Impact of Climate Risk on Investment Portfolios
The European Securities and Markets Authority (ESMA) releases a report on the impact of climate risk on investment portfolios, aiming to analyze the performance of the asset management industry under different climate scenarios.
The global asset management industry has a scale of more than 60 trillion euros, of which European asset management scale exceeds 17 trillion euros. The asset management industry plays a key role in financing the economy and green transition, and understanding the climate risks is critical from a sustainability and financial stability perspective.
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Climate Risk Identification and Climate Scenario Analysis
To study the impact of climate risks on investment portfolios, ESMA divides different climate risks into physical risks and transition risks, where physical risks refer to the financial costs related to climate change (such as severe weather events), and transition risks are related to changes of climate policies, consumer behavior and low-carbon technologies. If global climate action is implemented in a disorderly, delayed, or uncoordinated manner, climate risks will have a greater impact on investment portfolios as well as the financial industry.
The impact of climate risk on investment portfolios primarily involves the financial assets held within the portfolio, the performance of which is directly related to the financial condition of the company. Certain climate risks could reduce a company’s profitability or cause carbon prices to rise, ultimately causing a company’s share price to fall or bond yields to rise. At the same time, climate risks can also affect the macro economy and indirectly cause losses to the company’s operations. ESMA needs to build financial models to measure these impacts.
Model the Impact of Climate Risk on Investment Portfolios
ESMA uses climate scenarios provided by the European Central Bank, assuming asset prices fall sharply in the initial stage and then gradually recover. The impact of climate risks on investment portfolios will have two effects, namely static effect, and dynamic effect. The static effect refers to the decline in the price of financial assets directly held by the investment portfolio, and the dynamic effect refers to the inflow and outflow of investors due to changes in expectations, as well as the rebalancing process of the portfolio by investment managers. In contrast, static effects are faster, while dynamic effects may take longer to complete.
In the process of building the model, ESMA considered 19,000 investment funds in Europe, with cumulative assets of more than 10 trillion euros. ESMA assumes that changes in fund valuations only come from changes in asset prices, that inflows and outflows of funds are positively related to fund performance, and that selling assets at market prices will not cause a liquidity tension. In addition, ESMA has also made clear rules on the process of portfolio rebalancing.
Outcome of Investment Portfolio Performance under Climate Risk
ESMA forecasts portfolio values from 2023 to 2027 and finds that climate risks can lead to a maximum drawdown of 70%, with 80% of the downside coming from the financial, manufacturing and communications industries. At the same time, asset values in carbon-intensive industries have the largest changes. For example, the fossil energy industry and agriculture may decline by more than 80%. In terms of dynamic effects, negative performance of fund performance may cause investors to withdraw funds, with a maximum withdrawal of 18%.
Although financial models make simplifying assumptions and may not account for the knock-on effects of climate risk shocks, forecasts already indicate the climate vulnerability of investment portfolios. Due to outflows, the asset management industry may be less resilient to climate shocks than models suggest. ESMA plans to continue to improve the model and include the second round of climate risk shocks to assess the impact of climate risks more objectively and accurately.
Reference:
Dynamic Modelling of Climate-related Shocks in the Fund Sector
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