EU investment funds face transition risk, potential re-pricing impacts
The writing on the wall is clear: the price of inaction towards climate chance risks is costly, at least according to the latest joint research by the European Central Bank (ECB) and the European Systemic Risk Board (ESRB). The study looks at how a broad set of climate change drivers over long-dated financial risk horizons would affect thousands of financial firms in the European Union (EU). The granular mapping exercise looks at physical risks of climate change as well as transition risks.
A matching of all scopes of firm greenhouse gas (GHG) emissions to over 1.5 million eurozone firms revealed that exposures to emission-intensive firms are concentrated not only across economic sectors but also within. This leaves parts of the financial systems vulnerable to “potentially de-stabilising” financial market corrections. On the banking side, 14% of collective euro area banking sector balance sheets are concentrated in sectors such as manufacturing, electricity, transportation and construction sectors.
Urgent: greening of portfolios
For asset managers, the numbers make for grim reading. Portfolio greening needs of investment funds are great, because more than 55% of their investments are tied up in high-emitting firms, stated the report. An estimated alignment with the EU Taxonomy stands at merely 1% of assets. There could be a pronounced impact if the financial markets abruptly reprice the financial risk associated with climate change. EU investment funds may also be subject to increased scrutiny on transition risks, because only 11% of portfolios can currently be considered as green.
EU banks are heavily exposed to physical risk, as 70% of banking system credit exposures to firms subject to high or increasing physical risk hazards over the next decades are concentrated in the portfolios of 25 banks, according to the research. Physical and transition risk drivers in three climate scenarios – orderly, disorderly transition and a hot house world – show that credit and market risk could cumulate from a failure to effectively counteract global warming. Scenarios indicate that physical risk loses, particularly for high-emitting firms, would become dominant in 15 years in case of an insufficiently orderly climate transition, with falls of 20% in global GDP by the end of the century, if mitigation measures are ineffective.
Impact of climate change risks
What does this imply for financial services? The EU banking sector credit risk losses under adverse climate scenarios could amount to 1.60-1.75% of corporate risk-weighted assets in a 30-year time frame. For the insurance sector, market risk revaluation losses could be material in key climate-sensitive sectors for corporate equity and corporate bond (to a lesser extent) investments over the next 15 years, if there is a disorderly transition scenario. While average impacts amount to a modest 5 percentage points, modelling using sector-level production plans and technologies suggests large losses of 15% for equity holdings in oil, gas, and vehicles.
European investment funds’ market risk losses could be relevant in adverse scenarios, with a direct aggregate asset write-down of 1.2% in holdings or equity and corporate bonds in the next 15 years. Totally, this accounts for over 60% of around €8trn in investment fund assets. At the fund level, higher emitting investment portfolios could see losses of up to 14%, warned the joint report.