Pension scheme trustees in the UK are facing mounting pressure to consider how to reconcile their climate ambitions with their understanding of fiduciary duty. This renewed focus is driven by a myriad of concerns, including both the financial implications of climate-related risks on investment portfolios and the impact that climate change may have on their members’ welfare and societies at large. There may also be legal and reputational issues associated with trustees’ decision-making.
It is encouraging that many trustees are starting to work on this already, with compulsory disclosure activities relating to climate risks now bedded in for most larger schemes but still questions about the application of fiduciary duty linger for many. In this article, we delve into the dual nature of climate risk and impact and, in this context, how investment decisions related to climate change can be reconciled with fiduciary duty.
Climate risks are systematic, hard to predict based on past experience and transcend individual asset classes. They require deliberate, forward-thinking strategies and considered transition plans. These risks encompass both physical threats, such as extreme weather events, and transition risks, including policy changes and technological advancements. Left unaddressed and unmitigated, climate risks could lead to significant disruptions in asset values, sponsor covenants and even life expectancies – all examples of the effect of climate risk on a pension scheme.
Looked at from the opposite direction, the investment decisions made by a pension scheme will have an impact on climate change and by extension the welfare of individuals around the world, including pension scheme members and beneficiaries. Investment decisions could also look to exploit the climate opportunities of the transition to a low-carbon economy.
The complexity of climate risk and the dual nature of the relationship between climate-related risk and impact, poses the need for a re-evaluation of traditional investment behaviours and the application of fiduciary duty.
To set the scene, let us quickly recap fiduciary duty and how it should influence trustees’ investment decisions. Fundamentally, a trustee's fiduciary duty is understood to mean acting for the proper purpose of the trust in the best interests of beneficiaries, prioritising prudent management and safeguarding assets, without taking one’s own personal interests into account. Historically, this has translated into a focus on maximising returns while minimising risks.
To support trustees in fulfilling that aim of maximising returns while minimising risks, the Law Commission of England & Wales has previously differentiated between “financial” and “non-financial” factors with trustees always being expected to take financially material factors into account when making investment decisions[1]. For example, these factors have included the expected return, the variability of future expected returns or inflation protection offered by the investment – in fact, anything that might affect the financial outcome of that investment. “Non-financial factors” (that is, anything else), can be taken into account by trustees when selecting investments only if certain (very restrictive) tests are met[2].
There has been significant debate recently around where climate change sits between these two groups and whether it is appropriate for pension scheme trustees to factor climate into their decision-making process. The recent paper from the Financial Markets Law Committee (FMLC)[3] explored these issues in detail and was cited by experts, including WTW’s Debbie Webb, who provided evidence to the House of Commons Work and Pensions Committee. We draw out a few conclusions from that paper below.
So, can pension scheme trustees consider climate risk when making investment decisions, and if so, how?
The answer, according to the FMLC, is yes, and increasingly, they must if they are properly fulfilling their fiduciary duty. Trustees are not only permitted but also encouraged to integrate considerations around the sustainability of returns and factors that affect beneficiaries’ quality of life into their decision-making processes, as these may be reasonably considered “financial factors” as defined by the Law Commission. This includes assessing the resilience of investment portfolios to climate-related shocks, engaging with companies on sustainability practices in order to drive better future returns, and incorporating climate scenarios into risk assessments. Of course, this should all be considered in the context of the specific circumstances of the scheme and the employer that supports it.
Taking this further, sentiment is already starting to move in favour of also factoring the potential climate impact of investments into decision-making, with over half of those who participated in WTW’s 2023 Emerging Trends in DB survey indicating that they believed investments supporting the environment delivered better long-term performance and over one third saying that schemes’ investment strategies should support environmental considerations even if risk-adjusted returns are expected be moderately worse (something the current legal framework makes challenging).
This is encouraging, but hurdles remain as the pensions community continues to debate the extent to which trustees can factor the impact of their investment decisions on climate change into their decision-making processes.
To some, the price or expected return of an investment might be irrelevant if the climate impact is positive, so they view climate impact through a “non-financial factor” lens. The Law Commission’s strict tests must therefore be met before investing in this case. For others, the price is also a relevant consideration, alongside the climate impact. These investors therefore believe climate impact can be included within the “financial factor” list. Trustees’ objectives and motivations are therefore a key part of the decision making process and could lead to different trustee boards receiving different advice and reaching different conclusions.
Early movers are already actively navigating the area of climate change with input from their legal advisers although as mentioned above, legal opinions can differ.
In relation to climate risk, the FMLC’s paper considers how pension scheme trustees might approach the issues surrounding climate change when making decisions in keeping with their fiduciary duty. In particular, it notes that pension scheme trustees have the benefit of not generally being involved in the day-to-day detail of the asset management and can often consider the schemes’ investments more holistically. It goes on to reflect that trustees may be failing to meet their fiduciary duty by not considering all of the risks inherently present (of which climate is a very present risk to the economy and investment markets).
Similarly, the Institute and Faculty of Actuaries has issued guidance on climate change to its members, with the aim of aiding professionals who support trustees on assessing, advising and facilitating conversations on these long-term risks.
In our view, what the industry needs now is a greater consensus on whether (and if so, how) trustees can build the climate impact of their investments into decision-making.
Looking ahead, trustees are being encouraged to develop Climate Action Plans, which the Pensions Regulator believes might help focus trustees’ attention on plausible actions that can be taken in addition to meeting the disclosure requirements. These action plans could involve investment strategy changes, stewardship actions, changes to risk management processes and more. In our next article, we will explore some of the actions we are seeing trustees adopt.
