A global clean energy transition is underway. In 2015, investments in clean energy—including renewables such as wind and solar, as well as energy efficiency—far outstripped investments in traditional, high-carbon fossil fuel infrastructure such as coal, oil and gas power plants and distribution systems. 1 The successful outcome of the December 2015 U.N. Framework Convention on Climate Change Conference in Paris (referred to as COP21) was a turning point. Those negotiations concluded with the adoption by 196 countries of the Paris Agreement, described as a universal pact that sets the world on a course to a zero-carbon, resilient, prosperous and fair future. 2 Implementation of the Paris Agreement will significantly accelerate clean energy investments, with the aim of making renewables more cost effective and widely available than ever before, in all corners of the world.
This energy transformation has significant implications for fossil fuel companies and their investors. Worldwide, it has been estimated that a third of oil reserves, half of natural gas reserves and over 80 percent of coal reserves from 2010 to 2050 will need to remain unused to meet the Paris Agreement commitment to limit global temperature rise to well below two degrees Celsius. 3 The concept of carbon asset risk (CAR)—that a significant quantity of the world’s fossil fuel resources will be left in the ground, and that both these high-carbon fuel resources and associated fossil fuel infrastructure will become stranded assets—is gaining traction as Wall Street analysts, investors, regulators and governments increasingly recognize this as a significant and actionable financial risk that must be addressed. 4
Several studies released in 2015 highlighted that institutional investors face exposure to a range of climate change related risks, including carbon asset risk. Investing in a Time of Climate Change, published by the investment consulting group Mercer with support from sixteen investor partners, the International Finance Corporation and the UK Department for International Development, concluded that annual investment returns for coal, oil, gas and utilities will be the most negatively impacted of all industry sub-sectors evaluated, and that the biggest impacts will be in the next decade. 5 In essence, after long being considered “safe” core investments, oil, gas, coal and utilities are becoming more risky for the world’s investors.
This new Ceres report, Assets or Liabilities? Fossil Fuel Investments of Leading U.S. Insurers, focuses on the risks to insurance companies—the second-largest type of institutional investor after pension funds based on assets under management. 6 U.S. insurers’ year-end 2014 statutory financial statements show the industry owned cash and invested assets totaling just under $6 trillion. 7,8 It is already well understood by U.S. insurance regulators that insurers’ massive bond and equity holdings expose them to both credit risk (the risk that a particular investee company will default), and systemic/market risk including macroeconomic factors such as interest rate fluctuations. As insurers also face uncertainty related to the size and timing of their insured loss payouts, insurance regulators require companies to invest conservatively so they can meet their financial obligations and remain financially stable.
In light of these factors, as well as the crucial role of insurers in providing a safety net in the face of climate change and other risks, Ceres believes that an examination of individual insurers’ (or insurance groups’) potential exposure to carbon asset risk is warranted and timely. A December 2015 Standard & Poor’s (S&P) Rating Services report concluded that climate change is a greater threat to insurance companies than has been previously recognized, particularly in regard to insurers’ investments. 9 Through an analysis that drew on the work of other experts including Mercer and Risk Management Solutions (RMS), S&P calculated the likely erosion of insurers’ capital adequacy, and concluded that increasing risks related to climate change may require insurers to hold higher levels of capital. The investment impact on insurers’ capital adequacy is expected to be greater than the weather-related impact for all types of insurers analyzed.
However, despite growing awareness of insurers’ portfolio risks related to climate change, including carbon asset risk, it is unclear whether insurers have taken action to identify and evaluate their potential investment exposure, both of which are necessary before implementing strategies to reduce identified threats.
CONCLUSIONS AND RECOMMENDED ACTIONS
An energy sector-based portfolio analysis is a key first step insurance groups should be taking to understand their carbon asset risk exposure. A more granular analysis would reveal other factors, including the amount and credit quality of investments, the type and seniority of the financial stake, and specific characteristics of the investee company (i.e. the fossil fuel company which the insurer has invested in). It is crucial that insurers, industry regulators and market oversight bodies work together to keep abreast of these emerging investment risks to ensure that they are appropriately managed.
Insurance Companies
Climate change risk management is a board level governance issue and corporate directors of insurance companies should be actively involved in establishing and monitoring strategies to reduce wide-ranging climate-related investment risks, including carbon asset risk. Boards should consider requiring the insurers’ Investment Policy Statements (IPS) to explicitly include a carbon asset or climate change risk management strategy, which the board would review on a regular basis. These strategies could be informed by top-down evaluations of investment portfolio risk (as demonstrated in Mercer’s climate change research), bottom-up assessments of exposure to high-risk assets (as demonstrated in this report) or a range of actions in between.
Insurers need to know how the fossil fuel companies they are invested in are considering future demand shifts and to what extent there may be stranded-asset exposure. Engagement by insurers comes at a critical time given recent oil price declines, which are squeezing company earnings, and elevating concerns about future spending on expensive, risky projects that may be unprofitable in a low-carbon future. Dialogues between insurers and fossil fuel companies should focus on the extent to which oil and gas companies are adequately preparing for changing market dynamics, managing carbon asset risk, and evaluating potential threats they pose to investment returns and income streams.
On an operational level, climate change risk management, including carbon asset risk, needs to become an integral part of each insurer’s overall Enterprise Risk Management approach. Expertise from underwriting and risk management functions should be shared with the investment function and vice versa. It is likely that most insurers will need to develop internal staff expertise on carbon asset risk or access it externally so investments at the portfolio, asset class, sector and company level can be specifically evaluated. Ultimately, insurers need to be able to make informed strategic choices, aligned with each company’s investment policy statement, to reduce potential carbon asset risk exposure, either through limiting investments in risky companies or by engaging with investee companies to address and mitigate potential carbon asset risk.
Insurance Regulators
Insurance regulators should assess the options available, adopt a universally recognized source for industry sector classifications and require insurers to disclose their fossil fuel investments using these classifications—for example, within their Supplemental Investment Risks Interrogatories. Based on data submitted through insurers’ Supplemental Investment Risk Interrogatories, state insurance regulators could use the financial examination process to review the detailed risk register and determine whether insurers are appropriately managing their exposure to carbon asset risk in all aspects of their businesses.
Hypothetically, since an insurer's failure to adequately manage its exposure to carbon asset risk may have negative financial consequences for investors and insurance policyholders, it is recommended that state insurance regulators consider implementing a data call, similar to the one announced in January 2016 by the California Department of Insurance requiring all insurers to publicly disclose carbon-based investments annually.
Insurance regulators should also consider a number of additional actions to strengthen risk focused surveillance on potential exposure to carbon asset risk. For instance, regulators could evaluate insurers’ annually submitted Own Risk and Solvency Assessment (ORSA)20 reports regarding management of this emerging risk consideration. Regulators on the NAIC’s Valuation of Securities Task Force 21 could also review the Securities Valuation Office’s treatment of carbon asset risk in their ratings actions.
THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)
The NAIC’s risk-based capital (RBC) requirements operate as an early warning system for U.S. insurance regulators. The RBC formula calculates the minimum amount of capital required to support an insurer’s overall business operations based on considerations of size and risk profile. In light of prospective risk considerations related to carbon-intensive assets, state insurance regulators should consider enhancements to the risk-based capital (RBC) formula to include fossil fuel sector concentration risk. It is noted that the RBC formula is already quite detailed as it pertains to investment risks, however fossil fuel concentration risk is not included. Therefore it seems both important and feasible to evaluate the merits of updating the formula to help identify insurers that may be weakly capitalized relative to their CAR exposure.
Overall, state insurance regulators should consider directing the resources and expertise of the NAIC, especially its Capital Markets & Investments Analysis Office, to better understand how carbon asset risk might impact insurers’ credit risks and systemic/market risks.
For example, it may be necessary to strengthen the NAIC’s Securities Valuation Office (SVO) staff’s credit assessment of relevant insurers’ oil and gas, and electric power utility securities. Given insurance regulators’ reliance on authorized credit rating agencies, the NAIC SVO may want to work directly with credit rating agencies to better understand the degree to which they take carbon asset risk into account in their credit assessments of fossil fuel energy companies and electric power utilities. Lastly, the NAIC’s Capital Markets & Investments Analysis Office may need to assume a more active and transparent role in stress-testing companies’ investment portfolio exposure to fossil fuel energy sectors on behalf of the state insurance regulators.
Regulators should consider directing the NAIC’s Capital Markets Bureau (CMB) to conduct additional independent research and analysis on the potential impact of the full range of carbon asset risk factors on insurance sector portfolios. For instance, the CMB could consider including an analysis of insurers’ overall holdings in the oil, gas, coal and electric/gas utility sectors to identify over-exposed portfolios. State insurance regulators could also direct the CMB to conduct detailed asset reviews to identify insurers with substantial carbon asset risk exposure.
FINANCIAL STABILITY BOARD (FSB) TASK FORCE ON CLIMATE-RELATED FINANCIAL DISCLOSURE (TCFD)
Ceres recommends that the FSB TCFD include the following disclosure guidance, applicable to all insurers as institutional investors, in order to provide greater transparency regarding insurer investments with the biggest carbon asset risk exposure. First, insurers should publicly disclose if and how carbon asset risk is being addressed within their governance and risk management processes. Insurers should also submit financial information regarding their fossil fuel investments and results of portfolio carbon asset risk analyses. Lastly, insurers should submit a description of their specific actions for managing and reducing the company’s potential carbon asset risk.