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EU regulator: Stress test shows pension funds have much more to do on ESG risks

"Much more needs to continue to be done" to address the environmental, social and governance, or ESG, risks in European pension funds' investments, according to European Insurance and Occupational Pensions Authority Chairman Gabriel Bernardino.

The results of the European regulator's pension fund stress test, published Dec. 17, showed that 30% of the participating pension funds had formal processes to manage ESG risks and that 19% assessed the effect of ESG factors on the risk and return of their investments. Furthermore, the report found that pension funds' investment portfolios had a greater exposure to carbon-intensive industries than the average EU economy, particularly on the equities side.

Speaking to journalists about the stress test results, Bernardino acknowledged that the majority of pension funds are taking steps to identify and manage ESG risks, and that the biggest EU pension funds are leading the way "not only at European level but also, I believe, at the international level."

But for smaller and medium-sized pension funds, he said management of ESG risks was "not so much present" and so "we all need to do more in this area."

Bernardino also contended that although pension funds' inherent long-term investment view allows them to weather shorter-term shocks better than other types of financial institution, it also makes the need to identify and manage ESG risks more pressing. The effect of their investment decisions, he noted, lasts for many years and so "they are much more prone to transition risks than other types of more short-term activities."

Cautious on carbon

Bernardino said there was also work to be done to manage the relatively high carbon footprint in European pension funds' investment portfolios that the stress test exercise uncovered. He said pension funds should engage with companies they invest in and exercise their voting rights as shareholders to give companies "clear incentives" to shift toward a lower carbon footprint.

But he also said the shift to a lower carbon footprint should be done gradually to avoid market instability, which "would not be a benefit for anyone." Pulling out of investments in carbon-intensive industries was not the only answer, he said, adding that the solution should be more focused on encouraging the companies "to move to a more sustainable path." This gradual approach "will be very important in managing the transition risk that we have in climate change," Bernardino said.

The stress test covered 176 pension funds across 19 countries. France was included for the first time, yet the U.K. was absent because of uncertainty about its exit from the EU at the time of testing.

The next pension fund stress test will take place in 2022. Bernardino said that following lessons learned from previous exercises, the European Insurance and Occupational Pensions Authority will start work in 2020 on updating the methodology framework of the tests, in part because the regulator has "more or less exhausted" the stress scenarios it could apply in the tests.

EIOPA also wants to expand the horizon of tests beyond a one-year impact, and integrate the analysis of the defined benefit, or DB, and defined contribution, or DC, pension markets, which it currently evaluates separately in the tests.

DB schemes pay out a pension for the remainder of the beneficiary's life, while DC schemes pay out until the pension pot is exhausted.