As climate change risk management beds in to the UK legislative agenda, pension funds are under pressure to make important decisions on how to incorporate it into their strategies.
This has been at the top of the agenda since 2019 when The Pensions Regulator (TPR) brought in the first stage of its multi-year reporting rules for schemes.
TPR says that, for schemes to properly address the climate change issue, relevant environmental factors need to be fully integrated into mainstream f inancial decision-making across all sectors and asset classes.
The changing rulebook
David Fairs, TPR’s executive director of regulatory policy, analysis and advice, says that the Taskforce on Climate-related Financial Disclosures (TCFD) is one of the most significant and influential international initiatives to achieve this. The TCFD’s recommendations are at the heart of climate change reporting legislation within the Pension Schemes Act 2021.
The government is still consulting on draft versions of the regulations and guidance. It is obvious from the drafts, however, that the burden on trustees will be significant.
“The new requirements are not just about disclosure,” says Pinsent Masons partner Carolyn Saunders. “They are about making trustees adopt effective governance systems so they can properly assess and understand what climate change actually means for their particular scheme.”
As schemes prepare for these regulatory changes, a key decision to make is whether to engage with companies on climate issues such as carbon footprints, or to divest entirely.
Divestment is a course of action supported by many campaign groups. Extinction Rebellion and other environmental groups have staged protests targeting pension industry conferences and specific major pension schemes, calling for asset owners to exit from fossil fuel related investments.
However, this course of action is not always supported by regulators or politicians, and in any event, trustees are obliged to try to achieve the best return for investors. Engagement is gaining traction as a preferable risk management strategy among asset managers.
To sell or not to sell?
Selling off holdings is a clear, direct course of action and it can send a powerful message to the company affected. Divesting can also attract publicity and help asset managers demonstrate their environmental, social and governance (ESG) credentials, but the core objective of such action should be achieving sustainable long-term returns for investors.
Pensions giant Scottish Widows nailed its colours to the mast late last year when it announced it was divesting £440m from companies that have failed to meet its ESG standards. While this marked just 0.3 per cent of its £170 billion of assets under management, it was highlighted as a major step by the provider.
The provider warned that the figure could rise if companies do not take action to improve the sustainability of their business practices.
While it did not name specific companies, its exclusions policy targets, among others, companies that derive more than 10 per cent of revenues from thermal coal and tar sands.
“There’s a threshold to cut off those companies that are not making the transition out of coal fast enough,” explains Scottish Widows head of pension investments Maria Nazarova-Doyle.
In contrast, for some companies, the fundamental nature of a business can make it inadmissible. For example, in common with many other pension funds, Scottish Widows completely excludes manufacturers of controversial weapons such as cluster munitions. “There’s no amount of engagement that will change them,” Nazarova-Doyle says. “You’re not going to change them. That’s what they do.”
Several funds across the Local Government Pension Scheme have also pledged to ‘decarbonise’ their portfolios in a similar way, usually by shifting to low-carbon nvestment funds or benchmarks – which typically results in divestment from fossil fuel companies.
Starting a dialogue
Many asset managers prefer to engage with companies to encourage positive change.
Oil giant BP is among the companies with which Scottish Widows has an active dialogue, according to Nazarova-Doyle. Fossil fuels still account for most of the company’s profits, but it has repeatedly stated a desire to grow its renewables business.
Speaking to the media about BP’s first-quarter results, published in April, chief executive Bernard Looney used the word “greening” on several occasions – underlining its public statements and pledges.
BP and other fossil fuel companies have been under pressure from shareholders for years to disclose more information about their plans to reduce reliance on fossil fuels. Large investor coalitions involving asset managers and asset owners have led to tangible improvements in reporting, sho wing ho w engagement can work.
Asset managers argue that these companies are among the biggest investors in new renewable energy technologies, and so should be supported.
However, there must be limits to how long investors can wait for action. If companies do not reform their ways, they will not survive, argues Nazarova-Doyle. For example, the combination of carbon taxes and other regulation means that high carbon emitters “will be managed out of existence”, she says.
Guy Opperman, pensions and financial inclusion minister, supports engagement over divestment. In a speech to a Pensions and Lifetime Savings Association event in March this year, the minister argued that divestment was “utterly the wrong way forward”.
“I oppose totally knee-jerk or blanket divestment,” Opperman said. “It seems to me that the way ahead is proper stewardship, and you don’t end your savers’ exposure to climate risk by selling the stock to someone else and passing the problem on.”
An indexing quandary
Aegon head of investment Tim Orton says his company has conducted several surveys of customers that have shown the importance attached to ESG investing.
As a result, Aegon has committed to achieving net-zero carbon emissions across its auto- enrolment default pension funds by 2050. Many of Aegon’s investments use the BlackRock Lifepath funds, which have increased their ESG element in recent months.
Aegon has also partnered with HSBC to increase its sustainability credentials: the Aegon Workplace Default fund is now invested in the newly launched HSBC Developed World Sustainable Equity Index fund.
Orton says the plethora of ESG-themed index products available is positive for pension funds and savers as it offers a bigger range of options. With many different considerations of what is important regarding climate change and ESG more broadly, the market is more nuanced and investors are more likely to find a product that matches their needs.
However, allocating to index funds changes the discussion around whether to engage or divest, as managers are usually tied to an index and cannot cut holdings as an active investor can.
The largest pension funds can work with providers to develop bespoke indexes and products to reflect their needs, but for most schemes this is not an option.
While strategies may be ‘passive’ in its approach to asset selection, the asset managers are rarely passive in their stewardship of investments.
Companies such as BlackRock, Vanguard, Legal & General Investment Management and State Street Global Advisors (SSGA) are leaders in passive investment and as such are responsible for a considerable chunk of the investments into listed markets. Each company publishes an annual stewardship report showing how they voted at shareholder meetings, allowing pension schemes to monitor their activity and draw out data for their own reporting needs.
Larry Fink, chief executive of BlackRock, and his SSGA counterpart Cyrus Taraporevala have written open letters to listed companies this year placing climate change at the top of their engagement agendas, although both asset managers have also been challenged by climate activists to do more.
While divestment will remain as the ‘nuclear option’ for pension schemes, it is clear that a longer- term focus on engagement and positive change is emerging as the investment industry’s preferred approach.
The post Analysis – DC pensions: Engage or divest on climate change? appeared first on Corporate Adviser.
