Thanks to climate change, pension scheme portfolios are in danger of overheating. So what are trustees doing to protect savers?
Climate change is changing. It is no longer an issue championed solely by sandal wearing, lentil-eating lefties; people from all walks of life now acknowledge the negative effect it is having on our world.
Its most high-profile impact is on our health. In 2013, a nine-year-old girl in London died following an asthma attack in a tragedy linked to air pollution. But it also has ramifications for the economy, and thus the value of pension funds. So trustees need to consider this risk in every investment decision they make.
Global warming has specific threats to pension pots. It could erode investment returns or hit a sponsoring employer’s ability to pay contributions. It might also have a say in funding decisions, especially in how mortality rates influence liabilities and in the way insurers price buy-outs.
At the portfolio level, there are two main risks to investment performance. The first is physical, such as changing weather patterns. The other is the transition to a low carbon world, which is manifested as policy, regulation, technology and market changes.
The financial risks of these are real. Energy companies and insurers feature prominently on the danger list here. Insurers could face higher claims linked to extreme weather, while oil and gas companies suffer as governments implement the Paris Agreement, which seeks to keep global temperate 2°C above pre-industrial levels. To meet this target only a third of known oil, gas and coal reserves can be burnt.
So when trustees assess an investment, climate change risk should be on par with asking how many times its dividend is covered by earnings.
“Ignoring climate change is taking a risk; a risk for their business and for us as their investor,” says Meryam Omi, Legal & General Investment Management’s (LGIM) head of sustainability and responsible investment strategy.
There appears to be little worry here that trustees are unaware of the issue, according to a recent pool by Aon. “What our clients are telling us is that it is top of the agenda when it comes to ESG considerations,” says Tim Manuel, Aon’s UK head of responsible investment.
Public concern over climate change is also strong. More than half (54%) of UK voters yet to celebrate their 40th birthday would back a political party that has a policy on curbing pollution, a survey by Tory think tank Bright Blue discovered.
Yet it appears that only 17% of pension schemes across Europe share their values. A survey published in June found that less than a fifth of 912 schemes questioned consider the financial impact of climate change when making decisions. However, this is an improvement on the 5% of schemes that had the issue on their checklist 12 months earlier, supporting Aon’s research.
So while the level is disappointingly low, it is improving rapidly.
Regulation, pressure from members and an awareness of the financial materiality of these risks are behind its growing popularity.
“There is an increasing recognition of the materiality of the issue and that means there will be an impact on financial returns if you don’t have a smart approach to climate change,” says Solange Le Jeune, Candriam Investors’ senior SRI analyst.
Also seeing the debate around this topic increasing in intensity is Victoria Barron, a responsible investment analyst at Newton Investment Management. “I get asked almost every day about climate change,” she adds. “Trustees are beginning to realise that this is a long-term issue that represents a massive tail risk.”
Newton met with Shell’s chair last year to discuss the disclosures it wanted from the oil giant and the chair wanted to know what more he could do to help. “In the past 12 months we have seen a shift in mindset,” Laura Sheehan, an oil and gas analyst at Newton, says. “Management talk now without being prompted about how they deploy their capital in a changing energy economy.
“They are thinking long term,” she adds. “They are thinking about how their investments today can change and re-direct their strategy in line with the energy transition.”
A WIDER PROBLEM
Climate change is a man-made problem. Carbon dioxide, methane and nitrous oxide emissions are named as the likely cause of global warming. So cutting emissions could be crucial in trying to improve the situation or at the very least stop it from deteriorating further.
The effects of climate change include rising temperatures, changing rainfall patterns and rising sea levels. Switching to greener energies, using power more efficiently and reducing emissions from agriculture and de-forestation could help and is where regulators, governments and ethically-minded companies are focusing their efforts.
But it is not just oil and gas companies that carry carbon emission risk. John Streur, president and chief executive of responsible and sustainable investor Calvert, has some surprising names on his list of high carbon companies, such as Berkshire Hathaway, Nestlé, Walmart and Pepsi. All signs that investors should assess how products are made and used before investing.
The financial risk of climate change is expected to increase, meaning that that those who start drawing their pensions in 50 years’ time face a greater danger.
So those sitting in the House of Commons have stepped in to protect savers’ pensions. The cross-party Environmental Audit Committee wrote to the country’s 25 largest pension schemes to find out what trustees are doing to protect those saving for their retirement against climate change.
A series of recommendations on how companies should disclose their climate change risk have already been made by the Task Force on Climate-Related Financial Disclosures in June 2017. They centred on governance, strategy, risk management and metrics and targets. These are, however, voluntary measures.
There are laws that could be used against trustees if they fail to factor such risks into their stewardship of a scheme. The Occupational Pension Schemes (Investment) Regulations 2005 requires trustees to state the extent to which they take account of environmental, social and governance or ethical considerations into their investment decisions.
However, there appears to be some confusion. In a consultation, the Department for Work and Pensions (DWP) complained that there is widespread misunderstanding amongst trustees on the scope of their fiduciary duty in relation to environmental risks.
Aon’s Manuel welcomes one of the DWP’s suggestions that a scheme’s statement of member views and implementation plan should be available as public documents. “In my mind that is the part of the consultation that is most likely to lead to a change in behaviours and perhaps some new actions because making public statements tends to lead to more action,” Manuel says.
Streur does not believe that regulation is an effective way to make investors adjust their portfolios. “What is more likely to happen is that the market delivers changes that differentiate companies that have managed these risks well versus companies that have not.
“In an environment where we have a fossil fuel price spike, companies that become less dependent on them and have secure access to renewable energy are going to win. The companies that are stuck on fossil fuels are going to lose,” he adds.
One method of reducing harmful emissions is to invest in fossil fuel extractors and then work with management to cut emissions or boost investment in green energies.
Culvert does not refuse to invest in a company with a “significant” carbon footprint. The plan is to persuade management to adopt strategies and practices to reduce that risk. If there is little progress then Streur is not afraid to ditch the stock, which doesn’t happen often. “It would be rare in 2018 to find a management team that wasn’t working to address carbon risk or climate risk,” he says, pointing out that this does not mean that he is satisfied with the pace of process across the board.
“The pace is accelerating in terms of what corporations are doing,” he adds. “It is possible that the surprises from here on out are more biased towards companies beginning to change more quickly than people expect. That creates risks for companies that are not moving very quickly. They will be flat-footed and a market event will put a financial penalty on them.”
LGIM is another investor that uses divestment as a tool to drive progress. “Engagement with companies must have consequences in order to drive meaningful progress,” Omi says.
“We want companies to have a credible low-carbon strategy and a board that is capable of implementing it,” she adds. “As shareholders, we continue to push companies in this direction, as that is in the best interest of the companies and our clients whose future income relies on their success.”
Candriam can exclude fossil fuel companies or those with operations negatively impacting the environment from their funds, but the asset manager also has people who exclusively focus on engaging with companies.
This year, Newton launched sustainable versions of its global equity, fixed-income and multi-asset strategies. “One of the main focuses of these sustainable versions is climate change,” Barron says.
“There are some red lines that companies must jump over in order to be eligible for those funds; one of those is regarding climate change. Will they be profitable in a world with a 2°C policy? Do they have a strong carbon emissions-reduction approach?” If the answer to either is ‘no’, they will not appear in Newton’s funds.
But building a low carbon portfolio does not mean that investors have to sacrifice performance.
“We have designed a fund that allowed its underlying investors to reduce the carbon footprint by an amount equivalent to the emissions of 40,000 cars over a year, while still capturing market returns efficiently,” Omi says.
Marion de Marcillac, MSCI’s business manager for ESG carbon, controversies and sustainable impact products, says the low carbon indices that her organisation launched in 2014 have proved popular. “Since the indices were launched the market has evolved in terms of what it wants to do when it comes to climate change. We are getting some requests that go beyond that footprint reduction, but that is still an important first step.”
She explains that investors want to know how companies are managing their climate change risk. So even if a business is carbon intensive it would consider investing if it is managing this risk better than its peers are. “So going beyond the initial foot-printing reduction exercise and looking at more forward looking indications in terms of how companies are managing it,” de Marcillac says.
This could be the result of investors being more proactive in raising awareness of such risk. Newton was one of 60 global investors who wrote a letter to the Financial Times calling on the oil and gas industry to take action on climate change. Barron described it as a unified message from global asset owners and asset managers.
Initiatives like this appear to be working. Fawzy Salarbux, Candriam Investors’ global head of consultant relations, says: “There are clients who understand that in the coming years’ climate change will create winners and losers in the stock market.”