Financial firms still overexposed to climate risk

Financial firms still overexposed to climate risk

A report released earlier in March stressed the need to address high carbon risk in financial firms’ assets. Large institutional investors continue have continued to divest from fossil fuel stocks.

A recent study found that the EU financial sector’s exposure to carbon risk amounts to €1 trillion worth of assets with pensions funds bearing the highest risk, followed by insurance companies and banks. The study, commissioned by the European green party, has investigated the exposure in “high-carbon assets” of 43 of the EU’s largest banks and institutional investors and calculated their potential losses due to climate risk under a variety of scenarios.

While the risks borne by some are high, there is doubt whether a carbon bubble could be a source of systemic risk. “Carbon bubble risks, while significant, are not so large that they pose a threat to the pension, banking and insurance sectors as a whole,” the authors conclude.

However, many UK pension funds, such as USS and BAE, along with some of Europe’s biggest banks, could suffer losses totalling several billion euros. Industry giant Barclays was found to be particularly exposed to carbon risk in its loan business, with more than one out of ten corporate loans going to “high-carbon risk” firms including coal, oil and gas mining companies. Findings derived from individual sector analyses were extrapolated to correct for data inconclusiveness.

The study adds to the expanding body of literature warning investors of the risks posed by stranded assets, often referred to as carbon bubble risks. These risks denote a situation where fossil-fuel assets are likely to lose value due to carbon mispricing.

As the debate has drawn public attention, analysts have started pushing the financial industry to extend their risk models to include environmental risks in the investment process and to increase disclosure on so-called non-financials.

Recent findings published by Ceres reveal that reporting standards on climate change risk remain too weak to enhance investor protection. While the SEC, a U.S. regulatory body, has attempted to fill the transparency gap in disclosure on business risk, corporate reporting still falls short of its potential.

The state of such reporting is not very different in the EU, where businesses are not bound to provide detailed information on how they seek to mitigate environmental related risks.

However, some expect European regulators soon to call financial firms to perform climate risk assessment as part of their fiduciary duty, which obliges trustees such as pension funds to act in their clients’ best interest.

Anticipating such regulatory risk is vital for businesses and their bottom line. Many long-term investors, including pension and government funds, have started shifting assets out of the carbon sector triggering a growing debate on large-scale fossil divestments around the globe.

Norway’s sovereign wealth fund, worth $840 billion, is being pressured by the government to ditch its holdings in carbon intensive companies, such as BP and Shell, which could send out a strong message to the market. The fund holds an estimated 1.3% of global shares and is the world’s largest sovereign fund. A similar step might soon be taken  by institutional investor SEFERS, the San Francisco-based retirement fund, which is reported to pull out its $600m investments from fossil fuel stocks.

While climate change is merely perceived as uncertainty, there is a case for re-defining it as quantifiable risk, which should be approached through modern accounting and reporting. High carbon risk has been found to affect investments across all asset classes, from equity to corporate bonds, but still it seems largely unaddressed by  most within the industry.

Categories: Finance, International

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