New Ceres Report Analyzes Unaddressed Climate Risks in the Derivatives Market

Ceres, today released a new first-of-its-kind report, Derivatives & Bank Climate Risk: Financing a Net Zero Economy, on the $600 trillion global derivatives market. The report examines the financial risks that derivatives activities pose for the 25 largest U.S. banks and offers concrete actions to address them.

Derivatives are financial instruments that “derive” their value from an underlying asset class such as interest rates, credit markets, equities and even energy commodities and are used by banks and borrowers to, among other things, de-risk financing packages.

In the space of two years, Ceres has seen massive investor interest in climate finance, the establishment of global standards through new and existing banking initiatives, the advent of climate stress testing and prudential supervision in many countries, and a flood of net zero commitments and 2030 sector targets from many of the world’s largest banks. That said, huge parts of banks’ businesses are still a black box in terms of climate risk – including under explored asset classes like derivatives.

The third report in Ceres’ Financing a Net Zero Economy series on the banking industry and climate risk, this report builds on prior analysis laid out in the two previous banking reports: Financing a Net Zero Economy: Measuring and Addressing Climate Risks for Banks (2020) and Financing a Net Zero Economy: The Consequences of Physical Climate Risks for Banks (2021).

“Derivatives can directly contribute to real-economy greenhouse gas emissions and as such need to be measured and disclosed as part of a bank’s climate strategy,” said Blair Bateson, Director of the Ceres Company Network at Ceres.

“Given the size of the derivatives market and its systemic importance, it is the proverbial ‘elephant in the room’ when it comes not only to banks’ calculation of financed emissions and enlarging a bank’s sustainable finance opportunity set,” according to Jim Scott, Senior Advisor for Financial Institutions for the Ceres Accelerator for Sustainable Capital Markets at Ceres.

The report’s analysis led to five key findings that banks, investors, and regulators need to consider:

1. Derivatives have the potential to dramatically change a bank's climate risk exposure, increasing it by up to 3x in certain cases.

2. There are actions that banks can take now to mitigate climate exposure by correctly pricing the climate risk in their derivatives portfolios.

3. Derivatives could serve as an amplifier of climate risk at a systemic level, given that bank counter-parties across lending, derivatives, and other asset classes often significantly overlap.

4. The availability and cost of derivatives have real-economy climate effects and can either incentivize or discourage decarbonization in high-emitting sectors.

5. Derivatives are relevant to a bank's carbon accounting and climate target setting.

Since the top five U.S. bank derivative providers hold approximately 95% of the U.S. derivatives market, these banks not only have increased risk but also have considerable leverage to make an outsized impact in accelerating the transition to a net zero economy. The availability and cost of derivatives instruments can effectively encourage or deter decarbonization in high-emitting sectors. Incorporating derivatives in banks’ financed emissions is crucial to establishing accurate net zero targets and climate-aligned transition plans.

Ceres provides the following six recommendations for banks to address the climate risk posed by derivatives:

• Begin evaluating how derivatives can impact both your overall climate risk and opportunity.

• Update internal models (such as Credit Valuation Adjustment reserve models) to include climate risk factors.

• Proactively advocate for smart financial regulations and policy actions in support of enhanced climate risk management of your derivatives activities.

• Continue to engage with your borrowers to help them develop transition plans and start including derivatives activity in these engagement initiatives.

• Account for derivative transactions as additional sources of financed emissions and include these in your disclosure of firm-wide total financed emissions.

• Update your 2030 targets—and 2050 commitments, if necessary—to include derivatives.

At 11:00 a.m. ET on Nov. 4, Ceres will host a webinar with report authors and partners to dive further into the findings and recommendations of the report. Click here to register for the webinar.

About Ceres

Ceres is a nonprofit organization working with the most influential capital market leaders to solve the world’s greatest sustainability challenges. The Ceres Accelerator for Sustainable Capital Markets is a center of excellence within Ceres that aims to transform the practices and policies that govern capital markets to reduce the worst financial impacts of the climate crisis. It spurs action on climate change as a systemic financial risk—driving the large-scale behavior and systems change needed to achieve a net-zero emissions economy through key financial actors including investors, banks, and insurers. The Ceres Accelerator also works with corporate boards of directors on improving governance of climate change and other sustainability issues. For more information, visit ceres.org and ceres.org/accelerator and follow @CeresNews.