Integrating climate risks into your risk management
One of the important functions of financial markets is to accurately price risks, so people and organizations can make well-informed investment decisions. To allocate capital at given risks, sufficient information and transparency are vital. A lack of transparency makes financial markets less stable and less resilient.
The Dutch central bank and the Bank of England have already emphasized that climate risks can pose a serious threat to financial markets. Not only through physical risks, such as extreme weather events, but also through non-physical risks, like new regulation or emerging technologies.
Since the ratification of the Paris Agreement in 2016, the direction of future policy is set to keep the rise in global temperature below 2˚ C above pre-industrial levels, and limit the increase in temperate to 1.5 ˚C. The result of the agreement, amplified by the developments in renewable energy and energy efficiency, is that carbon-intensive companies need to adapt their business models to prepare for a new future. Mitigating climate risks is no longer only a long-term concern.
A major risk these companies face is what we call the ‘carbon bubble’. Their assets may very quickly become worthless due to more stringent (climate) regulations or technological developments. This devaluation of assets also affects the associated financial markets.
The Dutch pension market
In the Dutch financial sector, the pension market has the highest exposure to the potential burst of such a carbon bubble. The pension fund is the administrator of the retirement savings of its participants. For the allocation of this capital at an optimal return against a given risk, the fund outsources the investment activities to the pension provider.
Pension funds and providers have sizeable fossil-related investments. These investments carry a higher risk on sudden impairments than loans and government bonds, which are predominantly owned by banks and insurance companies. This implies future pension payments can also be affected by such a carbon bubble burst.
Since oil and gas (O&G) companies control large portfolio shares of the Dutch pension market, and these companies account for 50 percent of global CO₂ emissions, pension markets can seriously impact the energy transition. This leads to the question: Is the Dutch pension market adequately managing the carbon risk of the O&G companies in their portfolios?
How climate risks are valued
There are large differences in how pension providers manage their portfolios. Some have been experimenting with new tools for years, while others just flat out ignore climate risks in their investment decisions.
For actively managed portfolios, pension providers include both quantitative and qualitative data, of which the proven oil and gas reserves of O&G companies are typically included. However, pension providers also have passively managed portfolios, which implies following an index. Why does that matter? These indices often include O&G companies as these companies are expected to deliver solid returns. While managing such portfolios saves time and money, it comes at the cost of good knowledge of the (carbon) risks. Moreover, not all companies similarly report their carbon data, making it more difficult to price the carbon risk of companies in the pension portfolios.
Exposure to the Carbon Bubble Risk
The potential reach of a climate bubble burst is enormous. The total Dutch pension market has about €1,300 billion in assets under management, which is approximately twice the value of the Dutch GDP and one of the largest pension asset-to-GDP ratios in the world. The exposure to O&G companies in the Dutch pension portfolios is on average 7.5 percent, ranging between 2 and 15 percent. This is even an increase compared to 2016.
A crucial aspect of the carbon bubble theory is whether the carbon risk is currently priced into the financial markets. The Dutch Central Bank has conducted a survey with 28 financial institutions on energy transition risks. The financial sector almost unanimously agreed these risks are not completely priced into financial valuations, which indicates a carbon bubble is likely. Yet, the largest Dutch pension providers are divided on this issue.
To deflate a potential carbon bubble, pension funds and providers need to decarbonize their portfolios. Despite its apparent urgency, this process is slowed down by an impasse as we speak. Pension funds can instruct the pension providers to sell off carbon-intensive assets, but they lack the risk management knowledge and expertise. The pension providers, however, lack the normative mandate to divest these carbon-intensive assets.
Due to this impasse, pension providers keep investing in the increasingly expensive exploration of oil and gas fields. Debt levels of O&G majors are rising. While all these developments have become a concern for pension providers, they have not led to divestments yet. One of the reasons is that these activities are considered part of the general market fluctuations and, therefore, not perceived as a substantial risk.
Foreign pension markets are leading by example by moving their investments towards greener assets. The Norwegian Pension Fund, the Danish National pension fund, the French Fonds de Réserve pour les Retraites (FRR), UK’s Environment Agency pension fund and the Swedish government pension fund (AP4) are already decreasing their exposure or are even completely divesting their fossil fuel assets.
To adequately manage climate risks, valuation methods should be adapted to bring pension providers’ portfolios in line with the Paris Agreement. Improved methodologies include the use of more scenarios, and other forward-looking risk management methods. Stress-testing on global warming within 2˚ C is a key method to be used to assess the impact of the energy transition on portfolios.
At the same time, laws and regulations can support climate risk assessments for the financial sector. The European Parliament accepted the so-called IORP II Directive in line with the Paris agreement, which requires European pension funds and providers to assess ESG risks of their investments. In the Netherlands, a Climate Law is still under negotiation, yet it aims to reduce GHG emissions with 95 percent in 2050 compared to 1990-levels, and have a CO2-neutral energy production by that same year. This provides certainty for investors when determining their investment strategy. Sharing best practices on climate risk management is, among others, facilitated by the Taskforce for Climate-related Financial Disclosures.
Although regulatory steps have been taken, the Dutch pension market can and should do more to adequately manage the carbon risk of the O&G companies in their portfolios. None of the O&G companies believe that their own assets are overvalued. It is up to the financial sector to determine who is right and who’s wrong.
Don’t wait until the bubble bursts. A stitch in time saves nine.