get the economy running again during a global pandemic? We need to bring that kind of energy to the issue of climate risk, which is potentially a much bigger source of financial turbulence well underway.
The U.S. Financial Stability Oversight Council (FSOC) purportedly hopes to solve the financial risk of climate change by updating the systems in place for measuring and disclosing these risks. While I admire the use of a risk framework for analyzing climate change, the recommendations in the report don’t go far enough, fast enough. When your house is burning, is it a risk or an emergency?
Is assessing climate risk going to help us take climate action?
On October 21, the FSOC declared Climate Risk a threat to U.S. financial stability for the first time ever in its report on Climate-Related Financial Risk. One reason for the FSOC report (beyond the immediate direct impacts of climate change) is there is a significant risk of insurance becoming unaffordable or unavailable for homeowners and businesses to protect themselves from direct climate-related impacts — like Hurricane Ida or the western wildfires. This could leave entire communities in certain regions vulnerable to disasters and unable to recoup their losses, which could collapse the economy.
The FSOC report also highlights the fact that climate impacts fall more heavily on underrepresented and underserved communities. Indeed, 30,000 people in Madagascar face level five famine due to drought, a population responsible for just 0.01 percent of the world’s annual CO2 emissions.
Considering that climate risks are becoming more frequent and intense, the risk of financial collapse could be closer to the near term than we might assume. For the purposes of a climate-related financial risk assessment, financial institutions look at two categories of risk: physical and transitional climate risks.
Physical risks
Physical risks include all of the doomsday scenarios: floods in NY subways, sea level rise swallowing Venice, multi-year droughts transforming agricultural breadbaskets into deserts. Physical risks include both the acute storms and the chronic changes like average temperature rise on the planet. The atmospheric changes underway are intensifying risks like these in ways that are hard to predict, considering the feedback loops between CO2 concentration rise and temperature rise.
Transitional risks
Next, you check the transitional risks, which are the changes to technology, policy, markets, laws, and reputations that need to take place to mitigate climate change. These present financial risks, however, because our current financial system has considered environmental damage “externalities” for too long. Sudden changes, or “shocks”, could completely gridlock the economy as we try to transition as gradually as possible.
However, a gradual transition is increasingly out of the picture. According to the Network for Greening the Financial System (NGFS), an organization of the world’s largest central banks and financial supervisors, given our current policies, the world is on a path towards a 3 degree Celsius warming scenario, which presents the world with grave challenges: migration, famine, severe heat stress, and the potential for sudden climatic changes due to positive feedbacks.
Meanwhile, climate-related financial risks impact the economy in ways that are hard to predict, presenting opportunities, too. In terms of our energy make-up, new technologies should mostly replace fossil fuels, creating entirely new market dynamics across the globe. This is why the FSOC and the TCFD alike have chosen scenario analysis as a tool of assessment.
What scenario analysis does and doesn’t do
Scenario analysis explores contingencies for different likely scenarios linked to policy changes and CO2 representative concentration pathways (RCPs) as a tool for strategic decision-making. Scenario analysis can be completed at the asset level or the sector level, but the important part is its ability to combine historical modeling with physical data for making risk projections. This helps interpret financial risk in a way that represents the unprecedented changes brought by atmospheric warming.
Scenario analysis provides long-term, forward-looking, exploratory climate physical and transitional financial risk modeling. Preparers of scenario analysis often pair objectives like transitioning a facility off of fossil fuels and moving it to an inland location safe from flooding with financial outputs like credit risk or operational risk to translate the climate risks into financial risk.
The problem with scenario analysis is it is very complex, and the FSOC would like to conduct the exercise of using it to assess climate-related financial risk across the entire financial system. To do so, it is calling for all of its policies and mandates to build their capacity, standardize their data, and start disclosing or requiring disclosures from scenario analysis.
The other problem with scenario analysis is it pits transitional risks and physical risks against each other, which could potentially make a no-action business decision look more appealing than taking any action. Indeed, both are costly, but transitional expenses tackle climate change and lead to an inhabitable planet.
Various countries’ central banks have already conducted scenario analyses only to result in outcomes that are difficult to compare. If this is the chosen mechanism to address climate-related financial risk, and it doesn’t lead to swift action, then it serves as a tool of climate denial and delay. This brings us to another point brought up in the FSOC report: the lack of comparable data.
Before scenario analysis comes data
Prior to conducting scenario analysis across an entire economy, you’ll need to gather data. And one thing you may have learned from Statistics 101 is that data needs to be consistent to be comparable. Yet, there’s a lack of reliable data on climate risk, particularly from fossil fuel companies. So far the FSOC hasn’t imposed any requirements for collecting that data, it just provides recommendations.
In fact, the lack of comparable data has been an outstanding issue with environmental, social, and governance reporting since standards began to be developed. One of the first standards was the Global Reporting Initiative, which was established in 2001. Then came a slew of others: the Sustainability Accounting Standards Board (SASB), the Climate Disclosure Standards Board (CDSB), the vague UN Sustainable Development Goals, and others.
Finally, in 2017, the Financial Standards Board created the Task Force on Climate-Related Financial Disclosures, which contains standards being adopted in many required reporting mandates. It looks at climate change from a risk management perspective, and indeed, the FSOC report borrows a lot from its recommendations. However, as an independent organization, it cannot require reporting in certain formats from certain industries, even though investors increasingly request this data. The difference with the FSOC report is that it has the power to require disclosure and reporting, but its report only recommends that its various committees take the next step to develop requirements, but with given no timeline to do so.
Why am I not more hopeful about this?
You’d think climate folks should be happy about this supposed “win” to embracing climate change as a risk impacting the financial system. At last, the language has changed to “risk.” However, without time-bound action, any gesture like this remains a symbolic victory.
Climate change is not a risk, it’s an emergency
Note, however, that the U.S. is still reluctant to call climate change an “emergency.” Perhaps it’s because for the wealthy, it isn’t an emergency. I recently read that the top 10% of wealthy individuals hold 89% of the corporate equities and mutual fund shares in the stock market. Considering the outsized influence they have over the U.S. economy, on the whole, I feel that the FSOC hasn’t gone far enough to protect the interests of everyone else.
The U.K. and Europe already have mandatory reporting requirements for climate risk. The FSOC report only signals the potential for regulations to result from further review, with no set deadline.
We’ve already had the means to collect data for the past 10 years
The FSOC report tries to reassure its naysayers by suggesting that actions are already underway at the SEC to update its requirements. However, when you look at the history of the SEC’s measures to address climate, this isn’t very reassuring at all. The SEC already created guidance on climate-related disclosure in 2010 that basically no one followed, and the SEC didn’t follow up on.
Climate action isn’t too expensive, we’ve already been footing the bill
Then you’ve got the handful of Democratic senators opposing climate policy who continuously say the “price tag is too high.” I strongly disagree, considering we’ve already spent over $2 trillion on direct economic losses from climate change-linked disasters since 1980, according to the NOAA. Even the language that climate risk is “emerging” in this FSOC report is inaccurate. It’s been here for decades already. At this point, we can afford to play catch up to an existing risk that’s expected to get much worse.
People still believe these bills are “too expensive,” when they’ve already been footing the climate risk bill all along with their taxes. It is improper accounting to suggest otherwise. We need more clarity on the costs to us from climate change, not just the expense to fix it. We need more transparency on what savings climate action brings to people across the board: health costs, home ownership costs, reliable weather conditions in which to work, etc.
The self-reporting dilemma
The FSOC report shows the US is still trying to reassure people that self-reporting produces results. However, environmental, social, and governance (ESG) standards have been plagued with inconsistencies and missing data all along. The OECD warns this hides material risks. With the amount of US economic interests invested in maintaining a fossil-fuel-based economy, this report falls short. It will not rein in our fossil fuel-burning economy within the timeline science dictates.
We don’t have time
The International Panel on Climate Change (IPCC) issued a report on 1.5 degrees Celsius warming in 2018 stating the entire world needs to reduce our emissions by half by 2030 and to net-zero by 2050 to have the most gradual transition available for a desirable planet. Let me repeat. This is the most gradual approach we have available to protecting our planet and our grandchildren’s future. With current policies heading towards a 2.7 degree Celsius warming scenario, we’re not transitioning rapidly enough. The FSOC has denied this timeline by failing to include deadlines and requirements in its recent report.
As Mia Motley, the Prime Minister of Barbados, said in her speech at COP26, “Will we act in the interest of our people who are depending on us or will we allow the path of greed and selfishness to sow the seeds of our common destruction? Leaders today, not leaders in 2030 or 2050, must make this choice.”
Erica Eller is a freelance content marketing writer working with climate tech, ESG, and sustainable finance clients.
