Investment funds threatened by climate change

The effects of climate change cannot be predicted completely, i.e., it is impossible to calculate the exact condition of, for example, the earth, a specific region, or even more so, a single company in a number of years. That is why tools such as scenario analysis are used. They show various possible future states in the event of specific circumstances.

Such a scenario analysis in relation to investment funds was recently carried out by ESMA (European Securities and Markets Authority). In a report published in December 2023,. article ESMA presents its model for analyzing the impact that climate change may have on the investment fund sector.

The analysis is based on dynamic modeling and assumes an initial shock to the value of fund assets resulting from the occurrence of transformational risk (e.g., a sudden increase in carbon dioxide emission prices) and subsequent effects resulting from the sale of certain assets, the purchase of others, the withdrawal of funds by their clients, and the inflow of new funds.

In one of the two scenarios examined—the more negative one—funds lose up to 70% of their asset value in the first year. This is not distributed evenly across all economic sectors of the companies in which the funds invest, and in the case of high-emission sectors (such as mining, waste management, or agriculture), the declines in value range from 80 to over 90%.

In October 2023, I wrote about this., how financial institutions mislead their clients by basing their analyses on meaningless models of the impact of climate change on the economy. It is a good sign that ESMA, the supervisory authority, has taken a fundamental approach to modeling the impact of climate on the capital market. The article outlines all the assumptions made and further directions for possible research. After all, the analysis to date covers only one type of climate risk (transformational) and has a short time horizon (until 2027). The future of the capital market in a world of climate crisis looks bleak – but it is probably better to know this in advance.