‘Climate-related financial shocks disproportionately affect brown funds’
ESMA, the EU securities regulator, stated that green funds are better protected than their brown counterparts from climate-related financial shocks. For this first-ever investment fund climate-related financial risk assessment, ESMA had recovered portfolios from 23,965 EU-domiciled investment funds, covering €10.7trn of investments spread out across 3.3 million positions, representative of the fund sector. Interestingly, EU funds’ equity and corporate bond investments in green firms is lower than 33% (the mean share of portfolio holdings in green firms across all funds in the sample stood at 11%) of the value of their portfolio, while exposures to brown firms tend to be overweight, with a mean share of 55%.
ESMA’s assessment revealed that funds whose portfolios are tilted towards more polluting assets (brown funds) distribute their portfolio over a large number of companies than funds with cleaner portfolios (green funds). This diversification hides a concentration risk, highlighted the EU securities regulator. “Brown funds are more closely connected with each other (have more similar portfolios) than green fund portfolios, which tend to ‘herd’ less (have less similar portfolios to those of other green funds). This suggests that widespread climate-related financial shocks are likely to disproportionately affect brown funds,” stated ESMA’s Trends, Risks and Vulnerabilities (TRV) report for 2021.
ESMA carried out a forward-looking climate risk scenario exercise backing the above assessment. Most brown funds’ losses range from about 8% to 19% of affected assets (in addition to total system-wide losses of €0.5trn to €1.3trn) while green funds’ losses ranged from 3% to 7%. Additionally, brown funds have a more systemic impact as they contribute more to a total system-wide loss (because of their greater interconnections within the fund universe) than green funds. ESMA hopes that these findings will provide support for ongoing EU regulatory and supervisory initiatives on sustainable finance.
Tightening supervision of ESG ratings services:
The EU securities regulator has also sharpened its focus on ESG ratings providers, pointing out that sustainable investing strategies amount to €45trn in 2020, with more than €2.5trn in institutional assets tracking ESG ratings and scores. ESMA highlighted that the absence of a common definition for ESG ratings leads to investor and issuer confusion and misunderstandings. For instance, ESG ratings are inconsistent across providers due to different methodologies, making it difficult to compare. Such factors can have an impact on the composition of ESG indices, especially at a time when a growing amount of money tracks these indices through passive ESG funds and other ETFs. Inconsistency of ESG ratings also leads to issues down the investment value chain, resulting in investment misallocation either through ESG rating-based indices or greenwashing and product mis-selling, impacting investor confidence and hampering development of sustainable finance system.
ESMA also highlighted concerns of a conflict of interest among such ESG data services providers. “The coexistence of ESG ratings with other business activities in several ESG rating firms, such as credit ratings, benchmark construction, consulting services or asset management, further creates fertile ground for potential conflicts of interest,” stated ESMA.