In recent months, pension scheme activity on climate change has reached a tipping point. Particularly among larger UK schemes, this is now a high priority topic. The main driver is the new mandatory requirements to produce annual Taskforce on Climate-related Financial Disclosures (TCFD) reports. These apply to £5bn+ schemes and master trusts from 1 October this year, to £1bn+ schemes one year later, and may be extended to smaller schemes after that.
The details of the new requirements are still subject to change as we await the outcome of the Department for Work and Pension’s (DWP) recent consultation, but the high-level policy principles have been set. These are grouped under the TCFD’s four headings: governance; strategy including scenario analysis; risk management; and metrics and targets.
These requirements form the bedrock on which all other activity rests. Trustees are required to put in place processes to ensure that climate-related risks and opportunities are being identified, assessed and managed adequately, with appropriate oversight. Everyone involved should have clear roles and responsibilities, with sufficient resources, knowledge and expertise.
Strategy including scenario analysis
Trustees must identify and assess climate-related risks and opportunities to the scheme, and then factor them into strategic decision-making. This represents a departure for many trustees: much of the focus to date has been on investment managers addressing the risks and opportunities at a granular level. How can trustees factor climate change into investment strategy and (for defined benefit schemes) funding strategy discussions?
In my experience, scenario analysis – which trustees are likely to be required to do at least once every three years – is an excellent starting point for these discussions. Top-down scenarios illustrate how the economic landscape may be affected by climate change, enabling trustees to explore the implications for asset allocation and journey planning.
This is the crucial stage: actually managing the climate-related risks that trustees have identified is vital, yet DWP’s proposals are surprisingly light on detail. The regulations require the risks to be managed, and for that risk management to be integrated with the trustees’ processes for managing other risks. The lack of detail probably reflects the scheme-specific nature of the risks and mitigating actions.
Those mitigating actions are likely to focus on the assets, with trustees often relying on their investment managers to manage the risks. The role of the trustees is to provide direction and oversight: firstly deciding on their climate requirements for each mandate (including whether they want a specialist strategy such as low carbon equities); then selecting a manager with suitable climate expertise and processes; and finally ongoing oversight to ensure the manager’s implementation meets expectations and evolves appropriately.
Metrics and targets
Trustees are often most concerned about these requirements, as there are well-known problems with the availability and quality of climate-related data. However, trustees only need to obtain the data for their three chosen metrics annually “as far as they are able” (taking all such steps as are reasonable and proportionate in the particular circumstances). Encouragingly, quality and availability are improving all the time.
At present, data coverage is high for most listed equity and corporate bond portfolios and is available from either investment managers or third-party providers such as MSCI or Sustainalytics. Sourcing data for other asset classes is harder and the data is likely to have to come from the investment managers. Coverage is currently patchy, particularly if trustees want to report more than greenhouse gas emissions (and at least one additional metric is required under DWP’s proposals).
The last requirement is to set at least one target, in relation to at least one metric. I’m seeing a lot of interest in net-zero targets, although there is no suggestion that this is what DWP expects. Indeed, a shorter-term target is likely to be appropriate. One concern is that meeting the target may be largely outside trustees’ control, particularly if assets are invested in pooled funds. I hope this an area where we’ll see considerable innovation from managers over the next few years, as they start to incorporate climate targets into fund designs. In the meantime, trustees can take comfort that DWP has confirmed that targets will not be legally binding.
The final step of the process is to publish a report online setting out how the trustees have fulfilled the various requirements. This must be done annually, within seven months of each scheme year-end.
Trustees should take care when preparing their reports as public scrutiny of the content is likely, especially for schemes with well-known employers. Climate activists will be ready to hold trustees to account.
Trustees of schemes within scope of the new requirements, particularly those in the first wave, are ramping up their work on climate change to ensure they are compliant. Investment managers can expect many more questions from trustees, who will be seeking: comfort that climate-related risks to their assets are being managed well; fund-level reporting of climate metrics; and investment products that incorporate climate targets.
Claire Jones is partner and head of responsible investment at LCP and an ESG Clarity editorial panellist.