EUROPEAN COMMISSION
Brussels, 16.5.2022
COM(2022) 213 final
REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL
on the common provisioning fund in 2021
{SWD(2022) 143 final}
EUROPEAN COMMISSION
Brussels, 16.5.2022
COM(2022) 213 final
REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL
on the common provisioning fund in 2021
{SWD(2022) 143 final}
Table of Contents
INTRODUCTION
1.SECTION I
1.1.Role of the CPF
1.2.Architecture and provisioning of the CPF
1.3.Key milestones in 2021
1.4.Financial statements of the CPF as at 31 December 2021
1.5.Guarantee calls and payment claims
1.6.Effective provisioning rate
2.SECTION II
2.1.Investment strategy
2.2.Composition and characteristics of the portfolio
2.3.CPF performance in 2021
3.SECTION III
3.1.Investment universe diversification
3.2.Inclusion of environmental, social and governance (ESG) factors in the CPF benchmark
3.3.Conclusions
INTRODUCTION
This report is the first annual report on the common provisioning fund (CPF) 1 , for the period from 1 January 2021 to 31 December 2021.
The CPF holds the provisions protecting the EU budget against losses which may arise in respect of operations supported by financial instruments, budgetary guarantees or financial assistance for third countries established by different EU legislative instruments. 2
The CPF was constituted in January 2021. At the end of 2021 its market value stood at EUR 12.31 billion, making it by far the largest portfolio directly managed by the Commission. 3
The CPF is the capital reserve from which funds are drawn to meet, fully and promptly, all required outflows and guarantee calls stemming from the financial instruments, budgetary guarantees and provisioned loan programs. In order to serve as a reliable buffer for these calls, the CPF is managed in a way that should, at least, strive for capital preservation over its investment horizon (9 years) 4 . Macroeconomic volatility which negatively impacted the fund’s results in 2021 presents new challenges for delivering this objective in the short-term.
This report outlines key developments related to the functioning of the CPF in 2021, presents it financial and investment characteristics against the prevailing market situation, as well as describes forward-looking actions that the Commission intends to take drawing on the lessons learned from the first year of the fund’s operation. It is focused on the asset management aspects; contingent liabilities will be discussed in the report under Article 250 of the Financial Regulation (FR).
The report consists of three sections:
–Section I presents the role and structure of the CPF, as well as key developments related to its functioning during 2021. It also presents an overview of calls on guarantees and transactions, as well as information on the level of the effective provisioning rate.
–Section II is focused on the portfolio’s composition, risk profile and performance in 2021 presented against the benchmark, as well as its environmental, social and governance (ESG) profile. It also describes the market environment and developments that shaped the fund’s performance in 2021.
–Section III presents lessons learned over the first year of operation of the fund and outlines the steps the Commission intends to take to ensure value protection and growth opportunities of the CPF over the longer term.
1.SECTION I
1.1.Role of the CPF
During the current Multi-Annual Financial Framework (MFF 2021-2027), the EU budget must respond to environmental, strategic and socioeconomic challenges. Budgetary guarantees have proven to be a viable means to multiply the policy impact of limited public finance already under the previous MFF, and the Commission has expanded their use to support investment. This logic underlies initiatives such as the European Fund for Strategic Investments (EFSI) and the InvestEU programme.
The use of guarantees has also been extended into the external sphere through the European Fund for Sustainable Development Plus (EFSD+) under the External Action Guarantee (EAG) established by the NDICI Regulation 5 . EAG consists of a mix of guarantees and guaranteed loans for investments and macro-financial assistance in pre-accession, neighbouring and other countries.
At the end of 2020, the EU budget covered contingent liabilities 6 amounting to approximately EUR 63 billion for the guarantees provided in the context of EFSI, European Fund for Sustainable Development (EFSD), and external lending mandate (ELM).
Under the current MFF the use of budgetary guarantees is expected to further increase through, inter alia, the InvestEU programme, which establishes EUR 26.2 billion of contingent liabilities 7 to support investment that contribute to objectives of the Union’s internal policies.
The CPF was established to manage the provisioning of financial liabilities made available by the EU budget, so that these can be released when required to meet any losses incurred through defaulting operations 8 . The CPF constitutes a large asset pool on which the Commission can draw to swiftly honour the required outflows and guarantee calls. It is divided into several compartments, which correspond to the financial liabilities under the respective instruments and programmes.
Under Title X of the Financial Regulation the Commission is entrusted as financial manager with particular responsibilities for setting up the CPF, defining its investment strategy and overseeing its sound management
1.2.Architecture and provisioning of the CPF
The CPF is created and functions as a single internal pooled portfolio with a single investment strategy, separate from the other portfolios managed by the Commission. Any generated gains are reinvested.
The resources of the CPF are accounted for in compartments for the purpose of tracing the amounts relating to the various contributing instruments 9 . This is necessary to ensure that the corresponding instrument is allocated its share of resources and any returns or losses proportionate to assets owed. The costs of defaulting operations are assigned to the respective compartments. In case one CPF compartment is exhausted, another compartment can be temporarily drawn on and replenished later.
On 31 December 2021 the CPF was composed of four compartments (EFSI, EFSD, GFEA 10 and InvestEU). In 2021 it received EUR 12.44 billion net contributions. As at 31 December 2021 the market value of the outstanding shares was EUR 12.31 billion, which is equal to the value of net assets.
Over the period 2022-2030, the CPF is expected to receive an additional EUR 19.3 billion in inflows from the contributing instruments, with annual inflows of EUR 1 to 3 billion. These inflows may be offset by outflows to meet guarantee calls and eligible costs. The CPF is expected to reach a size in excess of EUR 20 billion by 2026-2027.
The evolution of the portfolio is presented in more detail in the staff working document accompanying this report.
1.3.Key milestones in 2021
Following the adoption of asset management guidelines (AMGs), the Commission swiftly put in place all legal, administrative and technical arrangements, including the creation of accounts, definition of the investment strategy, setting the benchmark and risk limits. CPF commenced operations on 1 January 2021 upon receiving the transfer of the EFSI guarantee fund portfolio 11 . The first inflows from MFF 2021-2027 resources were received on 30 June 2021 with the first instalment of InvestEU provisioning. On 1 August 2021, the provisions for EFSD and GFEA were smoothly transferred to the CPF. The transfer of the GFEA portfolio was a complex operation requiring smooth coordination with its previous manager, the European Investment Bank.
The technical and operational infrastructure for the CPF is now well established and road-tested. It is ready for further contributions and opening of new compartments, when provisions are transferred by the contributing instruments.
1.4.Financial statements of the CPF as at 31 December 2021
The net assets of the CPF stood at EUR 12.31 billion as at 31 December 2021 12 . As per current investment strategy (see section 2.1), the main assets comprised the securities portfolio investing mainly in investment grade bonds (sovereign, SSA 13 , corporate, financial), classified as fair value through surplus or deficit (EUR 11.27 billion) and cash and cash equivalents (EUR 1.03 billion).
In terms of the 2021 statement of financial performance, the CPF ended the year with an economic result of EUR -133.3 million. The CPF performance and its macroeconomic context will be further discussed in the next two sections.
More information on the financial statements is available in the staff working document accompanying this report.
1.5.Guarantee calls and payment claims
The liquidity management of the guarantee calls and payment claims is built around the concept of a liquidity buffer, as provided for in the AMGs. The liquidity buffer is constituted by limited reserves of cash held at the Commission’s Central Treasury to cover the expected imminent cash outflows of the CPF contributing instruments. Out of a total amount of EUR 165 million held by the buffer 14 , a net amount of EUR 73.5 million was paid out in 2021. The remaining balance of the liquidity buffer amounted to EUR 91.5 million at the end of 2021.
These 2021 calls on the CPF provisions by the respective budgetary guarantees, as well as other demands on the resources held by CPF compartments, can be summarized as follows 15 :
·no calls have been made under the EFSD guarantee;
·guarantee calls of EUR 66.5 million were paid under the ELM guarantee. In addition, there were minor operational expense for an amount slightly lower than EUR 0.1 million;
·the net consumption of the EFSI guarantee amounted to EUR 6.9 million, including net positive value adjustments of equity portfolios of EUR 7.6 million, a cash outflow of EUR 11.1 million linked to the hedging of foreign currency exposures, a cash outflow of EUR 0.9 for SME Window guarantee call, and expenses of EUR 2.5 million.
1.6.Effective provisioning rate
Each CPF compartment contains assets provisioned from the EU budget, which are held against the contingent liabilities incurred by the corresponding budgetary guarantee instrument. Those provisions represent a percentage of the contingent liabilities as foreseen in the legislative act 16 .
Not all CPF compartments will experience guarantee calls of the same intensity at the same time. This inherent diversification in time and amount of calls on the different compartments allows the aggregate CPF provisions (for all compartments) to be reduced below the amount that would result from summing up the provisions of the different compartments when calculated separately.
This diversification effect is recognised by Article 213 FR, which allows the Commission to set a level of “effective provisioning rate” (EPR), which is lower than that resulting from simple addition of the separately calculated provisions. The EPR reflects the share of the aggregate provisions of the CPF compartments to be kept in the fund, after the diversification effect. The EPR is expressed as a percentage, floored at 95%, and calculated as a ratio between:
·the amount of cash and cash equivalents in the CPF required to honour guarantee calls, and
·the total amount of cash and cash equivalents that would be required in each guarantee fund to honour guarantee calls, if the resources were held and managed separately.
The EPR is calculated annually based on the observations of the correlation between expected calls 17 on different compartments and applies only to the resources in the CPF envisaged for the payment of guarantee calls on a one-year horizon.
When calculating the EPR for the first time in 2021, the Commission was confronted with the fact that EFSI was the only active compartment in the CPF for the first half of 2021 and by far the largest instrument in the CPF throughout the year. This eliminates the scope for any cross-compartment diversification. Consequently, the EPR for 2021 was set at 100% 18 .
2.SECTION II
2.1.Investment strategy
The AMGs stipulate that the fund should deliver capital preservation over its investment horizon, with a high level of confidence. This objective is pursued through implementation of a single investment policy, framed by reference to a benchmark/comparator portfolio, which embodies the level of risk that the CPF is willing to bear.
The AMGs set out the general principles which guide the process for constructing a benchmark portfolio, building on relevant indices of bond market performance. This benchmarking process guides the selection of assets which are held by the CPF portfolio.
On this basis, the day-to-day decisions on asset selection are guided by a clear reference, which limits the danger that the portfolio assumes too much risk. It is this investment policy and benchmarking process that has led to the current asset composition of the portfolio, and the resulting risk/return profile. Notably, the bulk of the CPF (and the legacy portfolios that it has absorbed from EFSI and EFSD) has to date been restricted to investment in euro- and USD-denominated investment-grade fixed income securities (bonds) issued by EU Member States, international financial institutions or sub-sovereign bodies, banks, corporates, as well as to mortgage-backed (covered) bonds.
Governance structure
The Commission has set up the asset management governance for the CPF based on the best practice in asset management and benchmarking with peer institutions. The asset management framework involves the following main actors:
The decisions taken by the Financial Manager and agreed by the Accounting Officer are based on rigorous preparation, organised through the Asset Management Board and its sub-structures (risk and investment committees), which propose courses of action for endorsement.
·the Financial Manager of the CPF takes final responsibility for the decisions related to the financial management of the resources of the CPF, as well as for the other portfolios managed by the Commission or outsourced to the European Investment Bank. This role has been delegated by the Commission to the Director-General of the Directorate-General for Budget;
·the Accounting Officer exercises independent control and oversight of the activities relating to asset management of the CPF. In addition, the accounting officer sets up the procedures to be applied to the revenue and expenditure operations and to the accounting of the assets and liabilities;
·the Compliance Officer provides independent scrutiny of adherence to agreed procedures and advises on new or significant legal or procedural issues.
2.2.Composition and characteristics of the portfolio
The CPF portfolio at the year-end is well diversified within the fixed income universe in terms of types of bonds. In addition, it is diversified in non-euro denominated securities (USD) in the form of an allocation to US Treasuries and other issuers (e.g. Supranational, other Sovereigns or Agencies), and cash. Currency gains or losses on non-euro securities are being largely offset by opposite changes of foreign exchange derivatives used as hedges.
Credit quality of assets owned
The credit quality of the CPF portfolio is high, with an average rating of A-, suggesting a low default probability (0.07% at 1-year horizon).
Over 26.8% of the market value of the portfolio is invested in AAA securities, of the highest quality, and the rest is well distributed across the whole spectrum of the investment-grade scale. Only 2.3% of the portfolio is sub-investment grade, and relates to Greek government bills with a maturity of less than one year. There is also 8.2% of cash or cash equivalents. The above mentioned AAA category of 26.8% otherwise includes for example securities issued by sovereigns such as the German, Dutch and US Government, supranationals like the European Investment Bank, European Stability Mechanism, agencies like KfW, and covered bonds issued by prominent financial institutions.
USD-denominated investments (such as US Treasuries) represented 5.1% of the portfolio market value as at 31 December 2021. The currency risk of USD-denominated investments was hedged via forward contracts.
Liquidity characteristics of the portfolio
About 26% of the portfolio consists of bonds with a maturity below 1 year, floating rate notes and short-term money market instruments and cash which provide a further liquidity buffer for the portfolio. This means that portfolio is well equipped to respond to guarantee calls.
Environmental, social and governance (ESG) footprint
The share of ESG-labelled bonds 19 was 13.4% at the end of 2021 compared with 9.5% at the end of 2020. This strong ESG-focus evolved through a proactive approach, which privileged investments in ESG-labelled bonds over other bonds. 22.9% of the ESG-labelled assets had an AAA rating, while the lowest rated asset class (BBB-) corresponded to 0.2%. Section III will further explain how the Commission intends to reinforce the ESG footprint in new investment strategy for the CPF.
2.3.CPF performance in 2021
As explained above, the CPF is a liquid and well diversified bond portfolio. While investing exclusively in highly rated debt instruments has served the Commission portfolios well historically, it reached its limits during 2021 when a long period of monetary policy easing came to an end.
The first year of the CPF’s operations coincided with an exceptionally challenging market environment for fixed income investment, impacting negatively the valuation of the fund’s securities. 2021 was the worst year for bond markets since 1999, with global bond market indices and euro-denominated bond market indices declining respectively by 4.7% and 2.85% 20 . This outcome was driven by higher inflation prompting market expectations of tightening of monetary policy by central banks. Consequently, the CPF return was also negatively impacted, although remaining in line with its benchmark and far surpassing the broader bond market evolution. These changes in the market environment, and their impact on bond investment returns are described briefly below.
The pronounced upward shift in European and U.S. yield curves in 2021 explains the CPF’s negative annual absolute performance of -1.17% 21 . This return is in line with the annual performance of the CPF benchmark (-1.13%) 22 .
Market developments in 2021
Market developments in 2021 were dominated by the pandemic, vaccination campaigns, and the overall strong economic recovery, which, however, was accompanied by rising inflationary pressures and geopolitical instability.
Governments and central banks maintained very accommodative policies in 2021, but forward looking expectations about the policy path changed over the year, especially due to inflation that turned out to be much more pronounced. Fuelled by a steady increase in energy prices and widespread supply chain bottlenecks, inflation reached multi-decade highs towards the end of the year (5% in Europe and 7% in the USA). In response, central bank communications and forward guidance changed as the year progressed and expectations for interest rate hikes were gradually moved forward by the market participants.
While the ever-changing landscape of infections and restrictions kept market volatility at elevated levels, the combination of higher inflation and expectations of tighter monetary policy pushed bond yields in an overall upward trend. As they move inversely to yields, bond prices fell and thus valuations suffered significantly. This was exacerbated by the fact that the income bonds offer hardly provides any cushion to returns, given the low, and mostly negative, yields offered by the high quality and liquid securities the CPF is invested in.
The return of the CPF benchmark in 2021 (-1.13%) was also negatively impacted by the upward movement of the yield curves. Its return falls within the expected range of return 23 .
Nevertheless, as discussed in Section III, a review of the CPF benchmark is expected in 2022 to include new asset classes and improve the expected returns of the CPF benchmark over the long run.
3.SECTION III
3.1.Investment universe diversification
The negative performance of the CPF in 2021 highlights the risks of investing exclusively in one asset class (fixed income). The outlook for fixed income portfolios remains challenging, possibly for several years, given the still low levels of yields and the resurgent inflation concerns.
To enhance the longer-term performance of the portfolio, the Commission intends to expand the investment universe of the CPF beyond fixed income investments, within the limits of the existing AMGs.
The results of the in-depth analysis of the risks and returns, as presented in more detail in the staff working document accompanying this report, showed the benefits that further asset class diversification can bring over the longer term. It would allow to mitigate against over-exposure to low yielding fixed income assets.
While risk would increase to some extent, a limited equity exposure of up to 20% of the portfolio would remain consistent with the risk tolerance of the CPF and would enhance the expected average return per unit of risk.
Exposure to equity can be built gradually through investments in Exchange Traded Funds (ETFs), which offer cost-efficient diversified exposure to broad stock indices. These indices are essentially baskets of stocks of major companies, across a broad range of sectors and geographical regions. As such, ETFs offer broader exposure to the targeted stock markets and mitigate the idiosyncratic risk from investing into the stocks of a few companies.
The Commission would seek to finalise all preparations for investment in equity ETFs by autumn 2022, depending on the completion of a number of necessary technical and operational processes. Such investment would be progressively built-up, taking into account market conditions and valuation levels – possibly through the investment of new inflows to the CPF.
3.2.Inclusion of environmental, social and governance (ESG) factors in the CPF benchmark
The AMGs already include negative screening criteria, such as the exclusion of bonds related to the activities involving gambling or tobacco. In addition, the AMGs require that the CPF integrates ESG considerations. Currently, the CPF portfolio has a large exposure to ESG-labelled securities (see also footnote 19), significantly larger than its benchmark (13.4% for the portfolio vs. 4.5% for the benchmark as of end of 2021). However, the Commission wishes to put the ESG policy for the CPF on a firmer footing and include the ESG footprint in the updated version of the benchmark.
In order to do so, it is envisaged to add an ESG tilt to the CPF benchmark to be updated due to implementation of the investment universe diversification, so as to provide a reliable point of comparison for the portfolios with the same objectives and attributes as the CPF. Remodelling of CPF investment benchmark can also provide for the opportunity to integrate ESG considerations more systematically. The share of ESG securities in the portfolio is expected to grow further in the future, supported by a benchmark with explicit ESG characteristics. Future annual reports will present the implementation of the ESG profile of the CPF.
There is strong economic evidence that markets have recently begun to favour ESG-sensitive investments. The Commission presents itself as a leader among political bodies who promote environmental and sustainable practices, thus it is opportune to use this diversification opportunity to closer align our investment strategy with the political priorities.
3.3.Conclusions
The first year of operation of the CPF was marked by smooth establishment of the necessary operational, technical and accounting facilities, as well as successful transfers of existing portfolios into CPF compartments.
The CPF, currently holding EUR 12.31 billion in assets, constitutes a robust capital buffer for budgetary guarantees and provisioned loans to third countries. No operational risk events occurred in 2021, as all guarantee calls were met and accounts were finalised on schedule.
The vast majority of the CPF assets are investment grade bonds or cash, which forms a sufficient liquidity cushion. However, a turn in the interest rate cycle, which has increased yields while decreasing bond prices, has significantly impacted this type of liquid assets. The 2021 was the worst year for the bond investors over more than 20 years 24 .
Faced with these challenges, the Commission intends to further strengthen the CPF’s resilience.
The Commission aims towards expanding CPF investment universe and thus mitigating against a single-asset-class-exposure risk. Internal analysis (see staff working document) has shown that a limited and progressive rebalancing of CPF to include up to 20% exposure to equity can have a significant positive impact on long-run expected earning, while only marginally increasing the risk. This work shows that a diversified portfolio (including up to 20% equity) has expected returns of 1.6%, while a portfolio with an exposure only towards fixed income assets has expected returns of 0.7%.
The diversification project is also an opportunity to simultaneously structure the Commission’s approach towards increasing its investing in ESG-labelled assets in order to address its political priorities of green and sustainable growth. The current organic approach of favouring ESG assets has already made the CPF the most ESG-oriented of all the portfolios managed by the Commission. By integrating ESG considerations more systematically into the benchmark, the ESG orientation of the CPF can be more actively steered.
As this report is being drafted in early 2022, the portfolio and benchmark performance continues facing pressure as yields and uncertainty have overall risen further, amidst rising inflation, expected tightening of monetary policy and the invasion in Ukraine. On the other hand, assets are now being invested in bonds with positive yields which, if sustained over time, will help to recover recently experienced losses. The recent period, marked by a strong shift in interest rate expectations, represents the phase in which CPF asset valuation is at its most vulnerable. Over the next 2-3 years, the losses incurred in the recent past are likely to be reversed, barring further market shocks. However, the experiences of a tumultuous 2021 underline the limits of an investment policy confined to a single asset class (bonds), no matter how prudently the assets are selected.