Europe’s pensions and insurance supervisor highlights sovereign debt climate risk

EIOPA works with academics on ground-breaking new paper

Fossil fuel exposure and low-carbon transition readiness can “considerably affect the fiscal and financial risk position” of countries, according to a new paper on European insurers’ sovereign debt holdings by the European insurance and pension supervisor, EIOPA, in collaboration with leading academics.

The joint paper ‘Climate Risk Assessment of the Sovereign Bond Portfolio of European Insurers’, which does not reflect the supervisor’s official position, was published last month as part of its Financial Stability Risk Report. 

"Climate risk is a new emerging risk and we have limited knowledge and sovereign bonds are the least covered area in this instance and that’s why we looked at this"

It is claimed to be the first collaboration between financial regulators, climate economists and climate financial risk modellers and is also believed to be the first paper to assess climate-related financial risks stemming from insurance companies’ exposures to sovereign bonds.

The paper assesses the impact of disorderly transition scenarios and their accompanying “shocks” on European insurers’ sovereign bond portfolios.

It concludes: “In general, countries that have already started to align their economy to the low-carbon transition (and thus where renewable energy technologies play a larger role in its GVA [Gross Value Added] and fiscal revenues) face a decrease in the PD [probability of default] and in the Climate Spread, and thus better refinancing conditions.”

This finding, the paper adds, could “have relevant implications” for the financial risk profile of insurers which own the sovereign bonds of countries that are “misaligned” with the climate transition.

The report also notes that “it would be in the interest of insurers’ supervisors” to “extend this climate financial risk pricing exercise (ideally in a climate stress-test exercise…) for financial risk monitoring and assessment purposes”.

Petr Jakubik, Financial Stability Team Leader at EIOPA and one of the authors of the report, described the paper as a “first attempt”.

“Climate risk is a new emerging risk and we have limited knowledge and sovereign bonds are the least covered area in this instance, which is why we looked at this,” he said.

Data for the analysis came from the anonymised quarterly Solvency II reporting and the Centralised Securities Database (CSDB), the security-by-security database used by European System of Central Banks (ESCB). 

"Under specific and feasible climate transition scenarios, the financial shock is not negligible at all"

Solo data of insurers from the 32 countries in the European Economic Areas were included. That amounts to a dataset containing 1,576 insurance companies, 142 bond issuers and 10,746 bonds – totalling €2.1trn.

Overall, the paper finds that the potential impact of a disorderly transition on insurers sovereign bond portfolios as “moderate” in terms of magnitude. 

But Irene Monasterolo, Assistant Professor of Climate Economics and Finance at the Vienna University and one of the paper’s authors, tells RI that “under specific and feasible climate transition scenarios, the financial shock is not negligible at all”.

Given the importance of sovereign bonds to insurers’ investment portfolios – comprising around a third of their holdings – the paper states that transition risks should be regularly monitored and assessed. 

The study uses the CLIMAFIN framework, which was developed by Monasterolo and fellow author Stefano Battiston, SNF Professor of Banking at the University of Zurich, to provide a “forward-looking climate transition risk assessment”.

Monasterolo told RI that this paper is the first step in a collaboration with EIOPA, one which may see it work with the supervisor on a sovereign bond climate Value at Risk (VaR) analysis and also potentially a climate stress test.

She said that there are also talks with Europe’s banking supervisor, the European Banking Authority (EBA), on potential collaboration and that she is currently working with the central bank of Austria, Oesterreichische Nationalbank (OeNB), on a climate stress test.

The authors of the report will present on the EIOPA paper and their wider work later this week at a sustainable finance conference at the University of Zurich. 

Despite its size and importance to investors, the sovereign debt market has so far largely not been a focus for ESG — but there are signs that this is changing. 

In November, the Riksbank, Sweden’s central bank, became the first central bank in the world to exit public debt because of climate exposure – revealing it has sold sub-sovereign notes from Queensland, Western Australia and Alberta.

It comes as credit rating agency Moody's Investors Service said today that while Australia's general and state governments “can absorb” the near-term credit impact from the ongoing bushfires — over time, the costs from climate change impacts would “test the government's capacity”.

Last week, RI revealed that under the latest draft of the EU’s Ecolabel scheme, eligible funds will not be permitted to invest in debt issued by sovereigns which have not ratified the Paris Agreement – including US Treasuries. 

But the Ecolabel may consider exemptions for US states able to demonstrate “strong evidence of political commitment” on par with Paris – a potential workaround for RI-focused investors.

Amid all this, the Principles for Responsible Investment (PRI) is next week hosting a webinar on ESG and sovereign debt.