Governments have tended to treat climate change as primarily an issue of environmental policy. Recent climate change-related events, ranging from hurricanes to forest fires to floods, and their devastating effects on the global economy, however, are gradually alerting regulators and governments to the risks of climate change to financial stability. This has spurred action in several countries, as well as globally, to address climate change as a financial risk. Nevertheless, the U.S. has been notably absent from these efforts despite being the home to several large financial markets.

Covid-19 has also highlighted the perils of ignoring seemingly non-financial risks. Perhaps this is the reason U.S. regulatory, and other, bodies are suddenly paying attention. In late September, the Commodity Futures Trading Commission became the first U.S. regulatory body to link climate change to financial stability. Its report concluded that “climate change [can] pose systemic risks to the U.S. financial system.” Months before, the Senate Democrats’ Special Committee on the Climate Crisis report reached a similar conclusion.

Despite the lack of wide-scale acknowledgement in the U.S., there is little doubt that climate change poses risks to financial stability and is poised to cause a shock to the economic system. The shock could arise from either a physical risk, such as a series of severe hurricanes or forest fires, or a transition risk, most likely in the form of policy changes to carbon emissions once global warming crosses a certain threshold. That shock could then impair the flow of capital, for instance, by stranding carbon-intensive assets, which could eventually threaten financial stability.

Yet the antidote has primarily been to recommend – but not mandate – climate change disclosure. Global initiatives such as the G20-appointed Task Force on Climate-related Financial Disclosures and the central banks-created Network for Greening the Financial System, for example, advocate for non-mandatory enhanced climate change disclosure for both financial institutions and corporations. BlackRock CEO Larry Fink has similarly touted the importance of improved climate change disclosure.

Disclosure certainly has many benefits. It enables companies to make early assessments of climate change financial risks, plan how to mitigate such risks, and make considering them routine. It also enables financial institutions and investors to price climate-related risks, allowing for a more efficient allocation of capital. However, studies have shown that compliance with climate change disclosure is weak, that some companies are using it to obscure poor climate change performance, and that it may not be providing adequate market discipline. Disclosure is therefore useful only as a complement to regulations that combat climate change.

What is needed are efforts to ensure economic stability while decoupling economic growth from greenhouse gas emissions. This could be achieved, for example, by introducing climate-change stress tests, which would gauge whether firms are able to withstand “the stress” caused by climate-change events. Based on these tests, firms could then develop a strategy for adapting to climate change. Notably, the Federal Reserve already has the authority to create climate-change stress tests under the Dodd Frank Act. All that remains is the will to do so.

A second possibility would be to work towards reducing financial institutions’ investments in fossil fuels. The four largest American banks have financed the fossil-fuel industry with over $811 billion in the last three years and earned the label of “de facto enablers of global warming”.

Still, efforts to reduce fossil fuel investments must proceed cautiously due to the size of those investments and the possibility that a sudden reduction could provoke a systemic crisis. One prudent approach would be to limit the amount of fossil fuel investments financial institutions can hold, with the aim of gradually decreasing that limit. A more cautious approach could involve limiting only new investments in fossil fuels. A third, even more cautious approach, would be to set targets for limiting fossil fuel investments and then allow firms to voluntarily reduce their investments while reporting their progress in achieving the targets through their management discussion and analysis reporting obligations. Regardless of the specific approach, Morgan Stanley and Barclays, both of which have committed to reaching net-zero financed emissions by 2050, recently underscored the feasibility of limiting fossil fuel investments.

Covid-19 has reminded us that we ignore issues that have solutions at our peril. It also provides a glimpse of the economic devastation that failing to prepare for climate change could cause. Post-pandemic, we can choose one of two paths to recovery: a return to business as normal or an approach that incorporates issues of climate change into economic measures.

This post comes to us from Barnali Choudhury, professor of law at University College London. It is based on her recent paper, “Climate Change as Systemic Risk,” found here.