European pension funds have higher carbon exposures than wider economy – supervisor

EIOPA stress test looks at ESG and climate for first time

The equity investments of European pension funds have higher carbon exposures than the wider European Union economy, according to a stress test by the supervisory body EIOPA.

EIOPA, the European Insurance and Occupational Pensions Authority, surveyed 176 schemes, known as IORPs (Institutions for Occupational Retirement Provision) as part of a stress test to assess the “resilience and potential vulnerabilities” of the defined benefit and defined contribution pension sector and potential impact on financial stability. 

"The average carbon footprint of IORPs’ equity investments exceeds the average greenhouse gas intensity of all economic activities in the EU"

Schemes from 19 countries (but not the UK) participated, including names such as the Netherlands’ ABP and PFZW and Bosch Pensionsfonds of Germany.

The revised EU legislation that governs the sector, known as the IORP II Directive, came into force this year; it requires IORPs to take into account ESG risks in their risk management system. 

In a 70-page report, EIOPA found that: “The average carbon footprint of IORPs’ equity investments (0.37 kg per € value added) exceeds the average greenhouse gas intensity of all economic activities in the EU (0.26 kg per € value added)”. The average carbon footprint of debt investments (0.22 kg per EUR value added) was lower.

EIOPA put this down to the high proportion of manufacturing companies in publicly traded equities and by the high share of government bonds within the debt asset class.

“A relatively thin data situation”

While noting the “limited granularity” of the underlying data (“relatively thin data situation”) and the “missing” EU taxonomy on sustainable investments at the time of the stress test, EIOPA said it was a “striking result”.

EIOPA said it made a qualitative analysis of how far IORPs contribute to mitigating ESG risks in society and how far IORPs reduce their own exposure to ESG risks. 

Further, a quantitative analysis based on IORPs’ allocation of investment assets by economic activity provided a “rough indication” of the exposure of IORPs to 'brown' assets and the overall carbon footprint, measured by reference to greenhouse gas emissions, of their investment portfolios. 

EIOPA found that only 30% of IORPs indicated having a process in place to manage ESG risks before the directive was transposed into national legislation. And it found that the integration of ESG factors “does not necessarily mean that IORPs can easily identify or find suitable, sustainable investments”. 

Of all IORPs, 22% indicated that they experienced difficulties in defining and identifying sustainable investments and 16% in finding sustainable investments.

At the time of the stress test, just 57% of the IORPs surveyed disclosed to plan members and sponsors how they integrate ESG into investment decisions.

Bank of England: pioneering exercise

The move comes as the Bank of England announced plans today to undertake a similar, “pioneering exercise”: to make climate change the focus of its next ‘biennial exploratory scenario’ (BES) – the two-yearly assessment of UK banks that addresses “emerging threats to financial stability and individual banks [that] may not necessarily be linked to the financial cycle”. 

 In a discussion paper, the bank lays out its proposals for the 2021 BES, which will assess both physical and transitional climate risks, using three scenarios: early policy action, late policy action and no policy action.

Unusually, it will cover insurers as well as banks and will take a 30-year look at risks – longer than the usual horizons used by the bank, to fit with the realistic timeframe of climate change and related policy interventions.

“The exercise will provide a comprehensive assessment of the UK financial system’s exposure of climate-related risks and therefore the scale of adjustment that will need to be undertaken in coming decades for the system to remain resilient,” the Bank of England said. 

As a result, it will focus on identifying “the scale of business model adjustment required to respond to these risks, rather than testing the adequacy of firms’ capital to absorb those risks”. 

The discussion paper is out for feedback until March 18, and the bank is inviting the views of financial firms, scenario modellers and climate scientists, among others, on “the robustness and feasibility” of the plans, as well as “whether the scenarios align with external expectations of climate-related risks and the related to changes in the real economy”.