Climate Roadmap for U.S. Financial Regulation

Climate financial reform must be a pillar of Biden’s whole-of-government approach to climate change

The Biden Administration has taken office with an urgent climate mandate and announced a “whole-of-government” approach in response.[1] Financial regulators have an important role to play. Managing climate-related financial risk is essential not just for responding to the climate crisis, but also for tackling the current economic crisis and promoting long-term growth and financial stability. To date, U.S. financial regulators have done little regarding climate-related risks. In recent months, there have been many calls for regulators to address this oversight.[2]

Climate change has been called “the greatest market failure the world has ever seen.”[3] There is widespread agreement that climate-related risk is underappreciated by financial actors and therefore is mispriced, likely to a degree that could threaten the stability of the financial system. Climate risks are complex, nonlinear, interconnected, and poorly understood. More than merely being underprepared, many financial actors are actively contributing to climate risk through their misallocation of capital.

Addressing climate risk has become a critical part of the missions of financial regulators, and they have existing statutory obligations to act on it. The question is not whether the government should take assertive action to use financial regulation to reduce the massive risks posed by climate change on the financial system, investors, workers, and the economy, but how to do so quickly, effectively, and sustainably. Regulators should use all tools at their disposal, including mandating disclosures, ensuring investor rights, modernizing fiduciary duties, and implementing a broad suite of supervisory and prudential tools.

The regulatory agencies tasked with overseeing the financial system must do so in a manner consistent with the powers delegated to them by Congress—including by accounting for the risks posed by climate change and the social, technological, and policy responses to it—in order to maintain the orderly function of public capital markets and the prudent and efficient operation of the financial system. Appropriate climate financial reforms will in turn cause firms to price risk more appropriately and to allocate capital more prudently, improving the economy’s climate resilience and shifting capital out of high-carbon activities that pose undue risk in a decarbonizing economy. In the long run, these impacts will also improve the health of markets, the economy, and society.

This report, prepared with the input of dozens of experts, advances climate financial reforms by providing a detailed “playbook” for financial regulators to integrate climate risk into their oversight responsibilities. It is organized in three broad parts: the first focuses on personnel, staffing and agency organization across the system; the second, on supervision and prudential regulation; and the third, on capital markets regulation. The recommendations comprising this report were prepared in the lead-up to the Biden Administration taking office and were shared widely with the incoming administration and its advisors.

Leadership starts at the top.

Leadership begins with President Biden: He has the power to prioritize climate financial reform among all financial regulators. President Biden should rescind and replace Trump Administration Executive Order 13,772, which established a set of  deregulatory and corrosive Core Principles for Regulating the United States Financial System. Biden’s new order should make clear that climate-related risk is central to financial regulators’ missions, and it should set forth the following climate-related priorities, which also comprise the overarching recommendations of this report:

  • Regulators should require more accurate, comparable, standardized, and decision-useful disclosures for use by themselves, investors, and financial institutions.
  • Regulators should protect and expand investor and fiduciary rights to manage climate risk. Regulators must implement policies on corporate governance and fiduciary duties that permit investors and fiduciaries to act on climate and other sustainability information, so that they may manage climate risk and adopt sustainable investment practices.
  • Disclosure and investor empowerment are not enough—regulators should make substantive prudential regulation a core pillar of the response to climate-related financial risks. Regulators must act with urgency, reflecting the risks posed by climate change, even given uncertainty. They should not wait for more or better-refined data or analysis before taking prudent actions that can be supported with the information that is currently available. They should
    • Use their supervisory powers and engage in prudential regulation to mitigate climate-related threats to individual financial institutions and financial stability, working quickly to implement prudential measures with respect to assets and activities with the clearest, most direct, and largest exposures to climate risk.
    • Develop macroprudential tools to address climate threats to the financial system, including the ways that individual financial institutions contribute to climate change through carbon financing.
  • Regulators should expand research to better understand and quantify climate risk in the financial system. The need for further research is not an excuse for inaction, but it is also urgent. Regulators should expand their research capacity to analyze and quantify climate change’s effects on macroprudential and microprudential financial risk and on the orderly functioning of the market. Such research will allow regulators to update and calibrate rules or guidance as more comprehensive or refined assessments of climate risk become available.
  • Regulators must protect marginalized communities from being harmed by efforts to mitigate climate-related risk. Climate risk mitigation should not raise the cost of financial services or render them unavailable to frontline communities. Regulators should seek and welcome opportunities to incentivize safe, clean investments in frontline communities and more generally, but they must proceed with caution. They must ensure that these asset classes are actually green in environmental terms and safe as a matter of consumer protection and financial stability.

The U.S. Department of the Treasury (the Treasury) should play a leading and coordinating role on both policy and research because it chairs the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR).

Because many of the relevant authorities are independent agencies, coordination by the Treasury cannot take the place of climate change capacity building and engagement within those agencies. Carrying out climate change priorities will require capacity and sustained action and monitoring from all federal entities with financial regulatory authority: the Treasury, FSOC, and OFR, the Board of Governors of the Federal Reserve System (the Federal Reserve, the Board, or the Fed), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), and the Department of Labor (DOL).

Climate-related financial reform is one of three intersecting reforms.

Financial reforms that address climate risk are urgent and central to financial regulation in their own right and should not and cannot effectively be addressed in isolation from other financial reforms. The recommendations of the report therefore emphasize two additional interdependent and intersecting issues:

Financial regulators must focus on equity and justice. Climate change is disproportionately harming low-income communities and communities of color, and regulators must take care to aid these communities and avoid compounding the harm to them. Policymakers must squarely address the distributional, equity, and racial justice dimensions of the metastasizing climate catastrophe. Communities of color and low-income or low-wealth, indigenous, rural, and rustbelt communities are more likely to be impacted by floods, storms, drought, food and water insecurity, increased diseases, faltering infrastructure, increased violence, and most other climate harms. These same communities often have the fewest economic resources with which to respond, particularly in terms of their savings and financial resilience. Policymakers must work to ensure that financial regulatory responses help communities victimized by economic marginalization and racial discrimination survive and thrive in the transition to a low-carbon economy by encouraging green investment in these communities, creating jobs with family-sustaining wages and benefits, and preventing unintended harm from public or private risk-mitigation measures.

Regulators must combat regulatory arbitrage and rein in shadow finance. We also note a unifying thread in this report: Regulation to combat financial risk must grapple with the problem of shadow finance and regulatory arbitrage. In the last three decades, financial services have increasingly migrated to less regulated spaces. The complexity of modern finance means that regulators must address not only lending, but also capital-markets financing mechanisms, many of which are currently outside any meaningful regulatory oversight. In securities, capital has flowed away from SEC registered offerings to exempt offerings and from public markets to private ones. Private equity, hedge funds and other private funds have enjoyed meteoric growth. At the same time, the shadow banking system—a constellation of less regulated capital markets, products, and intermediaries ranging from asset-backed securities to repo to money market mutual funds—has come to dwarf the traditional depository banking system. For climate financial regulation to be effective, policymakers must extend rules to private offerings of securities while simultaneously reversing decades of capital migration to less regulated, darker corners of the financial universe.