Estimated reading time: 4 minutes
Whilst trustees need to state their policies on ESG and climate change, this year they are beginning to report on how they are implementing those policies. Now, the Government’s amendments to the Pension Schemes Bill 2020 are going to take things further. Those running schemes will be expected to make sure they have effective governance around climate change risks and opportunities.
The updated text specifically references the Paris Agreement to limit global temperatures and means trustees are going to need to assess the contribution of their scheme’s assets to climate change, as well as assessing the exposure of scheme assets to climate change risks. The new powers will also allow The Pensions Regulator (TPR) to take action against trustees or managers, who fail to put effective governance measures in place or fail to publish required information.
Regulations are going to be published for consultation later this year. These will also set out requirements for those running schemes to determine, review and revise a strategy and/or targets for managing exposure to certain risks, measure performance against these targets and publish information on the effects of climate change on the scheme.
Changes in the climate are going to give rise to both acute physical effects (like increasing severity and frequency of extreme events like fires, floods, landslides and storms) as well as chronic effects (like long-term shifts in precipitation, extreme weather variability, ocean acidification, rising sea levels and rising average temperatures). At the same time, attempts to limit global temperature increases are expected to lead to aggressive mitigating actions to rapidly decrease CO2 annual emissions. These transition risks are likely to materialise more rapidly than the most extreme physical impacts from climate change, manifesting as increasing credit, market, operational and underwriting or reserving risks.
Divestment trends and falling renewables costs increase the risk of fossil fuel assets being ‘stranded’. Stranded assets can unexpectedly lose their value due to changes in demand during the transition to a low-carbon economy. Examples include:
- fossil fuel reserves
- coal plants
- or gas infrastructure
The issue is intensified for companies with large underground reserves that may not be used, but are included in earnings assumptions or asset valuations. The value of assets can drop significantly, overnight, as we are beginning to see this summer with write downs among fossil fuel giants and a crowd of US fracking firms entering bankruptcy protection.
So what does that mean for those running pension schemes? What can trustees and managers do to get ahead of the curve on climate change?
Helpfully, there’s draft guidance already out there from the Pensions Climate Risk Industry Group (PCRIG). Full disclosure, I was a member of the PCRIG in my previous role at TPR, so instead of essentially marking my own homework, I got together with the consultants and analysts in our ESG team to come up with a response to the recent consultation.
Here’s what we reckon
While the Task Force on Climate-related Financial Disclosures (TCFD) recommendations are designed for the whole investment chain, it can be hard to know where to begin. Translating the TCFD recommendations for pension schemes is really helpful and should give trustees the tools they need to take action. It is really helpful to frame the guidance within trustee legal duties and particularly fiduciary duty, as this is an area where there is still a lack of clarity (despite the work done over the years looking to clarify fiduciary duty).
The structure of the guidance makes sense. A useful addition might be highlighting what trustees should expect from their advisers, including what should they should be thinking about and some examples setting out what they should and should not be expecting. Including case studies should bring this to life for trustees and help them deliver good practice for their own schemes.
After reading this, with an understanding of a particular scheme, we think people running pension schemes can come up with actions to take with the whole process set out in five steps:
- Formalise and document governance and risk management of climate change (including investment beliefs)
- Integrate climate into investment and funding strategies, documenting risks and opportunities
- Ask consultants (and managers) to demonstrate climate competence
- Conduct scenario analysis, for example using the TPI and PACTA tools
- Monitor metrics including manager engagement
We think the guidance gives all schemes somewhere to start and a structure to begin taking action, which is no easy task. And the focus on governance, risk and strategy is helpful as schemes need to be doing this anyway.
There is still so much more to be done in this space, so we need to keep collaborating across the industry to keep improving sustainability and governance of UK pension schemes.
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