An amendment to the Pension Schemes Bill has been proposed which could force pension schemes to align their investment strategies with the Paris agreement. This article looks at the implications for trustees, and asset owners more generally, as they consider how they measure and report on the impact of climate risk and the UK commitment to reach net zero carbon emissions by 2050.
The Paris agreement, signed in 2015 by the majority of global leaders, established a legally binding commitment to curb carbon emissions in order to limit the global temperature rise to below 2 degrees celsius with the ambition to work towards a lower threshold of 1.5 degrees. In order to reduce the risks associated with long lasting or irreversible changes to the earth’s atmosphere and ecosystems the Intergovernmental Panel on Climate Change (IPCC) reported that global carbon emissions would need to reach net zero by 2050. In 2019 the UK government committed the UK to achieving this target and became the first major economy to pass this into law. Policy maker focus is supporting this transition and we are seeing a much greater focus on sustainability from the government and the regulator.
The levels of pension savings and wealth in the UK is a significant part of the UK economy and has a huge part to play in helping companies to meet this target through voting and engagement rights that share ownership brings. There is no doubt that climate risk is an investment risk and going forward those responsible for investment solutions will be expected to have explicit policies on climate risk to explain how they are addressing it and building a roadmap to move to net zero.
What is climate risk?
Climate risk could crystallise in a number of different ways given the complex nature of the risk and the different time horizons for impacts. Typically we see the risk impacts grouped into two categories – physical risk and transition risk.
Physical risk relates to the impact of climate change, for example damage to land, buildings or infrastructure as a result of adverse weather conditions or rising sea levels as well as the knock on effects such as food shortages, supply chain disruption and civil unrest.
Transition risk relates to the disorderly impact on markets as a result of the transition to a low carbon economy. This could include the impact of policy action such as carbon pricing, emission caps and subsidies or the emergence of changing consumer behaviours and reputational risk as expectations to address climate change evolve and increase.
It won’t have escaped you that some of the knock on effects described here are similar to those that many of us have experienced as a result of the COVID lockdown measures put in place by governments. The impact this has had on our lives, wellbeing and finances has not been neat and orderly, nor has it been the same for all of us and it’s not difficult to imagine how the effects of climate change could bring similar impacts, albeit on a much larger scale.
The scale of the challenge
To help bring the impact of climate change into a financial context a recent report by the Carbon Disclosure Project forecast that $1trn of climate related costs will be borne by 200 of the world’s largest listed companies within the next five years. Regulations currently require that trustees disclose and report on their climate policies and the government has made it clear that their aim is for schemes to start actively managing their exposure to climate-related risks in order to limit the risk climate change poses to their members’ future retirement income. This focus has also been extended to IGCs who now have a specific remit to provide an independent consideration of a firm’s policies on environmental, social and governance factors including climate change.
Where to start
Transparency is a key first step in order to understand climate risk and the impacts on the investment strategies and a good place to start is the Task Force on Climate Related Financial Disclosures (TCFD). It was set up in 2015 and delivers a set of consistent, climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders. It’s a widely-adopted approach to manage and report climate risk and provides a framework to help trustees embed this within existing governance and decision making processes including defining investment beliefs, setting investment strategy and manager selection and monitoring.
TCFD reporting is voluntary at the moment however it will become mandatory by the end of this year and as an asset owner we have already committed to report against the TCFD framework.
A net zero economy is the direction of travel and the risks that lie in how we get there will affect investment returns. Given the scale of the challenge the quicker we can understand and quantify these risks the better in order that we can manage them and deliver not only good returns for customers but also a more sustainable future.