HOW PENSION FUNDS CAN RESPOND TO THE CLIMATE EMERGENCY
Authored by Richard Folland, Co-Founder and Partner, Sustineri and Kerry Perkins, Senior Manager - Engagement and Implementation, The Prince’s Accounting for Sustainability Project (A4S)
A shorter version of this thought piece was first published on Pensions Expert.
Climate change is accelerating, and fast. Its effects are become increasingly visible, not least in escalating incidences of extreme weather, ranging from the California wildfires to record-breaking heat in Australia. The UN Intergovernmental Panel on Climate Change (IPCC)’s recent report authored by the world’s leading scientists has declared that we have only 12 years for global warming to be kept to a maximum of 1.5°C increase in global average temperatures above pre-industrial levels. In monetary terms, the London School of Economics predicted in 2016 that climate change alone would wipe $2.5tn off global financial assets. Whereas taking action to keep climate change to below two degrees would see the value of financial assets falling by $315bn less, even when the costs of cutting emissions were included.1 This is enough to pay off the UK’s total Defined Benefit pension deficit three times over.
Policymakers are responding domestically and internationally. In the UK, the House of Commons responded on 1 May to the rising alarm of the scientific community by approving a motion to declare a climate emergency. The British Government has now moved to enshrine a 2050 net zero emissions goal in legislation. British parliamentarians were also responding to civil society’s call for more radical action. Just a week before passing their motion on 1 May, 16-year old schoolgirl Greta Thunberg took to task the entire political class for not acting in time on climate change and for “selling our future”. In the recent European parliamentary elections, there was a green wave of voter support for more ambitious climate action. Proponents of the Green New Deal in the US are helping to bring climate to the forefront of the debate there.
However, despite these positive signs, the over-arching question remains, especially considering IPCC’s 2030 deadline to keep warming to 1.5°C: are we collectively acting fast enough before we run out of time?
The Role of Government and Financial Regulators
When civil society demands more from governments, attention is understandably trained on policy makers and regulators to raise the level of ambition for cutting carbon emissions. This is what Secretary-General Gutierres has in mind (“it must be more than a talkshop”) in convening heads of government at the Climate Summit in New York in September.
Since Mark Carney spoke out four years ago about the threat that climate change poses to financial stability, the context in which financial policymakers and regulators is operating has been changing. There is now widespread recognition that institutional investors will play a crucial role in helping to manage the transition. In response, policymakers and regulators are starting to introduce tighter frameworks in which pension funds need to operate. In addition, pension funds are beginning to recognise that to protect the value of the pension, and therefore comply with its fiduciary duty to its beneficiaries, there is a need to integrate environmental, social and governance (ESG) into how they manage their money.
For UK local government pension funds (LGPS), the Ministry of Housing, Communities and Local Government (MHCLG) is the responsible overseer. In 2017, MHCLG (known at the time as the Department for Communities and Local Government) revised their guidance to include the requirement that all LGPS should address longer-term financial risks arising from ESG factors in their Investment Strategy Statements (ISS). Some of the larger LGPS have responded: instituting progressive responsible investing strategies; and addressing how to decarbonise their funds.
The Department for Work and Pensions (DWP), with oversight of private sector occupational schemes, has likewise made significant changes in the way that it addresses social and environmental issues. The Occupational Pensions Schemes (Investment) Regulations were amended in 2018 to require corporate pension fund trustees to explain how “financially material” ESG considerations, including climate change, are taken into account in their schemes’ Statement of Investment Principles (SIP) by October this year. Further regulations were published earlier this month, building on these requirements and which will require greater transparency and reporting on these issues from next year.
The UK Pensions Regulator is also taking a closer interest. In a recent debate in the House of Commons on “Pension Funds: Financial & Ethical Instruments”, the Pensions and Financial Inclusions Minister, Guy Opperman, indicated that non-compliance with the pension regulations could lead to sanctions by The Pensions Regulator.
This strengthening of the regulatory framework, which carries direct implications for pension funds, is being reinforced by the broader measures on the sustainable finance agenda led by western European central banks and financial policymakers. Notably, the Network for Greening the Financial System (NGFS), an initiative bringing central banks and supervisors together to mobilise action by the financial system on climate risk and investing in the low-carbon economy, has recently published its call for action for central banks and supervisors. The NGFS has asked for the integration of climate-related risks into financial stability monitoring, as well as own-portfolio management.
In addition, the European Commission’s Sustainable Finance Action Plan, now going through the EU legislative process, requires investors to disclose full information on how they are addressing ESG factors. And, playing a significant role, the Financial Stability Board’s (FSB) Task Force for Climate-related Financial Disclosures (TCFD), which published its second status report earlier this month, has been instrumental in shaping a growing dialogue on climate-related disclosure, with both national and regional regulators now looking at integrating the TCFD’s recommendations into their own regulatory frameworks.
Asset Owner Action
The policy and regulatory changes described above are beginning to provide a more robust enabling environment for investors to address climate change, and to allocate the significant infrastructure investment needed to fund mitigation and adaptation efforts.
The Prince’s Accounting for Sustainability Project (A4S)’s Financing our Future report, released during the Secretary General’s ‘Financing the 2030 Agenda for Sustainable
Development’ session at the 2018 United Nations General Assembly, details how all parts of the financial ecosystem must undertake a valuable role in addressing our common future. Pension funds are both highly exposed to the risks of an unsustainable future and in a strong position to influence, and benefit from, a more sustainable outcome.
There are a growing number of examples of pension funds now taking action. These include steps to better understand and articulate their ESG concerns and impacts, viz:
- Signing up to global initiatives such as the UN Principles for Responsible Investment (UNPRI) and Climate Action 100+.
- Mapping the impact of investment portfolios on the SDGs (e.g. Australia’s CBUS and Sweden’s AP4.2
There have also been bolder steps to adjust investments and build sustainability into their investment mandates with asset managers, such as:
- Introducing low-carbon funds (e.g. Merseyside Pension Fund’s £400m index fund integrates climate change factors into its design, including tilts based on fossil fuel reserves, carbon emissions and green revenues).
- Committing a percentage of portfolio allocation to investments with high social or environmental impacts, (e.g. the UK Environment Agency Pension Fund allocates 25% of its entire fund to sustainable and green economy investments).
- Reporting in financial filings on the climate change risks and opportunities facing their funds in line with the TCFD recommendations (e.g. West Midlands Pension Fund became one of the first pension schemes to report within its annual reports back in 2017).
- Providing a DC default fund that incorporates steps to reduce exposure to climate-related risks (e.g. HSBC Bank (UK) Pension Trust along with LGIM and FTSE Russell created the Future World Fund, a pioneering climate-tilted default DC fund).
Catalysing a wider pensions movement
We are still, however, far from a situation where all pension funds act systematically and at scale to influence sustainable investments. Last year, the UK’s Environmental Audit Committee reported a mixed response to addressing climate change by the UK’s top 25 corporate pension funds, with 14 considering ESG at Board level but only seven committed to report in line with the TCFD recommendations.
Some still believe that their fiduciary duty is simply to maximise returns and do not see the management of ESG risks as integral to this. The significant risks and opportunities presented, and by climate change especially, are still seen as ‘ethical’ considerations that are outside of fiduciary duties by some pension fund boards. Asset managers can compound this problem by making ESG an ‘optional extra’ that has to be specifically built into a mandate rather than adopted as business as usual. Moreover, there is a question mark about who defines what is financially material. As the regulation is currently defined, pension funds are essentially making their own self-assessment of what ESG factors are or aren’t financially material to them.
Furthermore, there are gaps between what company sponsors and their pension funds are doing on climate change and the spectrum of ESG issues. A survey of some of the UK’s largest DC corporate pension schemes on the management of climate-related risks and opportunities by ShareAction earlier this year highlighted a dissonance between corporate sponsor commitments and those of their pension schemes, with 13 of the 15 corporate sponsors supporting low-carbon initiatives but only a small minority of their pension schemes matching this commitment.3 With many major corporates taking ESG issues extremely seriously, there will be increasing pressure on pension funds to match their sponsors on risk management and infrastructure development. Opening up a frank dialogue between the corporate pension scheme and its sponsor is an essential next step.
The Barriers
So, despite the promising progress since 2015, the year of the Paris Agreement and the launch of the Sustainable Development Goals (SDGs), what are the barriers stopping pension schemes from truly integrating sustainability into their investment beliefs and policies?
First and as previously mentioned, fiduciary duty is still poorly understood and the belief that social and environmental issues can be financial in nature is not consistently held or understood. Trustees and beneficiaries struggle to understand the distinctions and confuse financially material ESG factors with ethical matters and assume them to be a ‘nice to have’.
This overlaps with a second barrier, relating to the insufficient expert knowledge among the pension fund community on the implications of climate change for investments. This is perpetuated by the poor quality of information on ESG risk/performance of assets, and the inability to evaluate accurately the degree to which their investment products contribute to delivering the sustainability objectives reflected in the Paris Agreement and the SDGs. Even investment advisers and asset managers that lead the way on ESG knowledge in their field are only selling it to those who are informed enough to mandate it. Financial analysts and data providers are therefore crucial to the provision of the necessary evidence and rationale for sustainable and responsible investment, but they need to be building this into their standard offerings and not wait to be asked.
A third barrier to note is that, while there is a latent demand by beneficiaries for better ESG integration, various factors are preventing this demand from being much more vocal. These factors include a lack of financial literacy and confidence to make informed investment decisions, coupled with ESG integrated investment options being seldom easy to navigate both for members and for some trustees. This may help to explain the disparity between very strong survey results from beneficiaries asking for more sustainable investing, and the number of beneficiaries who are actively asking for their pension to be invested sustainably, or who are voluntarily moving their pension fund to a more sustainable investment fund within their scheme.4
There are, of course, other significant barriers including the issues around short termism, demanding workloads of trustees and pension teams and an aversion to tackling issues where few have done so already, to name a few.
What needs to be done?
There is a huge shift happening in how the market is responding to the climate emergency. In order to protect their beneficiaries as well as the world that their beneficiaries will be living in, pension funds need to find a way to keep up with this pace of change. Approaches, in our view, should include:
- Responding to what the regulators are requiring of them, with a mindset that is open and ready to address opportunity and innovation. Pension funds should also be prepared to cater for more radical policy measures.
- Recognising that responding to the climate emergency is as much about the investment opportunities as well as the risks.
- Asking tough questions of their asset managers and investment consultants, building ESG requirements and metrics into the instructions given to investment consultants and the mandates given to asset managers.
- Engaging and communicating with their beneficiaries, who increasingly want to know where their money is being invested.
- Upskilling Board members and management with the necessary sustainability competencies.
Policymakers and regulators, in turn, have a significant role to play in providing a progressively stronger enabling environment for pension schemes. This means working in partnership with investors and their trustee boards to create a policy approach that combines ambition, consistency and effective communication. Joined-up government strategy is needed if we are to unlock investment opportunities as well as driving action on climate risk.
Bringing policymakers and pension funds together to bottom out these barriers, work out solutions and, to this effect, drive a systemic change to how ESG considerations are integrated into investments, is a critical next step. It is why A4S, Pensions for Purpose and Sustineri are convening a group of senior representatives from LGPS, Corporate Pension schemes and the regulatory community - including the Pensions and Financial Inclusions Minister Guy Opperman MP - on 1 July during London Climate Action Week.
Ultimately, the voluntary approach that financial regulators are pursuing at present may be inadequate if the institutional investment community and wider financial ecosystem is to meet the “action yesterday” challenge laid down by Greta Thunberg and her generation. Whatever happens over the next two years - which will tell us a lot about the international political will to tackle the climate emergency - pension funds need to be clear that ESG is a core financial issue that not only sits at the heart of their responsibilities to their beneficiaries, but to the resilience of their own institution.
Authored by Sustineri and The Prince’s Accounting for Sustainability Project
1 Joint paper by 'Grantham Research Institute on Climate Change and the Environment' and 'ESRC Centre for Climate Change Economics and Policy at the LSE' 2015: http://www.lse.ac.uk/GranthamInstitute/publication/climate-value-at-risk-of-global-financial-assets/
2 http://www.oecd.org/daf/fin/private-pensions/2016-Large-Pension-Funds-Survey.pdf
3 https://shareaction.org/wp-content/uploads/2019/02/CorporatePensions2019.pdf
4 https://www.ftadviser.com/pensions/2019/06/10/savers-favour-ethical-investments-in-pensions
