A] Prelude*
* For more information about pension systems and investments, feel free to visit our dedicated webpages:
https://expatpensionholland.nl/global-pillars-systems
https://expatpensionholland.nl/global-investments-risks-0
Climate change is an enormous challenge and threat globally. Large investors, such as pension schemes, can have a significant influence in addressing this challenge. NetZeroWeekTM provides a reminder of the risks we face and actions that can be taken.
In this article, we aim to answer two important questions:
1] Do pension schemes have a duty to address the threat of climate change?
2] What role can pension schemes play in addressing the challenges faced?
As long-term investors, trustees of pension schemes should consider the potential risks of climate change on their ability to meet their fiduciary duties.
B] Climate Change and Net Zero
Before addressing the role that pension funds can play, it is worth reminding ourselves of what these terms mean. Climate change is the long-term shift in Earth’s average temperature and weather patterns. According to the Intergovernmental Panel on Climate Change, human activities are causing world temperatures to rise, mainly through the widespread use of fossil fuels, such as oil, gas and coal. These release greenhouse gas (“GHG”) emissions into the air when burnt, which leads to the warming of our planet.
‘Net zero’ essentially means achieving an overall balance between the greenhouse gases we emit and the greenhouse gases we take out of the atmosphere. Think of it like achieving balance on a weighing scale. At the moment, we emit far more emissions than we remove. Therefore, the weighing scales are tilted, and the planet is warming.
The consensus among scientists is that this could have many detrimental impacts on our planet and societies over the long term. This ultimately prompted the Paris Agreement, an international treaty adopted to combat climate change. The main aim is to limit global warming to well below 2 degrees Celsius above pre-industrial levels, ideally aiming for 1.5 degrees Celsius. So, we have established that climate change is a problem which needs addressing somehow but… How do we balance the “scales”?
There are actions that we can take individually and collectively:
C] Reduce emissions
The most intuitive and perhaps somewhat obvious action is reducing our greenhouse gas emissions. This can be achieved by transitioning away from energy sources that emit greenhouse gases, like the ones referenced earlier, by using more sustainable and renewable energy sources like wind and hydropower.
We can also improve our energy efficiency. This might include retrofitting and decarbonizing buildings, increasing the use of public transport, decarbonizing the manufacturing processes of widely used materials, adopt circular economy habits and more.
D] Remove emissions
The second action and perhaps less intuitive is removing carbon dioxide from the atmosphere. Planting trees is one way of achieving this, as they remove carbon dioxide from the air naturally. Other removal techniques include biomass carbon removal and storage, soil management and direct air capture.
The stark reality is that in order to limit temperature rises to 1.5 degrees Celsius, reducing and removing emissions are equally crucial. But you may be wondering – what does any of this have to do with the pensions and investment industry?
Do pension schemes have a “duty” to address the problems posed by climate change?
To fix the problem, it requires significant co-operation and action by governments and other “actors” globally. At the core, it requires significant capital and financing to achieve the aims of the Paris Agreement.
However, the reality is, government budgets worldwide are “stretched”, to put it lightly. Therefore, they are increasingly looking towards the private sector, including pension schemes, for support in implementing their “green/climate change policies”. Not least here in the UK.
Why? The pensions sector is a major allocator of capital. As at the end of September 2023, the market value of UK pension scheme assets alone totaled £1.8 trillion. To some, it may come as no surprise that governments, particularly in the UK for example, are encouraging pension schemes to invest in a way that helps governments meet their policy objectives and to consider the risks that climate change poses not only on the scheme itself but on the wider economy.
E] What duties do trustees have exactly?
Some might argue that the only responsibility that pension schemes have is ensuring that member benefits can be paid as they arise (in the case of Defined Benefit schemes) and ensuring that members have access to investments that will meet their investment objectives, allowing them to save for their future retirement (in the case of DC schemes).
Therefore, investment strategies should be designed in a manner which optimizes these outcomes, regardless of the knock-on effects on the wider economy.
On the other hand, whilst they agree that these are their main duties, they may also argue that climate change poses significant risks to the ability to fulfil these duties. Therefore, we should be actively considering the potential risks and seeking to mitigate/minimize them as far as possible. Both arguments have their own merit and like many things in life, the answers are not black or white.
It is near impossible to predict exactly how climate change will impact stewards of capital to fulfill their duties over the long-term. We can take educated guesses and try to quantify the risk in some way, like many trustees have been required to do so through their Taskforce for Climate-Related Financial Disclosures reporting obligations.
However, there has been much debate about the usefulness of the quantitative modelling and analysis provided in these reports and it’s not always about the numbers. Recently the Financial Markets Law Committee issued a paper which sought to clarify the legal position, the uncertainties and difficulties that exist over what trustees’ “fiduciary duties” demand from a sustainability and climate change perspective.
Whilst the conclusion was not firm, the main message still included the following:
1] Trustees must first and foremost balance return against risk, considering financially material factors followed by non-financial factors.
2] Pension schemes should take sustainability factors, like climate change, into account, assuming they consider them to be financially material.
3] If pension schemes do not consider them financially material, then non-financial factors may be considered if trustees have good reason to think that scheme members would share the concern and the decision should not involve a risk of significant financial detriment to the pension scheme.
This implies that trustees should explore how material climate change risks are to the scheme, by using both quantitative data and “narrative” based considerations. Should they conclude that the risks are financially material or if they think the scheme members are concerned about this issue, then trustees have an obligation to take these considerations into account when setting investment policies and strategies for the pension schemes that they govern.
Furthermore, omitting the subject of climate change from consideration because of its uncertainty is not a viable option. This extract from the paper sums this point up nicely:
“In constructing strategy, principles and policies, and throughout the management of the (pension) fund, it is proper for pension fund trustees to situate their pension fund within the wider economy. In doing so, sustainability and the subject of climate change, can, along with other factors, be considered by pension fund trustees when seeking to achieve the purpose of the scheme.”
What role can pension schemes play in addressing the problem (or mitigating the risks)? From a governance perspective, the new General Code of Practice which came into force in March this year introduces new requirements for all trustees of pension schemes to consider climate change risk.
This includes formally disclosing their policy on climate change, which is a now a requirement under the General Code and ensuring that climate change risk is being fully considered when the investment strategy is set.
Whilst the latter is not a requirement, it is recommended by the Pensions Regulator. We would always advocate having the proper governance structures in place to review all risks faced by pension schemes, and adding climate change to the agenda sounds reasonable.
On the assumption that trustees deem the risks posed by climate change to be financially material or meet the criteria to be a non-financial factor to consider, there are actions that trustees can take to address the problem and/or mitigate the risk within pension schemes. There is some debate in the industry between reducing the scheme level carbon footprint and actually influencing real world decarbonization.
F] Reducing scheme level carbon footprint
This method is fairly simple in practice. For example, pension funds can invest in funds that have a lower carbon footprint relative to its current position or the benchmark they are seeking to track. Low-carbon and climate-aware index funds are now widely available.
The theory here is that if you exclude high-emitting and unstainable sectors, then the scheme’s overall carbon footprint is lower and naturally your investment portfolio is less exposed to the transition risks of climate change, such as change in government policies and stranded assets to name a few examples.
However, some may argue that whilst the headline emissions figure will be lower and climate transition risks at a scheme level are potentially lower, this does not solve or address the issue of influencing real world decarbonization. By excluding certain sectors and tilting towards companies that are already more carbon-efficient, this reduces the capital pool available to high-emitting sectors which are crucial to fund their transition. This is discussed below.
G] Influencing real-world decarbonization
If pension schemes want to make real progress towards net zero and reduce the real-world impact of climate change, trustees can pull on three levers; investing in climate solutions, investing in the energy transition and encouraging asset managers to engage effectively with investee companies.
On the first point, investing in new and emerging technologies through private market or infrastructure funds is now achievable for many pension schemes. This might include investments in natural capital, renewable energy projects and private companies who are pioneering new technologies.
The second point, which is somewhat controversial to some, is “transition” investing. This recognizes that without certain high-emitting industries, the goal of achieving net zero is far more difficult.
The reality is, some crucially important sectors are notoriously difficult to decarbonize (for example, cement and steel) and so supplying the capital that will help them achieve this over time, and engaging with these types of companies, is critical if we are to achieve the net zero target.
In reality, all of these approaches are intertwined. A pension scheme may have an allocation to passive equity funds which track a “climate-aware” index, whilst also having an allocation to private market assets.
Some trustees might take the view that investing in the entire economy and ensuring that the asset managers they employ use their voice to encourage change across the board is the most effective solution to the “big” problem. It is difficult to argue against this case.
H] Conclusion
Despite pushback from certain governments and industry players, we think the issue of climate change is here to stay. NetZeroWeekTM serves as a reminder to us that the actions we take today can have an impact, whether that is positive or negative, over the long-term.
To answer the question: “Do pension schemes have a duty and a role to play in addressing the threat of climate change?”, whilst we do not think that trustees have an explicit duty to address the problem, we do think they must consider the potential risks that climate change may pose on their ability to achieve their fiduciary duty.