Climate &
Systemic Risk

The magnitude, breadth, and complexity of climate impacts stemming from many of these risks are systemic in scale, posing severe threats to the financial sector. Economic shocks originating from a physical or transitional risk can negatively affect asset valuations, household wealth, corporate profits, and economic growth. These impacts are far-reaching and can be transmitted to financial sector firms through loan portfolios, asset holdings, or insurance policies. Certain aggressive climate mitigation or adaptation scenarios may lead to tighter financial conditions, further escalating the associated risks. Particular risks and conditions—such as the abrupt repricing of large classes of assets or the creation of asset bubbles—have an acute potential to disrupt financial market functioning and ultimately financial stability. 

The imperative of managing these economic and financial risks is beginning to drive businesses and financial institutions to adapt operations in support of a net-zero future and develop strategies to mitigate their exposure to climate-related risks. The private sector is demonstrating this commitment through a variety of activities, including committing to net-zero goals, reducing carbon footprints, and disclosing climate risks. Due to the complexity of climate risks and their long-term horizons, however, these voluntary mitigation efforts by the private sector may not sufficiently manage climate risk at the company level. Fiscal, financial, and monetary policy are necessary to help mitigate private-sector exposure to climate-related risks and support the decarbonization of the global economy.

Carbon Pricing: An Economy-Wide Lever That Could Mitigate Climate Risk

Carbon pricing represents a powerful policy mechanism to curb greenhouse gas emissions and facilitate deep decarbonization of the global economy. Carbon pricing involves assigning a monetary value to carbon dioxide and other greenhouse gas emissions, the crux of rising global temperatures. When emissions are not priced, the associated costs are externalized in the form of future climate impacts such as extreme weather events. Carbon pricing ties these emissions and their climate impact back to the emitting source(s) and makes carbon-intensive practices and investments reflect the true costs to society. A strong price signal for carbon could accelerate adoption of more efficient, less emissions-intensive processes and practices and toward low-carbon, climate-resilient alternatives. 

Long an issue of debate, carbon pricing is gaining traction in countries around the world, but implementation remains far from universal. As of 2021, 45 national governments and 35 subnational jurisdictions have implemented a carbon price initiative, which covers less than 22 percent of global greenhouse gas emissions. These carbon-pricing mechanisms generally involve either a carbon tax or an emission trading system (ETS). The two policies are not mutually exclusive and are used in tandem in certain jurisdictions such as Sweden and British Columbia. It is important to note that most carbon-pricing initiatives are sector-specific, only applying to high-emitting sectors such as energy, utilities, and industrials. Global prices for carbon are also not uniform across initiatives and can vary greatly among jurisdictions. For example, carbon prices range from less than $1 per ton in Poland to more than $130 per ton in Sweden.

Despite these efforts, the cost of carbon remains too low to reduce emissions effectively. Prices for carbon emissions currently average about $3 per ton, which is far less than most estimates of its true cost. For instance, although the United States lacks a national carbon-pricing initiative, the country has estimated the cost of carbon at more than $50 per ton using a cost-benefit analysis known as the “social cost of carbon (SCC).” The SCC provides a dollar measure of the economic damages resulting from the emission of one additional ton of carbon dioxide into the atmosphere. The United States first introduced an SCC estimate under the Obama administration in order to guide federal climate regulations, such as fuel economy standards, and to inform investment decisions. A proposed alternative to the social cost of carbon, target-consistent carbon pricing, sets emission prices based on the minimal price level required to reach the Paris climate goals. Unlike the social cost of carbon, target-consistent pricing does not rely on long-term projections, which are uncertain, and instead bases carbon pricing around desired policy outcomes. Using a target-consistent approach, the High-Level Commission on Carbon Prices estimated that carbon pricing would need to be set between $40 and $80 per ton in 2020 and between $50 and $100 per ton by 2030 to align emissions with the standards set in the Paris Agreement. However, only 3.76 percent of emissions are covered by a carbon price above $40 per ton, which is woefully insufficient. 

The failure to appropriately price carbon hinders meaningful progress toward national and global climate goals, which translates into direct risk to the financial sector and global economy writ large. Without strong and methodologically rigorous carbon pricing integrated into commercial models, the private sector will fail to account for the true costs of future commercial operations and face mounting real-world costs from physical, transitional, and liability risks. As countries fall further behind their climate goals, and the effects of climate change become more pronounced, governments could pursue policies to rapidly transition to a low-carbon world to avoid a climate catastrophe. Abrupt policy changes could result in financial shocks if the prices of carbon-intensive assets are rapidly devalued.

Robert Litterman

Founder and Chairman of the Risk Committee at Kepos Capital LP

“We have to put a price on carbon. That’s the fundamental flaw in our risk management: we’re not pricing the risk.”

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The corporate universe is unanimous that we should price carbon. The CFTC subcommittee, which represented all of the major participants in the financial system ranging from banks and insurers and investment managers, asset owners, corporations, including oil companies, insurance companies, data companies, and exchange, academics, NGOs–we had a very diverse group—all agreed. We don't have incentives to reduce emissions. When we don't have incentives to reduce emissions, you can't expect people to reduce emissions. Incentives are so key. What are incentives? They're things that change behavior. So, if you want to change behavior, you're going to change incentives. And in a market economy, that's prices and wages.

In 2020, Dr. Litterman served as the Chairman of the Climate-Related Market Risk Subcommittee of the U.S. Commodity Futures Trading Commission, which produced a report entitled Managing Climate Risk in the U.S. Financial System.

The absence of a robust market price for carbon has led many companies to begin independently placing a monetary value on each ton of carbon emitted through their operations and investments. This process of internally pricing carbon can assist firms in preparing for the imposition of compulsory carbon-pricing schemes and can allow investors to get a clearer picture of firms’ ability to compete in a net-zero world. Internal carbon prices generally take one of two forms: a shadow price or an internal fee. Shadow pricing applies a hypothetical cost to carbon emissions that companies can use to price carbon risk and inform decisions about capital investments. It is the most popular form of internal pricing and has been used by large fossil fuel companies, including BP and Shell. Alternatively, an internal fee, used by companies such as Microsoft, internally charges business units for their emissions. Unlike shadow pricing, internal fees generate revenue that can be channeled toward investments in carbon-reduction efforts. 

Both schemes can serve as vital risk-mitigation tools, particularly for high-emitting firms. As of 2020, more than 2,000 companies worldwide have disclosed their use or planned use of internal carbon pricing to the CDP (a nongovernmental organization that runs the global environmental disclosure system)—an increase of nearly 25 percent from 2019.  Predictably, these internal carbon-pricing initiatives are highly concentrated in sectors that are vulnerable to carbon-pricing transition risks, including fossil fuels, energy, and finance. However, fewer than 15 percent of companies disclosing carbon-pricing risk to the CDP have implemented a carbon price so far, leaving many companies vulnerable to sudden shifts in carbon-pricing regulations. The median internal carbon price was $25 per ton in 2020—lower than most current carbon price estimates. As a result, major global companies may face up to $283 billion in carbon-pricing costs by 2025 if countries significantly ramp up carbon-pricing efforts, according to S&P Global.

Impact on earnings (USD billions) for certain sectors sector in 2025 under a high-carbon-price scenario

Source: Adapted from SPG Global Trucost

Note: Data featured is from the Trucost index, which covers 31 countries and approximately 70 percent of global stock market capitalization.

Climate-Related Risk Disclosure: From Voluntary to Mandatory Reporting

To achieve deep decarbonization, governments and private-sector actors need information and data on the risks that climate change poses to specific sectors, business models, and individual companies. Investors are leading this charge, demanding increased transparency from publicly traded corporations and financial institutions regarding their emissions and exposure to climate-related risks. Despite investor demands, this information is not widely available. Only 9,526 companies of the more than 43,000 publicly listed companies worldwide disclosed climate risk according to the CDP in 2020. Although publicly traded companies are legally required to file annual disclosures on financial performance, securities regulators historically have not required climate-related risk disclosure, but investor pressure to mandate disclosure of climate risks is mounting. 

Climate disclosures generally refer to public statements in which a company details the estimated financial impact of climate change on its operations and financial health under different warming and transition scenarios. In addition to the transparency they can provide, these disclosures provide valuable information for businesses and investors that can help frame and direct decision-making around future strategy and investment. Currently, however, reporting on climate risk by corporations is largely voluntary and often undertaken through measures such as the widely endorsed Taskforce for Climate-Related Financial Disclosure (TCFD) framework. Created by the Financial Stability Council, the TCFD is an industry-led initiative offering standardized guidance to assist corporations in understanding and disclosing climate risk. The taskforce specifically details eleven recommendations in the areas of governance, strategy, risk management, and metrics and targets.

Support for the voluntary disclosure framework has steadily grown among firms, institutions, and regulators since its inception in 2017. By 2021, 2,700 firms, institutions, and governments from 89 jurisdictions had pledged support for the TCFD, up from just 282 in 2017. Supporting the framework, however, does not require businesses to implement climate-related disclosures, thus lessening the significance of such widespread support. According to the most recent TCFD report, only 52 percent of 1,651 disclosures from public companies explicitly reported climate-related risks and opportunities in 2020. This marked a 10 percent increase from 2019, but implementation among public companies is far from complete. Disclosure across various sectors, including technology, remains weak. 

Limited implementation of the framework is due in part to the intensive nature of implementation, which requires the collection and analysis of emissions-related data across all areas of a company’s operations. Gaps in data collection, collation, and analysis are major initial barriers to implementing the TCFD, especially for financial institutions. Banks are particularly dependent on data from counterparties to disclose exposure to climate risks that will affect their own performance. Addressing these gaps requires companies to devote resources and to train personnel in the technical components of the TCFD framework. Implementation of the TCFD also requires buy-in across a company, beginning with leadership, according to a case study on Verizon’s implementation efforts.

Even among companies that do disclose climate risk, the vast majority fall short of disclosing on all TCFD recommendations. For example, only 13 percent of companies disclosed the resilience of their strategies and operations under different climate change scenarios. The quality of these disclosures is also often lacking, with many reporting only non-material climate risks. Low rates of disclosure may reflect the iterative nature of the framework and the complexity of the undertaking, with future iterations anticipated to improve as companies develop additional metrics and collect more data. However, the evolutionary nature of the process also means that most disclosures are not comparable, as companies are independently producing metrics to understand their unique risks. More likely, companies may be hesitant to disclose certain risks altogether when investors or regulators could perceive these risks as damaging, underscoring the limitations of voluntary disclosures and the need for greater harmonization of reporting requirements. 

The unreliable nature of voluntary guidelines is driving many countries toward compulsory climate reporting to produce widespread, comparable, and credible disclosures. Mandating climate disclosure represents a critical step in mitigating private-sector exposure to climate change while also helping to ensure that the Paris Climate goals are met. Information provided by climate disclosure will be necessary to redirect investments from high-emissions industries toward more sustainable alternatives, providing information on emissions and exposure to carbon pricing. One study from the Banque de France, for example, found that mandatory climate reporting prompted French investors to cut stakes in fossil fuel companies by 40 percent.

David Carlin

Climate Risk and TCFD Lead at UNEP Finance Initiative

“Mandatory disclosures are critical to improving both the quality and usefulness of disclosures.”

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The TCFD really is a de facto standard now. There's a large number of firms that see TCFD as a necessary and expected thing for them to be doing, and I think that that's really good. On the flip side, I would say there still isn't enough really strong disclosures around quantitative scenario analysis, nor is there adequate standardization in terms of metrics, even in terms of emissions disclosures.

Mandatory disclosures are critical to improving both the quality and usefulness of disclosures. With mandated reporting, reports become significantly easier to compare because there's more people submitting because they're required to, greater standardization, and also minimum standards for what the outputs will look like. I think a way to improve disclosures as well as a to make them a more useful tool is to set expectations around quality and detail.

Despite the benefits, mainstreaming TCFD recommendations into required disclosures will create complex accounting challenges that many businesses, asset managers, and banks will have to address in the near term. For governments, mandating climate disclosure may require a reworking of the TCFD recommendations to ensure comparability across sectors and countries as well as feasibility. At COP26, progress to enhance comparability and harmonization of standards was made with the creation of the International Sustainability Standards Board (ISSB). This new entity—which sits under the International Financial Reporting Standards Foundation, the organization responsible for the production of international accounting standards—is tasked with standardizing sustainability-reporting guidelines, using the four pillars of the TCFD, for companies across 37 countries.

Accelerating Change Through Financial Regulation

Despite progress, voluntary risk management tools remain inadequate to cope with climate change. As a result, financial regulation and monetary policy will be key to managing climate-related risks and ensuring financial stability as the world transitions to net-zero. Around the world, central banks are taking up this challenge. 

Spearheading this charge are members of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), which comprises 100 market and monetary authorities. NGFS members, such as the Bank of England, are actively integrating climate-related risks into supervision and financial-stability monitoring. While the exact policies implemented by NGFS members vary, consensus among major financial regulators is clear: central banks cannot afford to ignore climate-related risks. 

Although the authority of central banks is limited by strict legal frameworks, managing climate-related risks falls squarely within the mandate of central banks to maintain price stability. Climate change and its associated policy responses are expected to impact the prices of assets and goods, such as food and fuel, affecting inflation and portending significant implications for financial stability. Given these price and stability risks, central banks have an essential role to play in mitigating climate change. 

Managing these risks will require central banks and supervisors to gather information and data to better understand the size, scope, and likelihood of climate-related risks. This information can be collected through mandating disclosures as well as conducting stress and scenario testing for climate change. Like mandatory climate disclosure, countries around the world are beginning to stress test banks for climate change. While Banks and other financial institutions already undergo stress and scenario testing, which were introduced after the 2008 financial crisis to test banks’ resilience against economic shocks, climate scenario testing differs significantly from annual financial stress tests. Climate stress testing acts as a theoretical exercise that puts banks through various climate scenarios that span decades into the future. These exercises help banks understand their potential losses resulting from climate impacts, and central banks comprehend the threat level of climate-related risks to the overall financial system. The European Central Bank, the Banque de France, and the Bank of England are among the few central banks that have conducted climate stress tests for their respective financial sectors thus far. Within the next few years, a range of other countries may stress test for climate change, including the United States, according to statements made by current Federal Reserve governors.

Mark Zandi

Chief Economist of Moody’s Analytics

“Climate-risk scenarios are about designing and thinking about different possibilities about how climate change is going to affect the macro economy, industries, financial markets, the system more generally, and then trying to assess what that means for you as an institution.”

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Right now, they're not using the stress scenarios as a way to require banks to change pricing or capital levels or anything. There might be some teeth to these risks in the climate-risk scenarios, where they're used to actually impact capital levels and pricing. And if that's the case, then that's probably the best way for the central banks and regulators to impact exactly what kind of lending is getting done. So far, the first step is just “Let's do a scenario, see what kind of results we get.

Only after understanding these risks can central banks begin correcting misalignment that may exist between current regulation and climate-related risk concerns. Shifting regulation to reflect climate concerns could involve a variety of measures, including strengthening capital requirements, liquidity coverage ratios, or countercyclical capital buffers. Central banks can also contribute to decarbonization directly through policies such as green quantitative easing or green-targeted lending operations. Greening these monetary policy tools would tilt the economy’s allocation of capital in support of a net-zero transition. Although decarbonization will help mitigate the threat of climate change to price stability, opponents suggest that central bank policies that offer clear benefits to certain sectors or actors over others would violate the principle of market neutrality, under which central banks aim to minimize possible distortionary effects when intervening in financial markets. However, the current market is not neutral—markets continue to favor carbon-intensive assets due to their failure to fully price environmental harms such as carbon emissions. As a result, financial markets do not accurately reflect the price of carbon-intensive assets, which can affect the allocation of capital by central banks.

While direct support for decarbonization by financial regulators may be controversial, some central banks are working to ensure their activities are coherent with a net-zero government policy, regardless of market neutrality concerns. Certain central banks, such as the Banque de France, have a secondary objective to align monetary policy with national economic and industrial policy, provided that it does not interfere with price stability. Central banks with this policy-coherence objective can help to ensure that their activities are in lockstep with net-zero government policy.

Financial regulation will be critical in mitigating climate risks and transitioning to a net-zero world. While changing central bank policies are directly targeted toward the financial sector, these changes will reverberate throughout the economy. As financial sector actors face increasing pressure from regulators and investors to decarbonize their balance sheets and minimize exposure to climate risk, businesses failing to account for climate-related risk and transition their business toward net-zero may find it difficult to obtain loans or hold certain insurance policies. It is important to recognize, however, that the toolkits of central banks and market regulators are not sufficient to tackle climate change alone. Green monetary policy is not meant to be a substitute for government-led environmental regulation and carbon pricing, which will have comparatively more impact in mitigating climate risk and facilitating a net-zero transition. Green monetary policy can, however, complement government action, providing powerful short-term signals to financial markets that can begin to shift banks’ balance sheets toward net-zero.

Promising Financial Regulation and Monetary Policies to Facilitate a Net-Zero Future

The Path Forward: Making Net-Zero Commitments a Reality

As pressure builds to decarbonize the global economy, governments will continue to explore and implement new regulations and other policies to reduce emissions. This rapidly changing regulatory landscape will create new incentives and potentially devastating risks for businesses. While transitioning to a lower-carbon economy presents significant economic and financial risks, decarbonization also creates vast opportunities for organizations that are focused on climate change mitigation and adaptation solutions. For example, firms that successfully green their operations may experience cost savings, develop new products and services, gain access to new markets, and build resiliency along their supply chains. Harnessing these opportunities can also benefit the entire global economy, creating up to 18 million jobs and potentially improving livelihoods around the world. However, if this transition is hurried and unequitable, it could create unnecessary economic hardship for communities and workers and risks to business.

For the private sector, mitigation of climate-related risks must go beyond understanding exposure. Greening firm operations and products will be essential for mitigating climate-related risks in the long-term. The financial sector is particularly prone to climate-related risks and is expected to play a crucial role in financing the global economic transition to net-zero. Despite the global need for green financing and the risk of continued reliance on fossil fuels, fossil fuel financing has not slowed down: between 2016 and 2020, the world’s largest commercial and investment banks increased their financing of fossil fuels. Beyond fossil fuel investments, equity holdings of the largest asset management groups are misaligned with Paris climate targets, with companies underinvesting in green technologies for climate-critical sectors. Failing to align investments and loan portfolios with a net-zero future will leave financial institutions vulnerable to climate-related risks and less able to weather a transition. 

At COP26, over 450 financial institutions from 45 countries pledged to align their financing activities to achieve net-zero emissions by 2050. At least 300 other companies, members of the RE100 Initiative, have also committed to completely transition their energy usage to renewable sources. But many private-sector companies have yet to embrace any sort of commitment to shrink their environmental footprints, with most narrowly focused on passively mitigating long-term climate risk and meeting compliance standards in the short term. Failure on the part of companies to take bold action will undercut the energy transition and will fail to protect them from climate-related risks. 

Garnering additional net-zero pledges and making current pledges a reality will require companies to design and implement a governance framework that more accurately accounts for the costs presented by climate change and enables data-driven strategy and operations adjustments to advance toward a net-zero future. Moreover, it will demand adherence and action in the absence of compulsory measures from government authorities. Without clear direction from governments, the private sector must take the initiative and begin utilizing key mitigation tools, including internal carbon pricing and disclosure, to help make net-zero a reality. Financial regulators are well positioned to facilitate the transition. Failure to do would pose existential risks to firms’ commercial viability and to broader economic stability the world over.