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Taking Action on Climate Risk
The recent consultation from the Department for Work and Pensions (DWP) on pension scheme climate risk governance and reporting has brought a number of climate change disclosure proposals to the UK pensions industry. The Government is specifically targeting pension schemes so that they disclose their approach to managing climate risks and opportunities, in line with the recommendations of the Taskforce on Climate-related Financial Disclosures (TCFD).
This will be done using regulations and statutory guidance, as provided for through the Pension Schemes Bill currently before Parliament,
TCFD and their 11 recommendations have been gaining traction since their initial report in 2017 endorsed by the UK government and the Bank of England, and appear to be increasingly used within the pension scheme community.
Why should financial markets care about climate change?
The risks from climate change have two main channels into the economy: Physical and Transition Risks. As the chart below demonstrates, these will have far reaching impacts. Whilst there is an array of research on both the physical and transition risks, ultimately the financial system impact (in blue below) are just some of the possible consequences if climate change risks are not better disclosed and managed.
Ultimately, the financial industry has a significant role to help mitigate climate risk but also to encourage behavioural change. Indirectly, pension schemes support infrastructure projects in the real economy that can fundamentally change the way projects are procured. If these regulations encourage thoughtful selection of climate-friendly activities or encourage transitioning to low carbon economies, it is beneficial from a financial perspective, but also from an environmental and then a societal perspective.
Climate change: Physical and Transition Risks
Source: DWP consultation
What is being proposed?
The DWP consultation proposed:
- Pension schemes with £5 billion or more in assets, authorised master trusts and authorised collective money purchase schemes need to have arrangements on climate change governance, strategy, risk management, metrics and targets from October 2021
- Extending this to schemes of more than £1bn by 2023 and all schemes by 2024
It also sought views on proposals to:
- Assess climate risks and opportunities and publish a climate change report annually in line with TCFD recommendations by 2022
- Calculate the ‘carbon footprint’ of pension schemes and assessing how the value of the schemes’ assets or liabilities would be affected by different temperature rise scenarios, including global average temperature targets from the Paris Agreement.
The disclosures would be required to be made publicly available, referenced from the schemes’ annual report and accounts.
What does this mean for pension schemes, if made law?
For many pension schemes, it will mean greater disclosure and more public scrutiny on climate change specifically, rather than ESG more holistically which prior guidance has focused on. For those in more controversial sectors e.g. oil/gas and tobacco, increased scrutiny on the metrics and targets the pension scheme is committing to with regard to climate change specifically.
It may lead to an increase in looking at temperature rise scenario stress testing. As a recent example, the Lothian Pension Fund has pledged to no longer supply funding through new bond or equity investments to companies not aligned with the Paris Agreement and to measure the carbon intensity of every asset by 2022.
Greater scrutiny on climate change in all aspects of pension schemes, e.g. longevity risk, may (eventually) result in changes to risk assessments and pricing. Research by the International Monetary Fund has identified that equity prices do not reflect future climate risk. A shift in investors’ perception of this future risk could lead to a drop in asset values, generating a ripple effect on pension scheme portfolios (and financial institutions’ balance sheets).
Taking it one step further
Requirements to report on the average ‘temperature rise’ of scheme portfolios or alignment with the Paris Agreement were excluded from the consultation. However, the Government may consult on this “in the near future”.
A recent joint paper from the Institute and Faculty of Actuaries (IFoA) proposes three climate pathway narratives which are forward looking projections based on different CO2 emissions and economic variables. The challenge as ever, is to get wide-spread usage across the industry when scenario testing by definition is difficult to do, and is essentially trying to widen the funnel of doubt that pension schemes need to consider.
Most recently, the Bank for International Settlements (BIS) commented on the carbon impact of Green bonds and the need to rate corporate issuers with regard to their carbon intensity to fully appreciate the underlying impact of companies and their activities. This focus on carbon intensity (emissions relative to revenue), could prove to be an important additional consideration for all asset owners.
The greatest challenge arguably is the significant timing risk, whereby portfolio outcomes will depend on precisely when climate shocks and market repricing occur. For pension schemes this will be particularly important relative to how well funded they are and where they are relative to their long-term objectives.
In order to grapple with climate change, financial institutions need to understand both the risks and the opportunities involved. Whilst we now await the outcome of the recent consultation , the impact on disclosures to the financial services food chain could be far reaching. The DWP acknowledges that pension schemes are dependent on data from other parts of the investment chain and schemes will likely need more information from asset managers. Asset managers in turn, will require this from the entities in which they invest, ultimately forcing companies to provide this level of disclosure to ensure homogenous data across portfolios.
Better disclosure of climate change exposures and stress testing is needed by pension schemes and the recent proposals go a long way to improving that. There is acknowledgement by the IFoA that for actuaries advising pension schemes, some investment strategies are likely to be materially impacted under climate pathways relative to climate-uninformed projections. For pension schemes, this means funding risks may well be underestimated and that changes are needed to incorporate climate risks.
The important subsequent part is being able to complement policy measures to mitigate and adapt to climate change across a portfolio and array of asset classes, rather than just equity and fixed income where there are greater ESG disclosures to date. Taking the improved data and management information, and adjusting portfolios accordingly, will be the greater change and will take pension schemes much longer to implement. Nevertheless, it is a worthwhile initiative and should be taken seriously for the broader benefit.