As the world transitions to a less carbon-centric economy, in this edition of Pensions Watch we focus on the emerging best practice among those pension schemes and asset owner collaborations taking the lead in establishing a road map to net zero.
The increasingly central role of climate risk management1
Pensions Watch has long maintained that successfully running a pension scheme has increasingly become a complex exercise in risk management. Central to this exercise and ever more critical to the success of scheme outcomes is managing the Environmental, Social and Governance (ESG) risk factors, particularly the potential physical and transition climate risks, attaching to a scheme’s asset holdings.3 After all, a failure to act more decisively in stemming the myriad sources of greenhouse gas (GHG) emissions, curtailing the financing of carbon emitting technologies and in seeking to change industry and individual company behaviours and business models, could result in a deeply impaired economic and financial system. This would, in turn, severely inhibit the ability of asset managers to generate and pension schemes to derive sustainable investment returns and expose schemes to unacceptably high and largely unmanageable risks.4
Learning from the leaders – a short case study
NEST helpfully provides plenty of simple and highly relatable examples of how it’s putting its policy into practice. For instance, owing to the lack of progress in managing their climate change risk, NEST recently divested its holdings in five energy companies, including Exxon Mobil. Additionally, it has given notice to those companies involved in arctic drilling, thermal coal or oil sands that it will divest by 2025, unless they plan to phase out these activities by 2030. Likewise, to encourage sustainability in the global food industry, against the backdrop of an exploding human population, NEST has joined the FAIRR Initiative, a global network of investors managing over USD23tn,8 to push the big supermarkets away from intensive livestock production and other unsustainable industry practices. This highly relatable approach also extends to how NEST reports on the extent to which it has reduced the carbon footprint of its developed equities exposure, by citing the equivalent number of cars its climate policy has effectively taken off the road.9 Moreover, to reinforce its 2050 commitment to net zero, NEST has recently introduced a new staging post to reduce carbon emissions by 30% in its equities and fixed income holdings by 2025, baselined against its 2019 portfolio.10
Are engagement and divestment mutually exclusive?
Of course, any discussion of climate change risk management wouldn’t be complete without considering the long-running debate on engagement and divestment. Thankfully, the discussion is no longer a binary debate but one which is progressively moving towards the view that engagement and divestment are integral to one another and not mutually exclusive. Obviously, without engagement, company behaviours and business models are unlikely to change, at least not at the pace and quantum that is necessary for net zero to be achieved within the desired timescale. Indeed, all trust-based occupational pensions schemes are required to publish an annual implementation statement, which sets out how they’ve exercised their engagement strategy with investee companies over the course of the year. However, even a thoughtful and well-structured engagement policy doesn’t always lead to the desired outcomes, especially when climate risk factors need to be continually reassessed. This is when divestment increasingly comes into play – albeit as a last resort exit strategy.
Socialising the activities of the climate leaders
So, what practical steps can be taken?
So, what have I learnt from my regular interactions with the Paris Alignment Forum, combining this with my own experience of working with schemes in formulating and implementing a climate risk management policy? Well:
- Before even thinking about climate targets, in particular setting a net zero target, first ascertain your scheme’s climate exposure and where you are on your climate transition journey. If you’re a DB scheme, approach this as an integrated risk management (IRM) exercise, i.e. from a covenant, funding and investment perspective. Work with your advisers and asset managers in pinpointing exposures via key climate metrics and conducting climate scenario modelling to establish where the key stresses lie. (Of course, to derive the most benefit from the latter requires an appreciation of the analytics behind the former and an understanding of the requisite TCFD reporting).28
- Ask your scheme sponsor (with the help of your covenant consultant if you’re a DB scheme), to explain their net zero policy, what measures they’re taking and what interim targets they’ve set to achieve this, and understand why the sponsor may want (aspects of) the scheme’s climate policy to align with theirs. Often, this is to manage the sponsor’s reputational risk.
- Leverage your peer network by joining asset owner collaborations and forums, so that you may learn from and share ideas with your public and private sector DB and DC peers.29
- Undertake measures to improve your scheme governance around climate (amongst other ESG) risk factors. This might include setting up an ESG sub-committee and bringing key scheme decision makers and stakeholders, notably the scheme sponsor, onboard with the scheme’s climate journey.
- With the requisite governance in place, embed climate (amongst other ESG) risk factors into all investment decisions. However, do so in line with the scheme’s investment beliefs (which may need to be revisited if they haven’t been reviewed for some time). After all, investment beliefs should act as the rudders by which to steer all investment and associated risk management decisions.30
- With the help of your investment consultant and asset managers, compile and publish a responsible investment and climate change risk management policy with the inclusion of deliverable targets, ultimately a realistic net zero target,31 using appropriate metrics and staging posts, and institute the means by which to track progress via regular actual versus policy gap analyses. Again, be guided by your investment beliefs.
- Use existing frameworks, such as the IIGCC Net Zero Investment Framework32 and TCFD-aligned metrics to help move your scheme along its journey to net zero. Perhaps also consider becoming a signatory to the former.
- Ensure asset manager mandates align with the scheme’s climate policy and targets, appreciating the difference between segregated and pooled mandates when it comes to influencing managers’ voting on shareholder resolutions.
- Consider framing the risk budget applied to segregated mandates in climate risk tolerance terms, rather than traditional tracking error targets.
- Engage with your investment consultant and asset managers in sourcing climate (impact investing) opportunities.33
- Embrace the power of stewardship by becoming actively involved in shareholder resolutions and in making recommendations to policymakers.
- Design a reporting framework around the climate targets set and decide how best to impart your policy and progress to all stakeholders, having regard for the scheme’s statement of investment principles (SIP), annual implementation statement and TCFD reporting.34
- Finally, in the (current) absence of perfect, standardised data and with an admittedly foggy path ahead, don’t aim for spurious accuracy, or over engineer or over complicate what is very much an art, not a science. What matters is the scheme’s broad direction of travel, not measuring everything to two decimal places!35
There are, of course, challenges with taking a number of these suggestions forward, especially if a scheme’s governance is not sufficiently well advanced and ESG fatigue has already started to set in. Indeed, with this, comes the temptation to treat climate change risk management as a tick box exercise and to do no more than legislation and regulation requires. However, a good starting point for such schemes is to nail down the more obvious and easily managed climate risks, notably within the scheme’s equity holdings, and capture the more accessible climate opportunities. Believe me, it will be time well spent.
Why does all of this matter?
Transitioning to a low carbon, and ultimately a net zero emissions, economy (like any disruptive force) will invariably result in winners and losers. While some companies and economic sectors will disappear, or experience higher costs of doing business, others with the foresight and the ability to reinvent themselves – by transitioning to new low carbon technologies and/or offsetting their carbon emissions through carbon-capture technologies – stand to prosper, alongside those market entrants who emerge to tap into new areas of demand.
Of particular concern are the potentially monumental declines in the physical asset values of those companies that fail to anticipate regulatory, reputational and, particularly, transition risks or those unable to reinvent themselves. In extremis, many assets will be rendered uneconomic and, in popular parlance, become stranded. In such a scenario, this would leave those pension schemes that fail to act, exposed to unacceptably high and largely unmanageable risks – risks that should be identified, evaluated and managed far in advance of their impact materialising. Indeed, there is a very real risk of financial assets with either prominent underlying climate risks or strong climate-friendly credentials being materially repriced far in advance of company balance sheets, physical assets and the real economy being impacted. Therefore, if these asset repricing risks, which might otherwise compromise the ability to generate long-run sustainable returns, are to be properly managed, there is a potential first mover advantage to pension funds of overcoming the myopia surrounding climate change risk management. This is exactly what we’re seeing from those far sighted, typically larger, pension schemes which have the governance to implement climate change risk management policies that frame climate risk as both an unrewarded threat and a potentially rewarded opportunity. Thankfully, this good work is being both supplemented and socialised by a number of asset owner collaborations and forums.
Ultimately, we need to create a UK pensions system that has resilience to both transition and physical climate risks. While the steady flow of legislation and regulation go some way to achieving this, collaborative asset owner-inspired measures continue to lead the way in helping smaller schemes, in particular, square the climate risk management circle. After all, to say what happens next in the world’s climate journey is, in no small part, down to the actions of asset owners, particularly pension schemes, is no exaggeration. Indeed, pension schemes are not only very well positioned to be the catalyst for major transformative change, they have the potential to lead the world in tackling humanity’s greatest systemic challenge to date.