1 Measuring Transition Risk in Investment Funds Ricardo Crisóstomoa

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Measuring Transition Risk in Investment Funds

Ricardo Crisóstomo

CNMV Working Paper No. xx, December 2022

Abstract

We develop a comprehensive framework to measure the impact of the climate transition on

investment portfolios. Our analysis is enriched by including geographical, sectoral, company and ISIN-

level data to assess transition risk. We find that investment funds suffer a moderate 5.7% loss upon

materialization of a high transition risk scenario. However, the risk distribution is significantly left-

skewed, with the worst 1% funds experiencing an average loss of 21.3%. In terms of asset classes,

equities are the worst performers (-12.7%), followed by corporate bonds (-5.6%) and government

bonds (-4.8%). We discriminate among financial instruments by considering the carbon footprint of

specific counterparties and the credit rating, duration, convexity and volatility of individual exposures.

We find that sustainable funds are less exposed to transition risk and perform better than the overall

fund sector in the low-carbon transition, validating their choice as green investments.

Keywords: Climate change. Low-carbon transition. Asset allocation. Investment funds. NGFS scenarios.

JEL classification: G11; G12; G17; G32; Q54.

Comisión Nacional del Mercado de Valores (CNMV), Edison 4, 28006 Madrid, Spain. The opinions in this paper

are solely those of the author and do not necessarily reflect those of the CNMV.

Email: rcayala@cnmv.es

1. Introduction

The transition towards a low-carbon economy might trigger financial stability concerns stemming from

the materialization of transition scenarios than are not anticipated by economic agents. Changes in

investors’ preferences, technological disruptions and the abrupt implementation of climate policies

introduce a future uncertainty that can cause a sudden revaluation of financial assets. The green

transition is expected to increase the costs of carbon-intensive firms while decreasing the demand for

their products. These changes could generate stranded assets, deteriorated credit quality, reduced

firm valuations and higher financing costs, leading to losses in the financial instruments issued by

transition-vulnerable firms.

Analyzing the links between investment funds and high-carbon firms can provide early warning

indicators of the systemic risk originating from the green transition. Higher climate awareness and the

disclosure of new environmental information could make investors to reduce or reject high-carbon

investments, generating contagion across overlapping exposures and a risk of runs on brown assets

(Jondeau et al., 2021a; Jondeau et al., 2021b)

. Beyond the direct effect on brown assets, financial

institutions and investors with ownership and debt links to high-carbon firms could be also affected by

the transition through increased credit and market risk in their portfolios.

This paper develops a comprehensive framework to measure transition risk in investment portfolios.

The vulnerability of financial counterparties to the climate transition is derived from an assessment of

their carbon intensity and economic sector. Furthermore, market and credit risk metrics are specifically

retrieved for each portfolio exposure to account for the varying degree of risk of different financial

instruments and asset classes. This methodology allows us to quantify the loss of value that each

individual exposure, and hence the corresponding portfolio, could suffer upon materialization of a

transition risk scenario.

To our knowledge, there are two papers that employ a related approach to deal with climate risk in

investment funds. Amzallag (2021) studies the climate risk of investment funds by means of their

carbon footprint and shows that investment fund exposures to the climate transition are

heterogeneous, with funds investing in highly pollutant firms exhibiting higher interconnectedness

than funds investing in sustainable activities. Gourdel and Sydow (2021) analyze the impact of physical

and transition risks on European funds considering redemption shocks, losses from repricing risk, fire

sales and second-round effects. Their result shows a better performance of green funds in the climate

transition but generalized losses in case of a physical shock.

Compared to the literature, our contribution is threefold:

▪ We introduce an ISIN-level methodology that can be used to quantify the climate risk of any

investment portfolio. Our approach considers both climate and financial risk metrics to measure

transition risk.

▪ We perform the first climate-related description of the Spanish investment fund universe. We

derive from this analysis the main characteristics of Spanish fund portfolios, including (i) a

comparison with their European peers and (ii) an analysis of how sustainable funds perform in the

climate transition.

Contagion can occur when a fund selling its portfolio cause losses to other market participants with overlapping

exposures (Poledna et al., 2021)

▪ The granularity of our analyses is enriched by considering sectoral, geographical, company and ISIN-

level data. Compared to sectoral models, we find that the product mix, energy reliance and

technological portfolio of specific companies can significantly alter their climate risk profile.

Our analyses show that investment funds suffer moderate losses upon a materialization of a high

transition risk scenario. Overall, the average mark-to-market (MtM) loss in the investment funds sector

is 5.69%. However, the distribution of transition risk losses is significantly left-skewed, with the 1%

worst performing funds enduring an average MtM loss of 21.34%. While many funds respond

resiliently to the low-carbon transition, funds’ investing in equities of highly pollutant companies suffer

the highest losses. These figures should be interpreted as a low severity estimate of the potential fund

losses, as only direct portfolio effects are considered. Amplifying factors like the fund-flow relation,

market impact, indirect contagion or other system-wide drivers could trigger feedback loops and non-

linear effects that increase the final loss

We also find that sustainable funds outperform the overall fund sector in the climate transition. In

terms of tail risk, although sustainable funds held a higher share of equity investments, the worst 1%

and 5% vehicles suffer a limited 14.65% and 11.00% loss (vs 21.34% and 15.47% in the fund sector).

Similarly, the MtM loss observed across all sustainable funds is 5.70%, which is lower than the 5.92%

attributed to the comparable portfolio in terms of asset classes. These figures indicate that sustainable

funds are less exposed to transition risk and invest in financial assets that outperform their sectoral

peers in the low-carbon transition.

Finally, we show that Spanish funds exhibit lower transition risk than their European counterparts.

Using the framework developed by Alessi and Battiston (2021), the Transition-risk Exposure Coefficient

(TEC) of Spanish funds is 4.37% versus 6.11% in EU funds. Considering the portfolio share that is

included in the calculation, the adjusted TEC of Spanish funds increase to 12.91% (vs. 29.2% in EU

funds). Furthermore, sustainable fund portfolios exhibit significantly lower TEC and adjusted TEC than

both Spanish and EU funds, reinforcing their choice as green investments.

The remainder of the paper is structured as follows: Section 2 introduces the methodology employed

to assess transition risk in investment portfolios. Section 3 presents the data employed and the climate

scenario considered. Section 4 shows the results from our transition risk analyses. Finally, Section 5

concludes.

See for instance, Clerc et al. (2016), Peralta and Crisóstomo (2016), Cont and Schaanning (2017), Battiston et al.

(2017), Ojea-Ferreiro (2020), Roncoroni et al. (2021), or Alessi et al. (2022).

2. Measuring transition risk in investment portfolios

We develop a comprehensive framework to assess the vulnerability of investment portfolios to the

low-carbon transition. Analytically, we consider both climate indicators and traditional measures of

credit and market risk. Figure 1 provides a schematic description of the steps and risk factors employed

to quantify transition risk.

Figure 1: Diagram illustrating the steps and risk factors used to quantify transition risk.

Our climate risk assessment starts with the ISIN-level composition of financial portfolios. The

vulnerability of each counterparty to the climate transition is derived from their carbon intensity and

economic sector of operation. Companies operating with high carbon footprints are expected to be

more affected by the green transition, as higher carbon prices, changes in investor’s preferences,

technological disruptions and climate-related policies could reduce the demand for carbon intensive

products while increasing production costs. Consequently, the green transition is expected to generate

stranded assets, reduced firm valuations and increased credit risk, leading to losses in the financial

instruments issued by high-carbon firms.

In addition, the characteristics of economic sectors constitute a relevant risk driver to assess the cost

and opportunities arising from the climate transition. Economic sectors with higher levels of GHG

emissions, such as utilities, transportation, mining and petroleum are most at risk of suffering climate-

related losses, as policies aimed at curbing emissions and facilitating the green transition create

significant risks to carbon-intensive industries (see UNEP FI, 2019; BCBS, 2021; Dunz et al., 2021 and

Semieniuk et al., 2021)

However, even within a given industry, climate risk usually affects companies heterogeneously.

Company-specific drivers like their product mix, reliance in different energy sources or technological

portfolio can significantly alter the climate risk profile of individual firms. Therefore, in addition to

sectoral aggregates, we employ company-level data to perform intra-sectors comparisons and

discriminate among the best and worst-in-class in each economic industry (see the CO-Firm and Kepler

Cheuvreux, 2018 and NGFS, 2020).

Furthermore, even for a given company, the MtM performance of financial instruments will be

typically different depending on the asset class considered and the risk characteristics of specific

exposures. For credit instruments, the risk of loss can differ depending on the credit quality,

collateralization, duration, and convexity of each exposure. Similarly, the risk of loss in equity

instruments also varies depending on market risk factors like the volatility of each underlying.

Building on this, we develop a portfolio methodology that comprehensively assesses the climate risk of

five interrelated asset classes: i) equity investments; ii) corporate bonds, iii) sovereign debt; iv)

investment in other fund vehicles; and v) cash and cash-equivalents.

2.1 Equity investments

The climate vulnerability of equity exposures is derived from the economic sector and carbon intensity

of each counterparty. For equity instruments, we first assess the carbon intensity of specific firms

relative to its sector as:





where 

 represents the carbon intensity multiplier of exposure i, j and  is the quantile that

the issuer of i occupies in the carbon intensity distribution of sector j. For each counterparty, 



ranges from 0 to 2, effectively discriminating among firms that deviates from the median carbon

intensity of its economic sector.

We next obtain the market risk multiplier of equity investments by comparing the volatility of each

exposure  with the average volatility of its economic sector :









After assessing the climate vulnerability and market risk, the loss of value in equity position i, j is

obtained as

  







where 

 represents the average equity loss in sector j upon materialization of transition scenario k.

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1MeasuringTransitionRiskinInvestmentFundsRicardoCrisóstomoaCNMVWorkingPaperNo.xx,December2022AbstractWedevelopacomprehensiveframeworktomeasuretheimpactoftheclimatetransitiononinvestmentportfolios.Ouranalysisisenrichedbyincludinggeographical,sectoral,companyandISIN-leveldatatoassesstransitionrisk.Wef...

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