The first climate stress test for European Institutions for Occupational Retirement Provisions (IORPs) carried out by the European Insurance and Occupational Pensions Authority (EIOPA) has shown that IORPs have a material exposure to transition risks.

The first climate stress test of the sector – although not a pass or fail exercise – assesses the resilience of IORPs against a climate change scenario that simulates a sudden, disorderly transition to a green economy as a consequence of the delayed implementation of policy measures.

With a sample of 187 IORPs from 18 countries, the stress test covered all European Economic Area (EEA) countries with significant IORP sectors, EIOPA announced. On aggregate, more than 65% of assets in defined benefit (DB) schemes and defined contribution (DC) schemes were analysed.

EIOPA adopted a full balance sheet approach to examine the impact on IORPs’ asset portfolios as well as on their long-term liabilities. The exercise followed a dual methodology: in addition to a national balance sheet (NBS) approach based on national valuation regulation, a common balance sheet (CBS) approach with mark-to-market valuations was used to make meaningful comparisons possible.

Due to the nature of the disorderly transition scenario, the exercise focused on the asset portfolio of IORPs. The results show that IORPs are materially exposed to transition risks.

On the asset side, the stress scenario provoked a sizeable overall drop of 12.9%, corresponding to asset valuation losses of some €255bn. The bulk of the drop in value showed up in equity and bond investments. IORPs on average had around 6% of their equity and 10% of their corporate bond investments in carbon intensive industries such as mining, electricity and gas, and land transport, for which the scenario prescribed steep write-downs of between 20% and 38%.

According to EIOPA, the scenario, which included interest rate movements, also affected the liability side. Liabilities decreased due to the rise in risk-free rates, which helped cushion the impact of asset side devaluations on the funding ratio even though they did not fully offset the drop.

Financial positions therefore still worsened slightly. While funding ratios decreased by 2.5pp (from 122.7% to 120.2%) according to the national and by 2.9pp (from 119.9% to 117.0%) according to the common methodology, post-shock aggregate funding ratios in DB schemes remained above 100% in most member states – due, in part, to strong pre-shock positions, the Authority explained.

Petra Hielkema at EIOPA

Petra Hielkema, EIOPA

“When looking at both assets and liabilities, the impact on funding ratios appears manageable, which in itself is reassuring,” EIOPA Chair Petra Hielkema said.

“Nevertheless, the heavy losses on the asset side clearly showcase the sector’s vulnerability to climate risks, especially regarding investments in carbon-intensive industries. In this year’s scenario, a drop in liabilities due to rising interest rates helped counterbalance much of the asset-side losses, but this may not be the case in every scenario,” she added.

Said said it was “important to reflect on this and consider testing different scenarios in future exercises as they might give us even better insights into the environmental risks borne by IORPs”.

The stress test was complemented by a qualitative survey on mitigation and adaptation measures, which revealed that although IORPs are increasingly considering ESG factors in their investment decisions, they still experience noteworthy hurdles in allocating investments to climate risk-sensitive categories.

According to EIOPA, only 14% of IORPs reported using environmental stress testing in their own risk management. Importantly, results indicate that this subgroup performed better in the exercise than their peers that do not conduct such analyses, suggesting that own climate stress testing helps IORPs position themselves better against transition risks.

Another qualitative survey connected to the stress test explored to what extent IORPs seek to mitigate the negative effects of inflation on the purchasing power of future benefits.

EIOPA also noted that 55% of DB IORPs said they offer schemes where benefits are directly linked to inflation. 67% of all IORPs said they aimed to outperform inflation with their investment strategies or at least had among their targets the mitigation of inflation’s effects.

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