Sometimes big changes start quietly, but they can ultimately completely reset the global playing field. We think that just such a seismic shift, with very little fanfare, was launched earlier this month. We should all take note and – as they say – watch this space.
On September 9, 2020, for the first time ever, a subcommittee of a federal financial regulatory agency, the Commodities Futures Trading Commission (CFTC), produced a major report on climate risk and its threat to financial markets. That report, titled “Managing Risk in the U.S. Financial System”, covered a host of issues but what struck us is that it recommended that the climate risks facing businesses and asset classes be formally classified and disclosed as material risks for Securities Exchange Commission (SEC) financial reporting purposes, for insurance industry reporting purposes, and for a host of other financial-market requirements.
Moreover, this report came out only two weeks after a SEC meeting adopting new Reg S-K disclosure rules at which two of the five Commissioners dissented because the new rules did not cover climate risk and diversity, and other Commissioners indicated that they were “not necessarily opposed” to covering those topics but not yet ready to be prescriptive. But the discussion is underway, it is clear.
This matters. And if the climate related risks that are unfolding with increased rapidity need to be quantified and disclosed, it could have an impact on asset valuations, stock pricing, lending practices, investment risk perceptions, the way insurance and government guarantees in various sectors are administered, and the types of disclosures and due diligence that regulators, investors and financial institutions carry-out. Wildfires, floods, hurricanes and heatwaves have been battering much of the United States and the globe with increasing frequency and ferocity and scientists, environmental activists, business, community and government leaders have sounded the alarm on global warming and its associated climate risks for years. But now we see federal financial regulators talking about disclosures and reporting of these as material threats to individual businesses, asset classes, regional economies and potentially the entire financial system. This is an important and potentially game-changing shift.
With caveats regarding the challenges of forecasting, the CFTC report cites recent research suggesting that by the end of this century, the negative economic impact on the U.S. economy from climate change could amount to about 1.2% of annual gross domestic product (GDP) for every 1 degree C of average temperature rise. (CFTC p.13). That’s equal to "wiping out nearly half of average annual GDP growth rates in recent years". Moreover, that relationship could likely be nonlinear and if temperatures rise more rapidly the impacts could be significantly greater. It seems likely that little if any of this negative impact is captured in current estimates of asset and business valuations, so the recommendation that disclosures going forward attempt to capture this potential impact are significant. Of course, much also depends on the timing of when the climate impacts might impair an asset or operation.
Specific sectors of the U.S. economy will be impacted in a variety of different ways. Agriculture, for example, which the report says in 2017 contributed $1-trillion, or 5.4% of U.S. GDP and 3-million jobs, faces significant risks from climate change, including localized heat stress impacting both farm workers and livestock; potential declines in annual crop yields ranging from 6% for corn to 3.1% for soybeans, for every one degree C of temperature rise; degradation in water and soil quality; increased virulence and range of pests; disruptions to transport distribution systems due to severe weather (such as inaccessible ports on the Mississippi); and disruptions to ecological systems and biodiversity that supports both commercial and natural systems (including loss of insects for pollination). These impacts might be partially offset by mitigation strategies (such as more drought-tolerant strains of crops) but the concern is that this will increase both crop uncertainty and variability impacting not just the agricultural sector and consumers, but investors, commodity markets, commercial lenders, government crop insurance programs and others. (CFTC p.14)
In the infrastructure sector (including energy, water, transportation and communications) the CFTC report notes that climate change impacts threaten not just site specific assets with loss from flooding, wildfires or other destruction, but also potentially shorten the lifecycle and degrade the operational performance of those assets – and thereby compromise the long-term yields and creditworthiness of those assets. Where this is coupled with issues around deferred maintenance – which is the case with so many of our transport systems and aging water systems – the additional physical strain caused by extreme temperature and weather can significantly complicate those existing structural problems. (CFTC p.15) And this is not just a performance and creditworthiness issues, but as demonstrated by the 2019 Pacific Gas and Electric (PG&E) bankruptcy following the disastrous 2017 California fire season, aging infrastructure combined with deferred maintenance and extreme events can be both deadly and financially devastating.
The report notes that our water treatment, distribution and supply systems are equally, and maybe particularly, threatened. The Environmental Protection Agency (EPA) is quoted by the CFTC report as estimating that even without the impacts of climate change, some $427-billion of new investment will be required over the next two decades “just to maintain drinking water infrastructure”. Climate change challenges will only exacerbate these already existing requirements with hotter temperatures, reduced snowpack, shrinking aquafers, degraded physical plant and the like. (CFTC pp15-16). Without access to detailed analyses, it is unlikely that these future climate risks have been part of investors’ and lenders’ calculus.
Finally, commercial and residential real estate represent enormously important sectors for both individual and institutional investment, and our Musings have described the threats to both previously. The CFTC report notes the increased vulnerability of these real estate assets to sea level rise, hurricanes, tornadoes, flooding and wildfires, and cites research indicating that climate risk is beginning to be priced into real estate valuations – at least in some markets such as Miami -- and this is particularly the case for commercial properties and investment properties (less so for personal residences, at least to date). Declining real estate values, driven by climate risks that decrease the insurability or value of property, can depress tax bases and the economic activity of entire communities. Moreover, since most residential real estate in the U.S. is purchased with a mortgage, these climate-driven physical risks will likely impact the underlying creditworthiness and value of those mortgages and their insurability, and ultimately the financial institutions holding and securitizing those mortgages, including the government-sponsored enterprises (GSEs), primarily Fannie Mae and Freddie Mac, which guarantee the default risk of the mortgages they securitize. The CFTC report notes that: “Emerging evidence suggests that lenders are passing along riskier mortgages…to the GSEs, in part, to remove risk from their own books.” For now, that means that the U.S. taxpayers may ultimately be on the hook for default risks. But what does it mean if up-front risk disclosures are required? Maybe even the buyer-of-last-resort has a limit.
The CFTC subcommittee that produced this report outlined some 53 recommendations for policy-makers aimed at “protecting the stability of the U.S. financial system”, starting with creating proper incentives to spur investment in climate resilient infrastructure and low carbon technologies. That should, they asserted, start with establishing a price for carbon that is fair, economy-wide and effective in in reducing CO2 emissions in line with the Paris Accords. Beyond that, the authors outlined a broad range of recommendations ranging from federal agencies incorporating climate-related risks into their various agency mandates, to obliging state insurance regulators to require insurers to incorporate climate risk into their underwriting activity and investment portfolios, and to disclose these risks. But to our thinking, the most far-reaching recommendation was the development of standard definitions and taxonomies for classification of these climate change risks, a requirement that all publicly-listed companies disclose various types and levels of CO2 emissions, and that medium and long-term material climate risks should be incorporated into SEC and other financial disclosures. (CFTC p viii and Recommendation 7.2, p.99). Undoubtedly many will question the feasibility or even the degree of certainty that can be assigned to long-term risks, but the issue is on the table.
If enacted, this will alter the way assets are valued and insured, and the tradeoffs that will be made by businesses and consumers regard investments, technology solutions and a host of other critical issues. This will impact decisions about future infrastructure development – where we site roads, transit, water and power systems, and their useful lives. This will impact the kinds of systems that are put in place. This will impact our perceptions about future price volatility for agricultural products and energy. This will impact our thinking about the life-cycle of various categories of physical assets. This will likely impact the insurability and the cost to insure a broad range of assets. This will impact where we build and rebuild – and where we retreat. If enacted, as is being discussed, all these are huge game-changers.
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