Playing the Long Game: The Intersection of Climate Change Risk and Financial Regulation
Nov. 5, 2020
Keynote Remarks at PLI’s 52nd Annual Institute on Securities Regulation
Thank you, Keith [Higgins] for that kind introduction and for the invitation to be here today. I’m grateful for the opportunity to speak with you all virtually and I look forward to the time when we can meet again in person.
We are all growing accustomed to virtual meetings, and they have certainly brought moments of grace and humor into the workplace. We’ve watched toddlers and dogs steal the show during staid business meetings. We’ve had glimpses into one another’s homes, and carried on serious discussions in our sweatpants. Many of us watched with awe and deep appreciation as a Commissioner at the FTC testified virtually before a Senate committee while breastfeeding her newborn infant. These moments have driven home that we share so much more than work with our colleagues. We share personal struggles and triumphs and, in many cases, we appreciate and understand one another better as a result.
Still, I know I’m not alone in missing the simple luxury of in-person meetings, of running into colleagues in the hall, of impromptu coffee breaks with work friends, of planning for the holidays without worry about whether it’s safe to gather with family and friends, or responsible to travel.
I don’t think we could have imagined just a few short months ago living through a global crisis that would so dramatically change our way of life. And yet the prospect of a pandemic was out there, something we knew could wreak havoc, something that many governments did in fact plan for. It was something we understood intellectually to be a serious risk. But it was broadly something for someone else to worry about. And it wasn’t, at least for me, a risk I could really imagine affecting my day-to-day life. That has certainly changed.
Many of us now know what crisis feels like, not antiseptically through our TVs or phones, but firsthand as it unfolds in our homes, families, schools, and workplaces – not to mention in our economy. Seemingly theoretical risks have become very real.
One real risk looms even larger than the pandemic and could have even more grave human and economic costs than those we have witnessed these last eight months. That risk arises from climate change. A lesson we can take from the humbling experience of this pandemic is not to wait in the face of a known threat. We should not wait for climate change to make its way from scientific journals, economic models, and news coverage of climate events directly into our daily lives, and those of our children and theirs. We can come together now to focus on solutions.
That is what I’d like to talk to you about today – solutions related to climate change risk, or at least steps along that path. The science tells us that the need to act is urgent. A 2018 study by scientists in the U.K. and the Netherlands estimates that the so-called “point of no return” for achieving the Paris Accord’s two degrees Celsius goal by 2100 may arrive as soon as 2035.
Of course, financial regulators like the SEC are not at the forefront of substantive policymaking to address climate change. We don’t set emissions standards, implement carbon pricing, or otherwise shape energy or environmental policy.
So what is our role and our obligation? At the SEC, we protect investors, facilitate capital formation, and maintain fair, orderly and efficient markets. There are numerous ways in which the risks and opportunities arising from climate change intersect with our financial markets and those three pillars of oversight.
Broadly, we must ensure that we work with fellow regulators to understand and, where appropriate, address systemic risks to our economy posed by climate change. To assess systemic risk, we need complete, accurate, and reliable information about those risks. That starts with public company disclosure and financial firm reporting, and extends into our oversight of various fiduciaries and others. Investors also need this information so they can protect their investments and drive capital toward meeting their goals of a sustainable economy.
In addition to disclosure, we should consider our regulatory mission more broadly, including our oversight of funds and their advisers, credit rating agencies, and accounting standards. Today, I would like to consider the SEC’s mandate broadly through the lens of climate and other ESG risks and opportunities.
Climate Risk as Systemic Financial Risk
There is a growing consensus that climate change may present a systemic risk to financial markets. This assessment is shared by, for example, the Network for Greening the Financial System, the Bank for International Settlements, the Task Force on Climate-Related Financial Disclosure (TCFD), and the Market Risk Advisory Committee to the Commodity Futures Trading Commission, to name a few.
Let’s drill down a bit on why that is the case. There is no universally accepted definition of systemic risk, but, broadly, it is characterized by the following features: (1) “shock amplification” or the notion that a given shock to the financial system may be magnified by certain forces and propagate widely throughout; (2) that propagation causes an impairment to all or major parts of the financial system; and (3) that impairment in turn causes spillover affects to the real economy.
Climate change risk has the potential to trigger this chain of events. Systemic shocks are more likely when assets prices don’t fully incorporate the relevant risks – in this case physical risk, transition risk, and potentially a third type of risk referred to as liability risk. There is certainly evidence that climate risks are currently underpriced, particularly with respect to long-dated assets, utilities, commercial mortgage-backed securities, and potentially municipal bonds, among others. Underpricing can lead to abrupt and disruptive re-pricing as markets discover the anomalies. This reckoning could be triggered by massive climate-related events or significant changes in legal requirements that can render assets and even business models obsolete in a very short timeframe.
These risks and shocks can spread throughout the financial system in certain expected ways. For example, if, or more likely when, insurers pull back from or reprice insurance on certain types of real estate (think coastline properties), that will affect mortgage lending and other real-estate exposures in the banking sector.
But it can also spread in ways that are less predictable because climate risk is unique in terms of its scope, breadth, and complexity. Researchers at the Bank for International Settlements have identified climate risk as a type of systemic risk that represents “a colossal and potentially irreversible risk of staggering complexity,” something it calls a “green swan” event, different from its better known counterpart a “black swan” event in significant ways. Most notably different in its complexity, in that climate change risk represents a “new type of systemic risk that involves interacting, nonlinear, fundamentally unpredictable, environmental, social, economic and geopolitical dynamics.”
In other words, climate-related risks don’t operate in isolation. They interact with each other – meaning physical and transition risks interact with each other in ways that compound their joint effects, and climate-related risks interact with non-climate related risks and vulnerabilities. These vulnerabilities include, for example, historically high levels of corporate leverage, and the effects of the COVID-19 pandemic which has depleted household wealth and bank balance sheets, and created more debt. Climate related shocks could further magnify these vulnerabilities.
And finally, as mentioned, climate change, unlike other types of risk, is potentially irreversible in terms of the damage it can cause. All of these factors increase the likelihood of an overall shock to the global economy with systemic implications. This creates an imperative for the SEC to focus on climate risk as systemic risk, and coordinate with domestic regulators through the Financial Stability Oversight Council, and with international regulators through the Financial Stability Board’s Standing Committee on Assessment of Vulnerabilities, to monitor and address this risk.
Standardized Disclosures by Financial Institutions
Where to start? Data. All policy should proceed from a foundation and clear-eyed analysis of accurate, reliable data. Policy makers need it and, importantly, those steering the capital that drives our economy need it. That need is borne out by the extraordinary demand we see in markets today for climate-related disclosure. And the demand is not limited to climate, but also includes demand for ESG-related information more broadly. There is really no historical precedent for the magnitude of the shift in investor focus that we’ve witnessed over the last decade toward the analysis and use of climate and other ESG risks and impacts in investment decision-making.
What started out many years ago as so-called “impact” investing, that is investing specifically for the purpose of supporting positive outcomes on particular environmental, social or governance goals, has grown. Today, in addition to impact investing, ESG risks and metrics are used to support a number of sustainable investment strategies, such as inclusionary and exclusionary strategies. But, significantly, ESG risks and metrics now often underpin traditional investment analyses designed to maximize risk-adjusted returns on investments of all types. They represent a core risk management strategy for portfolio construction.
Indeed investors, asset managers responsible for trillions in investments, issuers, lenders, credit rating agencies, analysts, index providers, stock exchanges and other financial market participants have embraced sustainability factors and metrics as significant drivers in decision-making, capital allocation, pricing and value assessments. The bottom line is that businesses now actively compete for capital based on ESG performance, and that competition needs to be open, fair, and transparent.
This requires uniform, consistent, and reliable disclosure. I’ve spoken before about the need for this disclosure from public companies. As I’ve mentioned in several contexts, that is an effort that has progressed a fair amount through private ordering, but now needs some level of regulatory involvement to bring consensus, standardization, comparability, and reliability. I won’t rehash that discussion today, but invite all who are interested to reach out and lend your thoughts and expertise in this area. Today I want to highlight the need for disclosure by those who finance issuers that is sufficient to reflect the real risks and opportunities presented. Consider the role of banks in financing carbon-producing activities. One study, painstakingly assembled through various sources, suggests that since 2016 alone, 35 global banks have invested more than $2.7 trillion into the fossil fuel sector. The non-bank financial sector also plays a significant role in financing fossil fuels.
Conversely, banks and other financial institutions also hold the keys to climate solutions and the shift toward a lower carbon economy. This is a heavy lift. For example, the International Energy Agency estimates that globally it could take $3.5 trillion in energy sector investments alone every year through 2050 to reorient toward a climate-neutral economy.
The SEC should work with market participants toward a disclosure regime specifically tailored to ensure that financial institutions produce standardized, comparable, and reliable disclosure of their exposure to climate risks, including not just direct, but also indirect, greenhouse gas emissions associated with the financing they provide, referred to as Scope 3 emissions. There is a concentration of risk in the financial sector that is not readily ascertainable except through Scope 3 emission disclosures. I’m encouraged to see that at least one major U.S. bank has now joined its international counterparts in voluntarily committing to Scope 3 emissions disclosures. Again, however, some level of regulatory involvement is needed to achieve standardized, comparable, and reliable disclosure in this critical area.
There will be challenges in implementing the appropriate regulatory action as it relates to standardized disclosures. But that cannot deter us from our work. I have tremendous confidence in the staff of the SEC to tackle this challenge. And it’s critically important that we provide them with the resources they need. To that end, we need to ensure we are cultivating relevant expertise, both by hiring climate and sustainability experts in various roles and by enhancing training opportunities for staff. If we provide staff with the resources they need, and we bring diverse voices to the table, I have no doubt we will succeed.
Beyond Standardized Disclosures
Beyond disclosure from companies and those who finance them, I want to touch on just a few additional areas that merit the SEC’s attention with respect to climate and other ESG factors. These include funds and their advisers, credit rating agencies, and financial accounting.
Funds and their Advisers
There has been considerable attention focused on what it means for a mutual fund or other investment company sponsor to market funds as “green,” sustainable, or ESG-focused. Disclosure in this area is key, and funds and their advisers must be clear about what they mean when they use these or similar terms to describe a fund’s principal strategies or risks. They should also be clear as to how they ensure that the fund’s strategy is consistent with that disclosure. Standardized disclosure from issuers on ESG matters would facilitate clearer and more consistent disclosure from funds. If issuers are uniform in the information they provide, funds and their advisers could more easily and directly disclose how they use that information to inform their investment choices.
Beyond this, however, the SEC might also consider rules that would require advisers to maintain and implement policies and procedures governing their approach to ESG investment. There is precedent for separately requiring policies and procedures around a specific topic of particular importance. Take, for example, the requirement for policies and procedures governing the protection of material non-public information. Should we consider policies and procedures related to climate or ESG investing? Such policies and procedures might include how an adviser will assess and implement a client’s ESG preferences, including with respect to asset selection and in the exercise of shareholder voting rights.
Credit Rating Agencies
Many credit rating agencies incorporate climate and other ESG factors into their ratings. Should the SEC consider encouraging increased transparency regarding specifically how these factors are weighed? And should our annual examinations of credit rating agencies assess both the transparency of these models and the consistency and accuracy with which they are applied?
Mapping to GAAP
Finally, I note that the International Accounting Standards Board recently issued guidance addressing how existing requirements under the International Financial Reporting Standards intersect with climate-related risks, and discussing the ways in which climate-related risks may need to be reflected within financial statements. They include, for example, asset impairment, changes in the useful life of assets, changes in fair valuation of assets, changes in contingent liabilities and changes in expected credit losses. Should FASB undertake a similar analysis of how climate risks may translate when applying GAAP?
I pose these as questions to illustrate just some of the areas that warrant the SEC’s attention as we do our part in addressing the exigencies presented by climate change. This is an all-hands on deck effort. We need to solicit engagement from all market participants, leverage the work that has already been done by TCFD and others, and move forward with considered, informed rule-making and other initiatives in this space.
We have all recently witnessed in real time the market consequences of waiting until a crisis is upon us to respond. We need not suffer those consequences when it comes to climate change and ESG if we move thoughtfully and quickly. I encourage you and your clients to help us in this critical endeavor, and let me emphasize that we need everyone at the table for this work. All input is welcome, but I especially value hearing from those of you who disagree with these ideas or see them differently. These are complex issues, and we reach the best results by engaging in constructive dialogue across a wide range of perspectives. Thank you again for the invitation to speak with you today; it’s been a pleasure.
 The views I express today are my own and do not represent those of my fellow Commissioners or the staff.
 See U.S. Senate Committee on Commerce, Science and Transportation, Oversight of the Federal Trade Commission, Hearing (Aug. 5, 2020), https://www.commerce.senate.gov/2020/8/oversight-of-the-federal-trade-commission.
 See Matthias Aengenheyster, Qing Yi Feng, Frederick van der Ploeg, and Henk A. Dijkstra, The point of no return for climate action: effects of climate uncertainty and risk tolerance, Earth System Dynamics (Aug. 30, 2018), https://esd.copernicus.org/articles/9/1085/2018/.
 See Network for Greening the Financial System, The Macroeconomic and Financial Stability Impacts of Climate Change (June 2020) (“More frequent or severe extreme weather events and/or a late and abrupt transition to a low-carbon economy could have significant impacts on the financial system, with potential systemic consequences.”).
 See Patrick Bolton, Morgan Despres, Luiz Awazu Pereira da Silva, Frédéric Samama, and Romain Svartzman, Bank for International Settlements, The green swan: Central banking and financial stability in the age of climate change (Jan. 2020) (BIS Report) (providing that climate risk is “is a new type of systemic risk that involves interacting, nonlinear, fundamentally unpredictable, environmental, social, economic and geopolitical dynamics, which are irreversibly transformed by the growing concentration of greenhouse gases in the atmosphere”).
 See Recommendations of the Task Force on Climate-related Financial Disclosures, Final Report (June 2017) (“[W]arming of the planet caused by greenhouse gas emissions poses serious risks to the global economy and will have an impact across many economic sectors.”).
 See Managing Climate Risk in the U.S. Financial System, Report of the Climate-Related Market Risk Subcommittee, Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission (Sept. 9, 2020) (CFTC MRAC Report) (“A central finding of this report is that climate change could pose systemic risks to the U.S. financial system.”).
 See CFTC MRAC Report, supra note 7, at 26.
 See Bank of England, Climate change: what are the risks to financial stability?, https://www.bankofengland.co.uk/knowledgebank/climate-change-what-are-the-risks-to-financial-stability (describing the physical, transition, and liability risks to the financial system posed by climate change).
 See BlackRock, Getting physical: Scenario analysis for assessing climate-related risks (Apr. 2019), https://www.blackrock.com/us/individual/literature/whitepaper/bii-physical-climate-risks-april-2019.pdf (discussing the risks of extreme weather events to the creditworthiness of state and local issuers in the municipal bond market, risks of hurricane and flooding to the commercial real estate market, and risks of aging infrastructure in conjunction with hurricanes and wildfires to the electric utility sector).
 See BIS Report, supra note 5.
 See id.
 See Graham Steele, A Regulatory Greenlight: How Dodd-Frank Can Address Wall Street’s Role in the Climate Crisis (Jan. 2020) (“The interplay between physical and transition risks has a mutually reinforcing dynamic. The more that financial institutions invest in fossil fuels, the more climate change that they cause, leading to more potential and actual damage to their investments. At the same time, financial institutions’ continued investment in fossil fuel and deforestation-related assets makes the transition to a clean-energy economy more difficult.”); Andy Green, Gregg Gelzinis, and Alexandra Thornton, Center for American Progress, Financial Markets and Regulators Are Still in the Dark on Climate Change (June 29, 2020) (“The pandemic has laid bare the lack of financial security across households and small businesses—a challenge that could be even greater in a climate event in which physical property is destroyed along with the interruption in commerce. Banks, in turn, could see increasing default rates and new lending business negatively affected as well. Meanwhile, investment and pension funds could experience catastrophic asset valuation losses affecting the financial security of millions of current and future retirees.”).
 See BIS Report, supra note 5, at 1 (“Exceeding climate tipping points could lead to catastrophic and irreversible impacts that would make quantifying financial damages impossible.”).
 See, e.g., Climate Action 100+, an investor initiative with 375 signatories representing over $35 trillion in assets under management seeking improved climate performance and transparent disclosure from the world’s largest greenhouse gas emitters. See also State Street Global Advisors, The ESG Data Challenge (Mar. 2019) (“Asset owners and their investment managers seek solutions to the challenges posed by a lack of consistent, comparable, and material information. Investors increasingly view material ESG factors as being critical drivers of a company’s ability to generate sustainable long-term performance. In turn, ESG data has increasing importance for investors’ ability to allocate capital most effectively.”); Letter from Larry Fink, Chairman & CEO, BlackRock to CEOs (Jan. 14, 2020) (“Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk. Indeed, climate change is almost invariably the top issue that clients around the world raise with BlackRock . . . They are seeking to understand both the physical risks associated with climate change as well as the ways that climate policy will impact prices, costs, and demand across the entire economy. These questions are driving a profound reassessment of risk and asset values.”); Letter from Cynthia A. Williams and Jill E. Fisch (Oct. 1, 2018) (enclosing a petition for rulemaking to the SEC on standardized disclosure related to environmental, social, and governance (ESG) issues, including climate disclosure, signed by investors and organizations representing more than $5 trillion in assets under management).
 See, e.g., Bank of America/Merrill Lynch, Equity Strategy Focus Point, ESG Part II: a deeper dive (June 15, 2017), https://www.iccr.org/sites/default/files/page_attachments/esg_part_2_deeper_dive_bof_of_a_june_2017.pdf (“Prior to our work on ESG, we found scant evidence of fundamental measures reliably predicting earnings quality. If anything, high quality stocks based on measures like Return on Equity (ROE) or earnings stability tended to deteriorate in quality, and low quality stocks tended to improve just on the principle of mean reversion. But ESG appears to isolate non-fundamental attributes that have real earnings impact: these attributes have been a better signal of future earnings volatility than any other measure we have found.”); see also Mozaffar Khan et al., Corporate Sustainability: First Evidence on Materiality, 91 The Accounting Review 1697 (2018) (“Using both calendar-time portfolio stock return regressions and firm-level panel regressions we find that firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues.”); Gunnar Friede, Timo Busch & Alexander Bassen, ESG and financial performance: aggregated evidence from more than 2000 empirical studies, 5-4 Journal of Sustainable Finance an Investment 210 (2015) (finding that a majority of studies show positive correlations between ESG and financial performance); Robert G. Eccles, Ioannis Ioannou, and George Serafeim, The Impact of Corporate Sustainability on Organizational Processes and Performance, 60-11 Management Science 2835 (2014) (“[W]e provide evidence that High Sustainability companies significantly outperform their counterparts over the long-term, both in terms of stock market and accounting performance.).
 See Commissioner Allison Herren Lee, “Modernizing” Regulation S-K: Ignoring the Elephant in the Room (Jan. 30, 2020), https://www.sec.gov/news/public-statement/lee-mda-2020-01-30; Commissioner Allison Herren Lee, Regulation S-K and ESG Disclosures: An Unsustainable Silence (Aug. 26, 2020), https://www.sec.gov/news/public-statement/lee-regulation-s-k-2020-08-26; Allison Herren Lee, Big Business’s Undisclosed Climate Crisis Plans (Sept. 27, 2020), https://www.nytimes.com/2020/09/27/opinion/climate-change-uscompanies.html?searchResultPosition=1.
 Rainforest Action Network, Banking on Climate Change: Fossil Fuel Finance Report 2020 (Mar. 18, 2020), https://www.ran.org/wp-content/uploads/2020/03/Banking_on_Climate_Change__2020_vF.pdf.
 See Patrick Greenfield, World's top three asset managers oversee $300bn fossil fuel investments, The Guardian (Oct 12, 2019).
 See International Energy Agency, Deep energy transformation needed by 2050 to limit rise in global temperature (Mar. 20, 2017), https://www.iea.org/news/deep-energy-transformation-needed-by-2050-to-limit-rise-in-global-temperature.
 See Morgan Stanley, “Morgan Stanley Joins Leadership of Global Carbon Accounting Partnership” (July 20, 2020), https://www.morganstanley.com/press-releases/morgan-stanley-joins-leadership-of-global-carbon-accounting-part.
 See 15 U.S. Code §?80b–4a
 See, e.g., Moody’s Investor Services, “Moody's - ESG risks material in 33% of Moody’s 2019 private-sector issuer rating actions” (Apr. 14, 2020), https://your.fitch.group/rs/732-CKH-767/images/Fitch%20Ratings%20-%20ESG%20In%20Credit%202020.pdf?mkt_tok=eyJpIjoiT0dJd09UVTBNbVV3TXpObCIsInQiOiJCNlBlaFdaYjg4M1hTRzVQZHFyRmZiRzE4a1JibW9VdVwveHE4SWpHNWQ2YzJEVU1BdWEzdmdxR1wvUkhMOWhkT1dpYXJzbkVJenJpTVNFKytLOVh1cHljMGFUYjg1Wmp5a0dVamFrOWxjT0xYWTd0RDlFUUdvS3Z3Zmxhck5TVHJlUndSK21TSXpQczVRbmIyZ21xTVM3QT09In0%3D; Peter Kernan, S&P Global Services, “The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis (Sept. 12, 2019), https://www.spglobal.com/ratings/en/research/articles/190912-the-role-of-environmental-social-and-governance-credit-factors-in-our-ratings-analysis-11135920#:~:text=S%26P%20Global%20Ratings%20incorporates%20environmental,rating%20outlooks%2C%20and%20ratings%20headroom.
 See Ceres, Addressing Climate as Systemic Risk: A Call to Action for U.S. Financial Regulators, 23 (June 1, 2020), https://www.ceres.org/resources/reports/addressing-climate-systemic-risk (calling for SEC guidance encouraging credit rating agencies to disclose more about how climate factors into ratings and recommending the SEC examine for the same); see also European Securities and Market Authority, Final Report: Guidelines on Disclosure Requirements Applicable to Credit Rating Agencies, (July 18, 2019), https://www.esma.europa.eu/document/final-report-guidelines-disclosure-requirements-applicable-credit-rating-agencies.
 See Nick Anderson, IFRS® Standards and climate-related disclosures (Nov. 2019), https://cdn.ifrs.org/-/media/feature/news/2019/november/in-brief-climate-change-nick-anderson.pdf?la=en.