‘Brown’ Investments Risk Larger Losses from Transition Shocks

ESMA finds green funds less exposed to systemic network risks; TPI releases flagship transition report

Funds containing holdings in ‘brown’ securities are more at risk from losses from climate transition shocks than green funds because of higher levels of cross-investments in these, a European financial regulator has said.

In a scenario analysis published in its Q1 risk report, the European Securities and Markets Authority (ESMA) found total system-wide losses for EU-domiciled funds could range from €152 billion to €443 billion.

If impacted by climate-related financial shocks, the cleanest funds would face 3-8% and the dirtiest funds 9-18% in losses. The dirtiest funds would also contribute most to system-wide losses.

The analysis aimed to examine the climate-related financial risks within the network of EU funds and is part of ESMA’s work on climate-risk stress testing.

The study applied scenarios by the European Systemic Risk Board for its network analysis, which uses transition shocks from abrupt implementation of policies and from technology breakthroughs.

It found that European investment funds are overweight in brown firms, with about more than a third of investments, and that brown funds are more closely connected to each other. Dirtier funds have also greater exposure to transition shocks while some clean funds can even fully escape these.

At a presentation today, Adrien Amzallag, Risk Analysis Officer, Innovation and Products at ESMA, explained that green funds tend to have assets sold to fewer funds compared to brown funds, which means that brown funds play a more central role in transmitting climate shocks as well as being impacted by these.

“If there are tighter links between funds with the dirtiest portfolios, than they are with funds with the cleanest portfolios, that means you have a risk of herding when you have a climate shock, because you have funds with the dirtiest portfolios hit harder by climate risk and they are all invested in similar assets, so they are likely to move in similar directions, in other words to sell-off the assets together,” he said.

The study contributes to ESMA’s financial stability and sustainable finance strategy work.

The regulator examined the data of 23,352 EU-domiciled funds with investments worth €8 trillion and representing 51% of EU fund holdings.

Green firms were ranked in the lower third according to their amount of emissions, brown firms in the highest third, and neutral firms in between, when applying scope 1 and 2 data from companies’ direct and indirect emissions. Among other plans, ESMA said that it wants to include scope 3 emission data from value chains going forward.

To compare portfolio ‘dirtiness’ between funds, the study applied an absolute measure, the weighted average emissions per investment in the portfolio.

Separately, an asset owner-backed research project found mixed progress from firms in respect of emissions reduction plans.

The $25 trillion-backed Transition Pathway Initiative (TPI) found in its latest annual report that the number of companies with high-quality, credible net zero targets has more than doubled this year to 35.

In its ‘TPI State of Transition 2021’ flagship report, the initiative also revealed that 15% of companies are now aligned with a pathway to keep temperature rises to below 2 degrees by 2050.

But while this shows growing momentum behind net zero efforts, the initiative identified a performance gap.

No sector has been decarbonising at the rate required to achieve the 2050 targets companies have set themselves, the report said. Diversified miners with emissions reduction targets and aluminium producers have increased their carbon intensities.

The report assessed 401 of the world’s highest-emitting public companies on management quality and 292 companies on planned and expected carbon performance.

“Investing in credible, ambitious transition leaders is critical on the path to net zero. The 2021 TPI State of Transition report provides extremely valuable input to investors as it helps identify transition leaders and laggards in a robust manner,” said Eva Cairns, Senior ESG Investment Analyst at Aberdeen Standard Investments.

“Although a significant development it still represents only a limited leadership group that needs to expand rapidly. As we enter the ‘decade of transition’ having only 17% of companies with credible net zero commitments is not enough,” said Adam Matthews, Chair of TPI and Chief Responsible Investment Officer at the Church of England Pensions Board.



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