For asset managers and asset owners, the goal has always been to deliver returns with
appropriate level of risk. In today’s new paradigm of ongoing climate change, institutional
investors must increasingly make investment decisions within the context of aligning to
emission reduction targets at a portfolio level.
Embedding climate risk in investment decisions
New government policies focussing on compliance with emission targets, as well as the increasing frequency of natural disasters linked to global warming, are leading to increased climate transition and physical risk factors in financial markets. This can have several impacts:
- High price of emissions can lead to depressed valuations for high-emissions industries
- Emergence of green technologies can disrupt traditional industries but cause oversupply in green industries due to government subsidies (e.g. Solar, Electrical vehicles,..)
- New regulations can cause demand destruction and risk creating stranded assets (e.g. coal);
- The increased incidence of natural disasters is estimated to cause USD 25 trillion in damages to real estate globally by 2050.[i]
To assess the climate risk, asset managers need to think beyond traditional risk measures that usually focus on market risk and are based on past history. Climate change is without precedent, will play out over many years and will depend on the actual trajectory of transition and physical risk factors. Asset repricing in the markets, however, can happen suddenly and violently long before the full impact is felt.
To capture this type of risk that falls outside of normal market conditions, stress testing can be used. However, it is important to distinguish that climate stress tests are not the same as traditional stress tests that are usually based on past historical events. Instead climate stress tests employ a socio-economic scenario that models future transition (government policies on emission) and physical risk (flooding, heat waves, etc.).
The Network for Greening Financial System (NGFS), is one organisation that regularly publishes climate scenarios. NGFS unites 130 national central banks and aims to provide a common reference framework for climate risk modelling.
However NGFS scenarios forecast changes using only broad economic variables. For stress tests on actual portfolios, there is a need to translate these changes into market shocks. This is where it can become even more complex as there is no historical precedent to rely on.
European regulator initiatives in climate stress testing
When it comes to climate stress testing, Europe has been at the forefront with a number of stress test exercises completed in recent past:
- The Bank of England performed a climate stress test exercise in 2021 using 3 climate scenarios for the largest UK banks and insurers.
- The ACPR (the French Prudential Supervision and Resolution Authority) also conducted a pilot climate stress test in 2020 and launched a new climate stress test in 2023, focusing on the French insurance sector.
- The European Central Bank performed a climate stress test in 2022 for the banking sector.
- To know more: Results of the 2022 climate risk stress test of the Eurosystem balance sheet (europa.eu).
For asset managers and owners the most notable climate stress test was performed in 2022 by the European Insurance and Occupational Pensions Authority (EIOPA) on pension funds across Europe, with almost 200 firms participating (read more: Climate stress test for the occupational pensions sector 2022 – European Union (europa.eu)).
This stress test defined granular shocks across industries, asset classes and geographies and it was based on the NGFS’ disorderly transition scenario.
By the end of 2024 EIOPA will perform another Climate Stress Test, this time on insurance companies, with results expected by Q1 2025.
Climate Stress Test and scenarios for our financial institutions clients
Climate risk has come about as an important new risk factor and Securities Services can assist institutional clients to assess this risk. Our stress test solution is an extension of our risk analytics offer and it is based on EIOPA’s 2022 climate stress test specification.
This stress test can support the asset manager in understanding the climate risk within their portfolio in multiple ways:
- Quantify the overall impact on the portfolio/s;
- Quantify the impact by asset class;
- Assess exposure to sensitive sectors.
The climate stress test can be conducted at regular intervals to track the results over time.
Source: internal reporting on a fictitious fund
At Securities Services, we are actively monitoring the developments in the climate space and will be implementing new stress tests scenarios that rely on regulator frameworks.
The climate stress test is just one of the solutions we have developed to help our clients with their low-carbon strategy. We are constantly incorporating new regulations and information about climate risk into our analytics solutions; it is our commitment to accompany our clients on their transition journey to a low-carbon future.
Transition to a low-carbon economy
With average global temperatures steadily rising in recent years the question is what can we do to limit it. In climate science, the concept of carbon budget links the amount of carbon emissions released in the atmosphere with the corresponding increase in average temperature. Global warming will be a drag on economic growth, by recent estimate every 1%C increase in global temperature leads to 12% decline in global GDP.[ii]
In response both public and private sectors have committed to work on reducing carbon emissions. Within investment industry two global alliances, ‘Asset Manager Net Zero’ and ‘Asset Owner Net Zero’, with collective trillions of assets have pledged to the goal of reaching ‘Net Zero’ emissions target by 2050. Within public sector, EU ‘Fit for 55’ program aims to reduce EU wide emissions by 55% by 2030.
[i] “Global warming is coming for your home”, the Economist 12/4/2024
[ii] ‘The Macroeconomic Impact of Climate Change’ https://www.nber.org/papers/w32450
To read more on regulation
Sustainable Finance Disclosure Regulation (SFDR) – regulation memo
The EU SFDR aims to provide greater transparency on the degree of sustainability of financial products
UK Sustainability Disclosure Requirements (SDR) – regulation
The UK SDR regulatory framework is aimed at enhancing transparency and accountability regarding sustainability factors in financial markets.
Your guide to the European Commission’s Sustainable Finance Action Plan
Keep track of the regulatory developments of the European Commission’s Sustainable Finance Action Plan.
