2017 marked a significant shift in the financial community’s understanding of the risks and opportunities presented by climate change (climate risk). The majority of the world’s largest investors are now recognising the significance of climate risk to their investments and taking action to address it. Below, UKSIF and ShareAction have outlined why climate risk is an important factor for pension trustees to consider and provide a checklist trustees can use to consider climate risk management in their decision making.
As pension trustees, you have a long list of matters competing for your attention. Climate change may not yet be high on that that list. However, the transition to a low-carbon economy (an economy that produces minimal greenhouse gas emissions) is underway. This brings with it new investment risks and opportunities. By joining the majority of large investors taking action on climate risk, you can help the members of your pension scheme continue to benefit from good outcomes over the long term.
This checklist can help you to assess what progress you have made on managing climate risk and what further possible actions you could now take to protect your members’ returns. It is intended to help prompt and structure discussions about climate risk at trustee meetings.
Why is climate risk important?
Climate change presents financial risks and opportunities for companies and investors. Investors with long-term investment horizons, like many pension funds (particularly defined contribution), are very likely to be affected. Climate risk is likely to be more significant for investors with longer-term liabilities. However, if risks are recognised and priced in sooner (for example, through policy action) then investors could also be affected in the shorter term. For example, a recent survey of fund manager attitudes to climate risk, showed that 90% expect at least one risk, such as policy action or the risk of litigation to ‘significantly’ impact the valuation of Integrated Oil Companies within 2 years.
The Task Force on Climate-related Financial Disclosures has identified two types of market risks and opportunities presented by climate change:
1. Risks related to the transition to a lower-carbon economy, including:
Policy risks: action from policymakers to reduce greenhouse gas emissions, impacting on the value of high-carbon assets.
Legal risks: litigation claims brought against companies for failing to mitigate against climate change or disclose material financial risks.
Technology risks: new technologies affecting the competiveness of certain organisations.
Market risk: shifts in supply and demand for products and services as the market increasingly takes account of climate risks and opportunities.
Reputational risk: climate change has been identified as a potential source of reputational risk tied to changing customer or community perceptions of an organisation.
2. Risks related to the physical impacts of climate change.
Acute risk: increased severity of extreme weather events, such as cyclones, hurricanes or floods.
Chronic risk: longer-term shifts in climate patterns (e.g. sustained higher temperatures) that may cause sea level rise or chronic heat waves.
Some of these factors, such as policy action, could have an early impact on the value of carbon-intensive assets in your fund’s portfolio. Technology shifts, such as the move towards electric vehicles, may be more relevant in the medium term.
Over the longer term, if little action is taken to mitigate climate change, assets across the whole portfolio could be impacted by physical risks. Pension funds are particularly exposed to these broader risks as they have widely diversified portfolios that are dependent on the long-term health of the wider economy.
On a more positive note, the investment opportunities presented by climate change are significant. You also have an opportunity to ensure your beneficiaries retire into a world with clean air and water, clean and affordable energy and protected natural resources.
Why should you, as trustees, take action?
Your legal duties as trustees require you to address material financial risks to the fund. In 2014 and 2017, the UK Law Commission confirmed trustees should take account of environmental, social and governance (ESG) factors where they are financially material.
2016 and 2017 guidance from The Pensions Regulator for defined contribution and defined benefit schemes confirmed schemes should consider financially material ESG factors, highlighting climate risk as particularly relevant to pension schemes.
A 2016 legal opinion from QCs concluded that where climate risks carry material financial implications for fund performance, trustees must take those risks into account in their investment decisions.
The Institute and Faculty of Actuaries issued a Risk Alert in 2017 to raise awareness around the financial risks posed by climate change. It cited an increasing body of evidence demonstrating that climate change represents a material risk to future economic stability.
Note on scope
This checklist covers only the investment aspects of climate risk and not those relating to covenant and funding. However, both the covenant and funding aspects also need consideration. For example, the trustees of a defined benefit scheme sponsored by a fossil fuel company should be more concerned about climate-related investment risks, given that it has above-average exposure to climate risks through its covenant.
This checklist sets out suggested steps for good practice in climate risk management for pension trustees. We recognise that not every action will be appropriate for every scheme.