Trump’s Climate Policy and the Risks for Wall Street

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Wall Street on a rainy day

By walking away from the Paris climate agreement, the Trump administration has inadvertently made the U.S. financial system more unstable. With carbon pricing schemes to reduce GHG emissions off the table, future administrations will likely have to introduce more forceful mechanisms faster – with drastic consequences for intermediaries and financial assets exposed to the so called “carbon risks”. These risks are associated with the variability of the carbon prices that companies have to pay directly either in the form a “carbon tax” per ton of CO2 emitted or by purchasing carbon allowances in markets for the emissions cetificates (eg in Europe and soon in China).   

We don’t know how financial markets would react under this scenario, but recent studies are shedding some light on the magnitude of the risks. According to Nature Climate Change, despite European banks have limited their direct engagement in the fossil fuel sector, their combined exposure to all sectors whose revenues and costs would be affected significantly by a change in carbon prices is still considerable and amounts to up to 54% of their total assets. And since Europe has worked extensively on reducing its carbon footprint in recent years, we can assume that U.S. banks are even more exposed than their counterparts on the Old Continent. So much so that an abrupt change in carbon pricing could have wide and systemic repercussions on the financial system both in the U.S. and abroad. In fact, the climate change risks borne by the financial system today are similar in size to those that triggered the financial crisis in 2008.

These risks aren’t lost on financial regulators who are starting to put climate change on the agenda. The Financial Stability Board (the Basel-based monitoring body set up in the context of the G20) has created a task force on climate-related financial disclosures led by Michael Bloomberg. To help investors, lenders and insurance companies manage climate risks the task force recommends making carbon disclosures compulsory. ‘You can't manage what you don't measure,’ the old management adage goes, and an increasing number of investors seems to abide by it. Blackrock, the world’s largest asset manager, has recently announced its plans to put more pressure on companies to disclose how climate change could impact their business.

The question is whether the financial system can manage climate risks even if companies and banks measure them accurately. Around the world efforts are underway to integrate environmental factors into the investment process. Ideally, investors should exclude polluters from their portfolios and replace them with carbon-free assets, as some do. Initiatives such as the Portfolio Decarbonization Coalition promoted by the United Nations Environment Programme Finance Initiative or Gofossilfree (a large international network) are gaining momentum. Other investors prefer to exercise their voting rights at shareholder meetings and engage directly with the company at Management and Board level. In May, 63% of Exxon Mobil shareholders approved a proposal at the company’s annual meeting calling for the world’s largest listed oil producer to improve its disclosure on business risks through global climate change policies.

While exclusion lists and company engagements have helped investors reduce their exposure to environmental risks, the scope of the problem calls for more decisive action. Today’s lack of hedging instruments for climate-specific risks creates vast opportunities for innovation. The next few years will likely see the emergence of climate-related derivatives as well as carbon-neutral indices and other vehicles that help banks, insurance companies and institutional investors manage their climate risks. The necessary transition to a low-carbon economy creates an entirely new market for financial services. Wall Street would be a natural contender to break new ground and set in motion the next wave of financial innovation. But with the U.S. government pulling out of the Paris accord, Europe or even China are likely to take the lead on climate change finance – and reap its benefits.

Turning away from climate protection leaves the U.S. financial system exposed to climate risks and curtails its natural power of innovation. The financial solutions for one of the most pressing issues (as well as one of the largest opportunities) of our time will likely be developed elsewhere.