Roundtable: Future-proofing pensions in a changing climate, part one

Managing long-term liabilities in the context of a changing climate is an issue that's moving up the agenda for pension funds. An Environmental Finance roundtable, hosted by law firm Sackers, heard how they are grappling with climate-related risk and opportunity

Michael Hurley: How does the National Employment Savings Trust (NEST) look into the risks and opportunities that arise from the transition to the low carbon economy?

Diandra Soobiah: We have about 7 million members and the vast majority of those are in their twenties and thirties. They are the age bracket that are most likely to be financially impacted by climate change.

Secondly, we track all global equity indices, so we have exposure to the most climatically sensitive sectors of the economy.

In early 2017, we launched a Climate Aware fund. We worked with our global equity manager UBS to put in place a forward looking investment solution that managed both the upside and downside impacts from climate change.

The fund is particularly innovative because it looks at the carbon footprint trend of a company and assesses that versus the carbon emission reduction target to get to 2°C in 2050 for that sector. Those companies that are well-positioned will be rewarded with a higher weighting. Companies not reducing their carbon emissions will be underweighted. We are also underweight in companies whose carbon emissions are rising on an absolute and relative basis, and companies that have large fossil fuel reserves, or are involved in pure play coal.

We have written to all of the biggest underweights within the fund and set out what they need to do to change. Some have made commitments going forward. We are going to give them three years for us to see improvements. If we do not, we will start voting against the company on shareholder resolutions.

If you look at some of the marginal overweights in the fund, you may be quite surprised: we have names in there like SSE, or RWE. While they are big consumers of fossil fuels, they have made future commitments for shutting down coal power plants by 2020 and 2025, respectively.

This is a fund solution for the default fund because, for the vast majority of our members, this is a financially material risk that needs to be addressed. About 99% of our members are invested in the default fund.

The Climate Aware allocation in our default strategy is around 30% of equities, in the growth phase, and 40% in the foundation phase.

MH: Patrick, how does this differ from USS's approach?

Patrick O'Hara: Most of our assets are managed in-house, almost all of our equity exposure and a large proportion of our credit as well. That dictates our focus as well, and is slightly different, perhaps, from NEST.

We do have some quant portfolios and we've applied a low-carbon tilt to our low-volatility portfolio.

When we carbon footprinted the fund about 18 months ago, we found that the low-volatility portfolio was quite carbon intensive compared to the benchmark and had quite a heavy exposure to utilities, so we've applied a tilt eliminating the most carbon-intensive companies from the investable universe. We have brought down the carbon intensity of this portfolio quite significantly over the last two years.

We also have a process to systematically integrate environmental and social considerations into our voting. We are asking for greater disclosure around lots of 'E' and 'S' issues but particularly climate change and scope three – or downstream – emissions, for example.

In the first year, we write to every company after we vote, explaining how we voted and why. We ask for greater disclosure, then if we don't get it we are going to abstain, and then vote against reporting accounts where we think the disclosure is inadequate.

That is consistent with our views on integrated reporting and the need to have this critical data in the company disclosures.

Our default position on climate-related shareholder resolutions is to support, but we look at them all on a case by case basis.

Owen Thorne: We are open to new member accrual, which means we have pension fund liabilities stretching way out into the future. Our engagement with climate risk has been driven by our attempts to engage with the long term risk profile [of our portfolio].

We were conscious, as well, that we are increasingly accountable to a stakeholder base that wants action on this issue, that it was probably insufficient to carry on as we had been with a purely engagement based approach.

We felt, from an allocation point of view, that some of the longer term trends fitted with themes we were seeing across both our public markets and private markets investment strategies. We had already begun to invest in renewable energy. There is an interest in putting that into the longer term risk model, particularly as we consider that we would be allocating considerably more capital into private markets, particularly infrastructure, as part of our future allocation plans.

We are de carbonising our equity exposure. It is the largest component of our asset mix. We noted in particular, when we began working with carbon footprinting data, that the sort of structural risks in our portfolio are a high allocation to market cap weighted indexes, [and there is a] large concentration of ESG risks in those indexes.

We have therefore been working on looking at our low carbon indexation approach... to try and conceptualise a more risk efficient means of allocating to equities.

MH: How does considering ESG factors fit in with trustees' fiduciary duty?

Patrick O'Hara: Our trustees recognise that ESG integration is part of their fiduciary responsibility.

They recognise that it is a longer term risk. I think the signals are getting stronger in terms of the transition to a lower-carbon economy, what it will look like and who, potentially, are going to be the winners and losers.

Owen Thorne: With the fiduciary issue, in relation to climate, I think we have found it less of a barrier, the more we have recognised it is recognised by our stakeholders, by the wider industry as a financially material investment consideration. I think the discussion has moved on from any notion of this being a matter purely for consideration by interested parties, or an ethical consideration, to seeing climate as a systemic risk.

MH: In the consultants' view, do you feel that pension funds generally are effectively grappling with the issue of climate risk and opportunity?

Claire Jones: I think we are seeing a wide spectrum of responses from our clients. I would say most of the leaders are on the defined contribution side because of the long timescales involved before younger members retire. Some of the clients at that end of this spectrum are looking at these climate tilted funds.

However, there is a very, very long tail of our clients who are only just starting to grapple with responsible investment. The publication of revised investment regulations [by the DWP] will mean that many more clients start thinking about these issues and what it means for fiduciary duties.

The position has shifted a lot in the last year or two. Most of our clients are now familiar with the concept of ESG and responsible investment, and recognise that it is part of their fiduciary duty, and we are talking about these topics because they are relevant to the financial performance of their pension scheme. However, they have not got very far yet in thinking about what that means in practice and how they might do things differently.

MH: In terms of engagement, how willing are they to push their investee companies on the issue of climate?

Claire Jones: One of the reasons many of our clients are less engaged than the pension schemes that are represented here today is because they are smaller, and a lot of them do not have in house support. They are reliant on investment managers to engage with investee companies.

However, I think there will be more focus on engagement in the future. The Pensions Regulator (TPR) guidance encourages trustees to understand what managers are doing in relation to stewardship. We are therefore starting to see more dialogue between trustees and investment managers on this topic, but not direct engagement of trustees with companies.

MH: How has the regulator tried to encourage pension funds to look at this issue seriously?

Amanda Latham: We published our DC investment guidance in 2016, which mentioned climate change as an area to consider sustainability of scheme investments. Then, in 2017, we brought out our DB investment guidance, with mentions of climate change throughout, including in terms of monitoring investments and what you should be looking for from your managers.

However, we do not think we have seen a significant shift on the back of TPR publishing that guidance. That is why we have worked with the DWP to revise the investment regulations.

Unfortunately, regulator guidance is not enough to really move the market. What we need is everyone working together. We need advisors, legal advisors, investment consultants, like the people here today, to make sure trustees understand what their duties are and how to take action.

Owen Thorne: To what extent are advisors prepared to proactively lead their clients on this issue? Is there still a tendency to wait for that interest from their trustee clients?

Lydia Fearn: Up until recently I do not think there has been as much drive, either from consultants or from clients. I was at a discussion recently with a number of consultants, who said, 'Well, they have other things on their plate.' I found it quite frustrating that we even have consultants saying that, when actually it is up to us to help them drive the agenda forward.

The problem that we have seen, particularly on the DC side, is the lack of choice in the market around what the funds might be and how they might look.

Also, the concern a lot of trustees have is there is no history. How will I know that this is going to actually deliver the returns that I am assuming over the long run?

If it is a neutral return, then why should I pay more? Trustees are a risk averse bunch. They like to see past performance. Unfortunately, the data is just not there yet.

Karen Shackleton: In the local authority markets, my impression is that they are further along that path [than corporates]. I have sat in on committee meetings where there have been really well-thought-through and credible deputations from local campaign groups. However, I see the role of the investment consultant being there to say, 'Okay, let us take a step back and let us think about how we go on this journey. That has to start with setting out investment beliefs.'

Lydia Fearn: I think it is scale, time and the fact that for many it is not their day job. However, I would say, of the smaller schemes, I think they are just a bit lost.

To read part two of the pensions round table click here.

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