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Stress testing equity markets with higher carbon prices

Sustainability
Equities

10/3/2024

Comparing the impact on traditional and ESG equity indices

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Cedric Chavot

Deputy Head of Insurance Advisory EMEA, ex-Germany & Austria

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Virginie Galas

Head of CROCI Company Analysis

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Gyan Jaiswal

Senior Research CROCI Analyst

Murray Birt

Senior ESG Strategist

IN A NUTSHELL

  • European insurance supervisors have been highlighting the vulnerability of insurers to physical and transition climate risks, underscoring the need to strengthen consideration of climate risks and opportunities into insurers’ governance and strategies.
  • Carbon prices are a key transition risk for public equities, as countries are increasingly implementing carbon tax or trading policies , driven in part by the European Union’s carbon border tax.
  • This paper applies carbon price stress test scenarios to traditional and ESG equity indices.
  • We conclude that higher carbon prices could significantly impact company equity value by -10% to -15% for the MSCI World index, based on a carbon price of USD 150/tCO2 or USD 300/tCO2.
  • While this impact is consistently negative across indices, it is less pronounced on ESG indices. We recommend that investors, particularly in Europe, consider shifting their exposure from traditional indices to ESG indices in a capital protection strategy.
  • Another approach to hedge against carbon price equity risk is to consider investing in carbon allowances, a strategy which we explored in our report “Investing in carbon: a new asset class”.

1    Introduction

The heightened vulnerability of insurers to climate change necessitates urgent and strategic actions to integrate climate risks into their governance and strategies

Specifically, reform of the EU Solvency II Directive has created a new requirement[1] for insurers to identify and assess any significant exposure to climate change risks and use climate scenarios within their Own Risk and Solvency Assessment (ORSA), which will be closely monitored by the European Insurance and Occupational Pensions Authority (EIOPA)[[2]

Against this backdrop, this paper presents a possible approach for assessing the implications of higher carbon prices on the value of equities globally, through the following structure:

  1. Vulnerability of insurers to climate change: we remind why insurers are particularly vulnerable to climate change. This section examines the specific risks posed by climate events to insurers’ financial health, and the implications for underwriting and investment portfolios.
  2. Official climate scenarios may underestimate materiality of climate risks: we summarise the results of official climate scenarios that find limited risks for insurers. However, the UK actuarial professional industry body concludes that current climate scenarios underestimate climate risks
  3. Deriving a carbon price from a new short-term climate scenario narrative: we use a new, short term climate scenario narrative developed by the United Nations Environment Finance Initiative (UNEP FI) and the National Institute of Economic and Social Research (NIESR) leading to higher carbon prices globally. This scenario incorporates more extreme assumptions to better reflect the potential adverse impacts on financial stability and to provoke the necessary strategic changes and awareness among investors.
  4. Measuring the potential impact of higher carbon prices on the value of global equities: we analyse how the imposition of a more stringent carbon price could affect the value of global equities. This section also provides a comparative analysis between traditional and ESG equity indices for various regions, highlighting the financial implications of transitioning to a low-carbon economy.

Based on our proprietary analysis, we show that the impact of a higher carbon price on company equity value is significant, ranging from -10% to -15% for the MSCI World index, with a carbon price of USD 150/tCO2 and USD 300/tCO2. While this impact is consistently negative, it is less pronounced on ESG indices, which could encourage investors, particularly in Europe, to consider shifting their exposure from traditional indices to ESG indices in a capital preservation strategy.

By providing an in-depth analysis, this paper aims at guiding European insurers as they transition towards a more sustainable economy while ensuring their financial robustness in the face of future climate challenges. This analysis can also be seen as a useful guide for helping European insurers assess the impact of a given short-term climate scenario, in their ORSA, on the value of their portfolio invested in global equities.

 

Stress testing equity markets with higher carbon prices
Click here to download the full article
1

European Parliament, April 2024 Resolution on the proposal for amending the Solvency II Directive

2

EIOPA June 2024 Financial Stability Report

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