An Opportunity to Strengthen Climate Risk Management in the Derivatives Market

(This post was co-authored by EDF Climate Risk Attorney Elle Stephens)

Disasters that are fueled by climate change, like fires, floods, and hurricanes, increasingly pose risks to the U.S. financial system, including the derivatives market.

The U.S. Commodity Futures Trading Commission (CFTC) regulates the derivatives market and is now considering updates to its risk management regulations. These updates are an important opportunity to ensure that market participants properly manage climate-related financial risks.

Derivatives 101

A derivative is a contract that derives its value from the price of an underlying asset or physical commodity. The CFTC defines a commodity as “an agricultural product [e.g., wheat, cotton, rice, etc.] or a natural resource [e.g., oil] as opposed to a financial instrument such as a currency or interest rate.”

The most common types of derivatives on the market are futures, options, and swaps. Currently, the total notional value of the global derivatives market (meaning the value of all the underlying assets) is estimated at $600 trillion, and the U.S. market accounts for about two-thirds of this value.

  • Futures – A futures contract is “an agreement to purchase or sell a commodity for delivery in the future … at a price that is determined at initiation of the contract.” For example, an oil producer could enter into an agreement with a buyer to sell – and deliver – oil at a fixed price at a specified time.
  • Options – An option “gives the buyer the right, but not the obligation, to buy or sell a specific quantity of a commodity or other instrument at a specific price within a specified time period, regardless of the market price of that instrument.” For example, an investor could purchase a call option that allows them to buy a company’s stock at a set price even if the market price increases beyond that level in the set time period.
  • Swaps – A swap is “an exchange of one asset or liability for a similar asset or liability for the general purpose of shifting risks.” For example, a credit default swap is a derivatives contract where a seller agrees to pay a buyer a fixed amount if a borrower default or bankruptcy occurs over the contract’s lifetime.

The CFTC is responsible for protecting market participants against fraud, manipulation, and abusive trading practices, and ensuring the financial integrity of the clearing process.  Though the CFTC’s mission originally focused on futures and options for agricultural commodities, Congress expanded its authority over the years to include oversight of other types of derivatives as well.

Climate Risk in the Derivatives Market

As the CFTC’s Congressional mandate has grown, so have the financial risks posed by climate change. The CFTC’s  own Climate-Related Market Risk Subcommittee published a report in 2020 which concluded that climate change threatens the financial stability of the U.S., including the derivatives market.

Transparent, well-functioning derivatives markets can help the financial sector manage and adapt to climate risk. Derivatives serve as a tool to manage price uncertainty and hedge financial exposure. In addition, futures and other derivatives contracts – by their forward-looking nature – can provide pricing signals that highlight areas of risk and opportunity.

However, these important functions can also result in unexpected concentrations of risk in specific sectors and counterparties. The regulated markets already use tools and frameworks to assess risk, but do not yet specifically account for climate-related financial risks, even though they already exist and are growing rapidly. That means derivatives can introduce unexpected exposure and market instability (for a deeper dive, see this analysis by Ceres).

Climate risk can impact the derivatives market in the form of market risk, credit risk, and operational risk.

  • Market Risk – Because a derivatives contract is based on an underlying asset, any physical or transition risks that could result in volatile changes to the price of that asset introduce market risk. For example, a major hurricane could damage oil refineries in the Gulf of Mexico, causing the price of oil futures to rise rapidly.
  • Credit Risk – Credit risk is based on the likelihood that the counterparty to a derivatives transaction can no longer make its contractually obligated payment either due to default or a drop in credit rating. Prolonged or acute exposure to physical and transition risks of climate change could impact a counterparty’s probability of default or a drop in credit rating, increasing the financial risks to the seller.
  • Operational Risk – Climate-fueled events could affect the operations of facilities that house key derivatives market servers, either due to direct damage to the facilities themselves or due to disruptions to supporting infrastructure (like the downing of power lines).

The CFTC’s Role

To ensure that derivatives market participants effectively manage climate-related financial risks, the CFTC should either amend its risk management program regulations or issue guidance on the relevance of climate impacts to existing requirements, consistent with its legal obligations.

Following the 2008 financial crisis, in the Dodd-Frank Act, Congress directed the CFTC to issue regulations establishing risk management program requirements for major derivatives market participants. The regulations currently specify ten areas that these programs must address, including market, credit, and operational risks (described above).

Earlier this year, the CFTC announced that it was considering updating its risk management program regulations and sought public comment on how these rules could be improved. EDF and Columbia Law School’s Sabin Center for Climate Change Law submitted comments urging the CFTC to consider how risk management programs could account for the instability climate change will impose upon the derivatives market, whether through regulatory amendments or guidance.

As the CFTC’s own Climate-Related Market Risk Subcommittee recommended in 2020, with “better understanding … of the risk-transmission pathways and of where the material climate risks lie,” the CFTC should “consider expanding [its] risk management rules and related quarterly risk exposure reports to cover material climate-related risks.”

In the release of its original program regulations, the CFTC stated that the regulations were designed to ensure that market participants and the public were sufficiently protected while avoiding unnecessary rigidity. Like other already enumerated categories, the CFTC’s addition of a climate-related financial risk category would help ensure that market participants adequately identify and manage these types of risks, while still allowing flexibility on how that is accomplished. Even if the CFTC decides not to enumerate climate-related financial risk in its risk management program regulations, it may issue guidance on how climate change implicates the existing risk management areas.

Recently the Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of the Comptroller of the Currency voted to approve new interagency Principles for Climate-Related Financial Risk Management for Large Financial Institutions, which will help ensure that banks take the needed steps to manage financial risks arising from climate change. By updating its risk management program regulations to account for climate-related financial risk, the CFTC can build on its early leadership in this area, complement other regulatory progress, and improve market resilience to climate impacts.

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