Michael Sher discusses how pension fund trustees could demonstrate to stakeholders that they are acting on climate risk
The Pensions Regulator and the UK government (among other governments and regulators) have recognised that climate change poses material risks to investors and society. While they expect and hope that asset owners and investors will mitigate these risks, various pieces of legislation now require investors and asset managers to take practical actions. For pension schemes in particular, these include:
1. Identifying and assessing the impact of climate risks and opportunities on investment and funding strategy performance over short, medium and long timeframes.
2. Analysing changes in assets and liabilities under at least two climate scenarios.
3. Producing at least four climate-related metrics, of which three must be about:
- Absolute emissions (also called ‘carbon footprint’)
- Relative emissions (also called an ‘emissions intensity’ metric)
- How aligned a portfolio is with the Paris Agreement’s goal of keeping global warming ‘well below 2˚C’ (sometimes called implied temperature rise).
4. Setting targets for the chosen metrics and assessing performance against those targets.
5. Incorporating climate risks into their integrated risk management frameworks, especially around investment, funding, and sponsor covenant or support.
6. Reporting publicly on the above.
As of 1 October 2022, all UK pension schemes with over £1bn in assets must be complying with the first five requirements, and report publicly within seven months of their scheme year-end (starting with their first year-end after 1 October 2022). A scheme with a 31 December year-end must therefore publish its report by 31 July 2023.
As more trustees report publicly, other stakeholders may focus increasingly on how trustees are meeting their legal obligations to protect their assets and members’ benefits from climate risks, while benefiting the planet. What actions could they take to do that?
On your marks
To bring this to life, I will use a fictional example of a fast-moving consumer goods company, FTL Tachyon Ltd (FTL). FTL has a UK-based defined benefit scheme with £1bn in assets (the Fund).
In keeping with the Fund’s environmental, social and governance policies and UK regulation, the trustees have analysed its portfolios of equities, bonds and private assets, and produced a range of metrics and targets.
The trustees exclude their liability-driven investment portfolio of gilts and derivatives from their metrics and targets, in line with recommendations from the Institutional Investment Group on Climate Change.
They also hold no other sovereign debt (unlike some of their peers), which can complicate metrics, since many countries’ sovereign debt emissions data includes emissions from government, corporate and household activity. Including emissions associated with both holdings of a country’s sovereign debt and emissions associated with holdings of its corporates can therefore introduce double-counting.
Analysts from the trustees’ in-house team have analysed the output from the models to identify four key areas in which the trustees can usefully choose to focus their efforts during the coming years:
Missing data is higher for emerging markets. A key driver of missing data is that the Fund only has reported data on 30% of its emerging market holdings, versus 70% for holdings in developed markets. It has a target of increasing the proportion of portfolio holdings that publish data by 15%. The team suggests that achieving this is an opportunity to benefit other investors as well as itself.
Portfolio temperature alignment metric is above target. The Fund’s asset portfolio as a whole is aligned with a 1.9°C rise in temperature above pre-industrial levels, versus its 2030 target of 1.5°C. While the target is deliberately stretching, the metric’s current value is in line with the weighted alignment metrics for its asset class benchmarks.
The Fund’s carbon footprint is around 10% higher than its 2030 target. Emerging markets account for 10% of its portfolio value and 25% of its footprint. Similarly, holdings in the energy and building sectors account for 8% of portfolio value and 15% of emissions.
The team and advisers have recommended that the trustees refocus the Fund’s portfolio allocations and stewardship activities, taking these into account.
Climate scenarios show liability values falling more than asset values. The modelled climate scenarios show gilt yields and credit spreads rising, resulting in the discounted value of Fund liabilities falling by more than the value of its assets and hedges. The Fund’s funding level – calculated as assets divided by liabilities – therefore actually improves, despite the scenarios’ severe climate and economic outcomes.
This Fund, like all pension schemes, has finite resources to meet its current and future challenges. Its trustees held a sustainability-focused strategy meeting and, following robust discussion of their priorities, risk tolerances and covenant strength, decided on the following actions:
1. Improving metrics by engagement, not divestment, and to target selected companies to lower their emissions and improve their disclosures.
They acknowledged that they could move metrics faster to targets by divesting, for example from regions and sectors with higher emissions and worse data, but they believe that engagement can be an effective tool for producing real-world impacts. Conversely, divestment will likely have little real-world effect when other willing buyers with less strong climate consciences exist.
2. Implementing focused engagement on data and emissions during the next three years by requiring their investment managers to engage intensely with their four top holdings with high emissions (accounting for 20% of the portfolio footprint), and their three top holdings in emerging markets with poor data. Progress on these will also now be a standing agenda item at managers’ quarterly update meetings.
In addition, the chief investment officer is to ask other funds to join in their engagement activities, where possible. This was deemed a practical way to start mitigating real-world emissions impacts, as well as the risk that missing data could be hiding nasty surprises.
3. Commissioning more research into climate modelling, to develop a sophisticated range of scenarios that reflect varying degrees of climate impact.
4. Requiring its key suppliers to take positive climate action beyond the Fund. Recognising they are unique among their peers, the trustees have decided to start on this with their new audit tender. They will require whoever their newly appointed auditor is to report annually on the number of UK clients it has encouraged to produce first-time climate disclosures.
“Funds will be required to demonstrate that money and resources are being used to improve outcomes for their members and our planet”
5. Preparing to lock in potential improvements in funding level by exploring enhancement of their hedge programmes, as well as engaging insurers on longevity swaps and potential buy-in and buy-out transactions. The enhancements to hedges they will explore include:
- Using equity and credit derivatives – especially options – to mitigate market and credit spread risks
- Improving collateral management by maintaining low levels of leverage, plus asking counterparties to accept certain assets other than cash as collateral
- More frequent rebalancing to target hedge ratios.
The meeting minutes also noted the trustees’ view that these decisions are expected to support a reduction in its alignment metrics as well as reduce several of their key risks, notably those around covenant, climate, funding, and liquidity and markets.
Many pension funds are in a similar position to FTL’s Fund and may find it beneficial to explore, at a high level, several of the above options and actions with their advisers. While the priorities and resources available to each pension fund will differ, all will be required to demonstrate to their stakeholders that their money and resources are being used to improve outcomes for their members and our planet.
Michael Sher sits on the Board of the IFoA Sustainability Volunteer Group and leads a small team in building a user-friendly asset liability climate model