For UK pension funds that need to develop climate action plans in response to growing financial, regulatory and reputational pressures, the tendency may naturally be to focus on asset holdings. But the implications for liabilities and covenants can be just as, or potentially even more, severe.
Even before the COVID-19 pandemic focused additional attention on issues of resilience, socially responsible organisations and the need to ‘build back better’, the clock for UK pension funds to take action on climate change had already been ticking louder for some time.
Even if trustees haven’t all established their own impetus for action, regulators and politicians have been increasingly stepping in to apply pressure for progress towards the Paris Agreement aim of limiting global temperature increases to well below 2°C above pre-industrial levels.
Illustrative of the growing demands on trustees is the letter to the UK’s 50 largest schemes from Pensions Minister, Guy Opperman, sent in October 2019, signalling increased vigilance of funds’ responsibilities on climate change and adherence to ESG (environment, social and governance) requirements. In addition to the growing ESG policy and disclosure requirements already facing UK pension schemes, the Government’s Green Finance Strategy and the current Pension Schemes Bill is paving the way for required climate change risk governance and TCFD (Task Force on Climate-related Financial Disclosures) reporting.
Beyond the halls of power, what is abundantly clear moreover is that wider stakeholder activism is increasingly focused around climate issues and encouraging funds to act as a force for positive change.
As one of the largest blocks of investors, much of the attention and response to date within pension funds has tended to focus on assets and due diligence around them. Important as this undoubtably is, there is a danger that the impact on liabilities and other aspects can get overlooked without an integrated approach (see Figure 1). For example, this could include the impact on sponsor covenant where a company sponsor may be particularly adversely affected by, and unable to mitigate against, a transition to a lower carbon economy.
Central to this more holistic approach to assessing climate risks are the scenarios used to project physical and transition risks (such as extreme weather events and the move from fossil fuels to renewables respectively). Typical realistic climate scenarios might vary from coordinated global action to limit temperature change to the well below the 2°C target, to a continuation of ‘business as usual’, with resulting higher levels of temperature and catastrophic climate consequences.
From an asset perspective, another key variable would be the rate at which changes are expected to occur in each scenario. Investors therefore might want to compare the effect of an annual drag on asset returns with the potential for the short, sharp shocks that are often more common market re-pricing reactions - or variations in between.
Whichever climate scenarios and timings schemes subscribe to, the direct and indirect effects on mortality are critical to consider. Warmer winters, more heat waves and larger temperature swings would all be expected to affect ‘excess’ winter and summer deaths over a year, and equally, the indirect effects of different levels of climate change on things like clean air, healthy lifestyles, food and water security and healthcare provision all have the potential to affect mortality.
Our own recent analysis is that in a global coordinated action scenario (2°C or lower temperature rise), the UK could realistically see improvements in mortality around 1% p.a. higher than before allowing for climate effects. By contrast, a ‘business as usual’ scenario could see rates of improvement stalling altogether, or perhaps even declining in a worst-case scenario.
What these kinds of figures mean for overall liabilities will depend on the maturity of the scheme and the duration of liabilities. In the case of one large UK fund for whom we analysed this issue recently, the projected effect of the mortality impact on fund liabilities ranged from roughly +4% to -6% and were orders of magnitude bigger than the corresponding asset impacts. And even if the liability risks appear relatively small in isolation, the impact on journey planning can be much larger when combined with other dynamics such as covenant risk which can be quite acute and time sensitive for some employers.
The scale of impact is indicative of just why modelling of climate change scenario effects on an integrated basis can be so important to pension funds. Even where funds have made an allowance for a large longevity shock in their liability models, this will typically cover one year whereas climate change has a much longer time horizon. In many cases, analysis may strengthen arguments for better liability risk management and longevity hedging, or a significantly reduced reliance on covenant.
Only through a proper integrated assessment of the effect of climate risks will the potential magnitude and inter-relation of the risks become clear and allow schemes to address climate change in an effective and joined up manner.
See our other article on the TCFD.
