European investment funds, insurance firms and pension funds could face mounting climate-related losses from corporate bond holdings no matter how swiftly or slowly governments act on climate change, according to the European Central Bank (ECB).
The supervisor said that investment funds could lose up to an estimated 12 percent of their corporate bond portfolio value on average due to climate transition risk over the next eight years, with losses rising to 15 percent for both insurers and pension funds.
Absolute losses could reach €10-18 billion for investment funds, €6-16 billion for insurance companies and €1-2 billion for pension funds.
The findings were published today as part of the ECB’s second ever economy-wide climate stress test which it billed as “an important step forward in the field”. The 2023 test is the first by a central bank to consider a shorter time horizon lasting to the end of the decade, and to integrate recent energy shortages and inflationary pressures caused by the Ukraine war.
It is also the first to quantify the impact of climate change on investment portfolios, or “non-bank financial institutions”, focusing on corporate bonds. The data was derived from estimates of the likelihood of individual companies defaulting on debt due to climate losses, which was then mapped onto the combined €546 billion corporate bond portfolios of EU investment funds, insurers and pension funds as of Q4 2022.
The stress test only considered transition risks caused by changes in government policies, technology advances and consumer preferences in response to climate change, rather than its physical impacts.
The ECB’s approach could significantly shape a global effort by central banks to develop shorter-term climate scenarios under the banner of the Network for Greening the Financial System (NGFS) which is expected to start by the end of 2023.
The NGFS workstream for this project is currently chaired by ECB deputy director general Cornelia Holthausen.
The development of short-term climate scenarios – as opposed to the commonly used 30-year horizon – is a priority for central bankers as it could more precisely capture the economic impacts of climate change and severe natural disasters.
The ECB found that all three investor types “would follow similar dynamics but differ in magnitude” across three different climate scenarios: two of which would see the world meet its climate goals by 2030 albeit through an orderly transition where climate policies are introduced earlier (accelerated) or a disorderly transition caused by delayed action (late push).
Under the remaining scenario, climate policies are considered insufficient to reduce emissions and put the world on course for a temperature increase of 2.5C by the end of the century (delayed).
The variation of impact between investors is attributed to the relative size of their exposures to carbon intensive sectors, said the ECB.
It estimated that pensions and insurers have an average bond portfolio exposure of around 13 percent and 14 percent to the electricity, gas and steam sectors, and an exposure of 9.7 percent for investment funds.
Pensions and insurers were also found to have a higher exposure to the transport sector compared to investment funds.
Risk levels in 2030 are expected to be similar across the scenarios but would entail very different long-term implications.
The accelerated transition would drive up costs in the short term, due to rapid and severe increases in energy prices, but would lower future financial risks due to rapidly reducing energy expenses and investments in renewable energy capacity.
A late push would also meet climate targets, but would see mining, manufacturing and utility industries impacted disproportionately as they bear the brunt of higher energy expenditure and the need for immediate investment in carbon mitigation activities and renewable energy.
Under the delayed transition scenario, transition risks would keep increasing until 2030 and potentially further, due to a continuous increase in energy prices and less renewable energy capacity.
For bank loan books, the ECB said that a late push transition would generate the most defaults and annual expected losses, peaking at €21 billion in 2029.
In an accelerated transition, bank losses would rise sharply in 2023 and peak at €13 billion in 2026, before declining to €6.6 billion by 2030, while a delayed transition scenario would see smaller expected losses due to milder transition efforts.
The ECB noted that transition risk was concentrated in the bank sector, with less than 10 percent of banks providing 90 percent of all loans to carbon-intensive sectors.
However, it said that the expected losses and provisioning needs for banks resulting from transition risks “would not seem to generate financial stability concerns for the euro area”.
The report was welcomed by ECB vice-president Luis de Guindos, who called for quicker progress towards the establishment of a capital markets union (CMU), a policy initiative launched in 2015 to develop and integrate the bloc’s capital market.
“Firms would greatly benefit from progress towards a CMU which would help them undertake the massive amounts of green investment required. The CMU would facilitate cross-border access to funds, strengthen risk-sharing, avoid fragmentation and foster integration,” said de Guindos.
Meeting the EU’s climate targets would require around €3 trillion worth of investments by 2030, he added.