The investment fund sector faces some of most severe impacts in a climate stress test of banks, insurers, pensions and funds by European regulators, according to a new report.
On Tuesday, the trio of European Supervisory Authorities — the European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities Markets Authority (ESMA) — along with the European Central Bank (ECB), released the results of a climate scenario analysis that examined the impact of three possible scenarios under the region’s commitment to reduce emissions by 55% from 1990 levels by 2030, on a path to net zero by 2050.
The exercise found that, on their own, transition risks “are unlikely to threaten financial stability.”
However, it also concluded that when transition risks are combined with macroeconomic shocks, financial institutions’ losses may rise to a level that leads to disruptions.
“Adverse macroeconomic developments could disrupt the evolving transition and substantially increase financial institutions’ losses, thereby impairing their financing capacity,” the report said.
The test examined a baseline scenario, an adverse scenario that saw transition risks materialize as investors shed assets of carbon-intensive firms, and a second adverse scenario where these shocks were amplified by other macro factors.
Under the regulators’ baseline scenario, and the first adverse scenario, total system-wide losses amounted to €945 billion, and €1.5 trillion, respectively. In the more adverse scenario, the financial system faced total losses of €3.9 trillion.
“The scenarios modelled in this exercise do not appear to pose a substantial threat to the overall stability of the financial system,” the regulators’ report said.
“Major financial institutions are likely to cope with the estimated first and second-round losses, given their strong capitalization, high liquidity levels and diversification, which mitigate the effects from the shocks. Smaller investment funds, however, face larger adverse impacts, resulting in notable losses.”
The investment fund sector accounted for €396 billion of projected losses in the baseline scenario, “driven largely by declines in the values of equities held by the funds” — edging out the estimated €343 billion in banking sector losses, and €207 billion for the insurance and pension sectors, the report said.
The losses for investment funds rose to €602 billion in the first adverse scenario, and to €1.6 trillion in the second adverse scenario — given more severe macro effects that lead to a further decline in market values and higher default risk premiums for corporate bonds.
European funds would “experience similar overall declines in asset values to the rest of the global investment fund sector in all scenarios,” the report noted. It added that a key driver of the impact on funds “is likely to be the economic sectors they invest in, more than the asset class or the geographical focus of the fund.”
While the regulators noted that the exercise has a high degree of uncertainty, they said its results call for “a co-ordinated policy approach to financing the green transition and the need for financial institutions to integrate climate risks into their risk management in a comprehensive and timely manner.”