26 November 2018
The second part of Environmental Finance's pensions roundtable on climate risk and opportunity, hosted by law firm Sackers, heard how UK funds are tackling the thorny issues of divestment, availability of data and fiduciary duty.
Diandra Soobiah, head of responsible investment, National Employment Savings Trust
Patrick O'Hara, responsible investment analyst, Universities Superannuation Scheme
Owen Thorne, investment manager, Merseyside Pension Fund
Amanda Latham, policy lead, The Pensions Regulator
Lydia Fearn, head of DC pensions and wellbeing, Redington
Claire Jones, principal, Lane Clark & Peacock
Karen Shackleton, founder, Pensions for Purpose and senior adviser, MJ Hudson Allenbridge
Stuart O'Brien, partner, Sackers
Ralph McClelland, partner, Sackers
Chaired by: Michael Hurley, staff writer, Environmental Finance
Peter Cripps, editor, Environmental Finance
Michael Hurley: Patrick, how do you address the issue of availability of data?
Patrick O'Hara: It is an issue. There is limited data around Scope 3 emissions, for example.
As investors we need to identify which companies will face the impact of a transition first, and which companies may be well positioned. We need to understand where and how the physical risks associated with climate change could impact a company's supply chain. Many companies are not very good at disclosing the details around their supply chains, or where their physical assets are located, so it's difficult to do this analysis across a broad portfolio of stocks without that data. We are therefore looking at alternative sources; there are a lot of products out there, using artificial intelligence, satellite imagery, trying to fill gaps in company disclosures.
It is difficult to do back-testing around climate change as there is very little precedent for climate risk or the transition to a lower-carbon economy. Historical data relating to carbon emissions does not go back as far as we would like. However we know that the oil & gas industry and other carbon-intensive sectors face significant challenges associated with climate change.
Our Low-Volatility portfolio is a factor-based model and it will naturally select companies from the utilities sector. In such a model there isn't a fund manager analysing the stocks and the sector exposure, as is the case with our actively managed portfolios. Therefore we were comfortable applying an overlay to the model to introduce a longer-term perspective to the stock selection based on the fact that our back-testing showed that this intervention would not impact performance.
It must be a challenge for investment consultants to provide advice around climate change risks in the absence of verified, quantifiable data.
Lydia Fearn: You are absolutely right. I think [the problem] is getting comfortable as an advisor, as well as the trustee, as well as the investor manager, that the data is correct. A lot of it is not.
Diandra Soobiah: We had this discussion with our trustees. We actually showed trustees physical climate risks and showed them a range of indicators to show, 'Look, this is how sea temperatures are rising.' We were able to get hold of 20–30 years of data on the physical side.
I think the investment industry is very, very focused on the nuts and bolts of policy and transition risk. However, I think at some point the physical risk is also going to start having an impact on this issue.
Stuart O'Brien: Happily I think most trustees have now moved on from the historic confusion between making "ethical" investment decisions and the integration of environmental, social and governance (ESG) as a financial factor. However, they can still sometimes tie themselves in knots over what their fiduciary duties are. More often than not, trustees believe they are bound by a duty to 'maximise returns', albeit risk adjusted and considered over an appropriate timeframe. I think this can cause trustees to think about ESG in the wrong way. Trustees often feel that because of this perception of their duty they can't do anything without empirical data demonstrating ESG outperformance. Although that's starting to come through, it's probably still a bit early to provide trustees with the proof positive.
What we are trying to do is encourage our trustee clients to look at their fiduciary duties in a slightly different way. All trustees are given a power under their pension scheme's trust deed and rules to invest assets. What the law says is simply that this power must be exercised properly for the purpose of providing pensions. And further, that the power must be exercised in the manner that a prudent person would exercise it.
To my mind, the change that we're seeing is in how this second part of the duty bites. What would a prudent investor do?
Years ago, many trustees might have said, 'Well, I am not sure a prudent person would necessarily be worrying about physical risks, or transition risks of climate change.' But I think we have got to the point where that position is now untenable and prudential requirements essentially require trustees to consider these issues.
Ralph McClelland: It does feel a little bit like we are at the tipping point. However, there is also work to be done, particularly for the smaller schemes. The more work that is done by the first movers, the easier it is going to be for other schemes.
Karen Shackleton: The local authority regulations have required them to report on their ESG policy and their social investment policy for quite a while now. Perhaps this is why they are a little bit further down that path as well.
Ralph McClelland: They have had the real advantage of the Environment Agency, which has always been a class leader in this area.
Owen Thorne: When I looked around at my peers who were working on this, I could look to the Environment Agency, I could look to USS and some of the other big UK schemes which were taking action around climate and ESG – they were taking action that I could replicate. I would see Merseyside being part of a second wave, if you like.
Michael Hurley: Merseyside is part of the Northern Pool of Local Government Pension Schemes. The Brunel pool, which includes the Environment Agency, adopted the Environment Agency's sustainable and responsible investment strategy. I wonder if there is any kind of similar benefit you see from the pooling process?
Owen Thorne: The Northern Pool has been a real help for us carrying out collaborative engagement with companies, together with engagement undertaken through the Local Authority Pension Fund Forum. We have been co-filers of climate resilience shareholder resolutions at company AGMs and we are part of the Climate Action 100+ engagement initiative.
On the private market side, within the Pool, we have been leading in that area as partners of the GLIL [a collective vehicle for infrastructure investments which has commitments of about £1.3 billion ($1.6 billion)].
Karen Shackleton: For the Northern Pool, or even for Brunel, there are a lot of benefits. The challenge comes for a pool like the London Pool which has over 30 members, first of all, to get some commonality in terms of ESG policy, engagement, and voting. Then, also, if you look across the London borough funds, they are all at different stages and they all have different views over whether you should decarbonise, whether you should divest. Once you take all those views into account, how on earth do you offer a pooled solution that is going to meet all those needs?
Michael Hurley: How are they reacting to that challenge?
Karen Shackleton: They are trying to offer sustainable options alongside their standard fund range.
However, the funds who have already done low carbon index funds are now looking for more. It is therefore going to be a real challenge, simply because they have so many different needs to represent.
The London Borough of Islington Pension Fund recently announced its decarbonisation approach. They had already gone for low carbon passive and they had assessed the carbon footprint of their whole portfolio. They are now looking, over the next four years, to decarbonise the portfolio further. However, that will have to be done alongside the pooling agenda. They are among the leaders in this area and it is going to be difficult to meet their needs alongside some of the other London boroughs who do not place this as such a priority.
Michael Hurley: How do consultants approach the issue of divestment with their clients?
Claire Jones: Relatively few of our clients have been talking about divestment, perhaps because they have not come under the same pressure that local authority funds have done. There is more acceptance of engagement as perhaps a more constructive way to influence companies.
Michael Hurley: How do the pension fund representatives here consider divestment?
Patrick O'Hara: Not as a high-level policy. But at fund manager level, in our actively managed equities [and] in fixed income portfolios, our fund managers are responsible for analysing the risks associated with climate change. Through this bottom-up analysis, our portfolios are tilted away from the more carbon intensive companies in the benchmark index, while the required sector-level exposure has been maintained. These results are shown in our carbon footprint in our portfolio.
In terms of infrastructure, we do not have a pot of money dedicated to social impact investing, but we do have infrastructure assets in the portfolio that are positioned well. We have wind, we have forestry and we have renewable energy in there. They are investments that have been analysed in the same way as all the other investments in the portfolio on [a] risk return basis. As assets, they stand up on their own merit.
Owen Thorne: We try to avoid, wherever we can, making top down, exclusion type decisions or setting unhelpful, arbitrary targets.
One of the areas that we are looking at within our low carbon indexation in passive is being able to manage those tilts away from more carbon intensive, reserve intensive stocks and towards stocks that are more pro low carbon economy.
At present, we are moving approximately £400 million from our existing passive portfolio. Nearly a third, overall, of our passive equities have been going into our low carbon vehicle, a 'Smart Sustainability' multi-factor climate index.
Diandra Soobiah, NEST: We did not want an exclusion based strategy because... we felt it was important to take leadership of the market. Excluding companies that could potentially be the investment solution to this problem was not what we wanted to do. It was really important that we sent a signal to them
We think the index solution we have reached with [FTSE Russell] is something that will be replicable, particularly in the LGPS, and hopefully at a reasonable entry cost.
Diandra Soobiah: We deliberately did not want an exclusion based strategy because... we felt it was important to take leadership of the market. Excluding companies that could potentially be the investment solution to this problem was not what we wanted to do. It was really important that we sent a signal, a message, to those companies by underweighting them.
Ralph McClelland: Would you exclude if they were persistently not engaging?
Diandra Soobiah: At the moment we do not have the capability to do that. That is not the policy of the fund as of yet.
If nothing happens over a very long time period, we will have that discussion about exclusion. However, the fund does exclude pure coal, not deliberately but just because the methodology dictates that pure coal would be excluded because of their reserves and high carbon emissions. We are comfortable with that because those pure coal companies are not going to move, they have nowhere to go. However, those companies with a diversified energy mix can be encouraged to transition to a low-carbon economy and that is what they are starting to do, with encouragement from investors.
Michael Hurley: Can I move to the policy side of things and get the lawyers' perspective on the Department for Work and Pensions' (DWP) regulatory changes – what kind of impact do you see that having?
Stuart O'Brien: Although the DWP paper is called clarifying and strengthening trustees' investment duties, the one thing the regulations do not do is actually change the law on trustees' duties! The trustee legal duty has been the same throughout: namely, to invest trust assets for proper purposes and to do so prudently.
Stuart O'Brien, Sackers: What the DWP changes require is that trustees will have to disclose their ESG policies in their statement of investment principles. DC funds must go further and report against that policy on an annual basis from October 2020. That is a game changer.
What the new regulations do require, however, is that trustees will have to disclose their ESG policies in their statements of investment principles from October 2019. Defined Contribution (DC) funds must go further and report against that policy on an annual basis from October 2020. I think that is a bit of a game changer. The investment duty is not changed but the imperative for trustees to focus on that duty and think about it is heightened.
I think we are also going to see other changes in the regulatory direction of travel. These regulations on what trustees have to put in their Statements of Investment Principles (SIPs) are not the be-all and end-all. We also have IORP II [an EU pensions directive to improve governance and accountability in relation to workplace pensions] coming into force in January next year, which adds numerous references to ESG as part of trustees' risk management frameworks. In the UK we're expecting regulations that will require the Pensions Regulator to provide Trustee Codes of Practice on how issues like climate change should be embedded in Trustees' governance and risk management processes in line with these IORP II requirements.
There will be more to follow as well from the EU Commission's Action Plan on Sustainable Finance. Much of the coverage on that has been about the taxonomy, but for pension funds I am expecting a ramping up of disclosure requirements. I think that is going to be particularly pertinent to DC funds in the UK. I can see a world in a few years' time when all DC pension providers will have to have clear disclosures to their members at the point of joining on how the scheme's default fund manages climate risk. We have seen in Australia there is a case being brought by a member against his superannuation fund. That claim is grounded essentially in a failure by the provider to disclose sufficient information on climate issues to allow the member to make an informed investment choice.
Amanda Latham: We have had that in guidance since 2016. It is not a new thing, talking about climate change risks and opportunities. TPR will update our investment guidance to reflect these clarifications. Of course, climate change is already there on the face of it. For some of the other bits of regulation including publishing Statements of Investment Principles (SIPs) for DC schemes and implementation plans, publishing things is not new for DC schemes but the implementation plan is. So that is the sort of thing that we will be picking up in the new guidance.
Ralph McClelland: The problem has never been that the fiduciary duty was not settled. It has been quite misunderstood and I am sad to say that it is still quite misunderstood. I think the most significant change in recent years is not that legal change in regulations, I think it is the political impetus that comes from this that has been expressed in the Paris Agreement, and in all sorts of other ways across the field.
Stuart O'Brien: I think reputational risk is something that will change things as well. Companies have to worry about climate change risk for their own businesses, so it becomes untenable for them if the trustees of their own pension funds are not thinking about the same risks. For trustees having a hard time getting started on the topic, I've found it can really unlock things to say, 'You know your own sponsor has a very detailed sustainability risk policy on their publicly available website, so do you not think it is slightly odd that you, as the trustees of their pension fund, are not thinking about the same issues?'
Peter Cripps: Stuart mentioned that there is a clearer acceptance that climate should be part of a prudent definition of fiduciary duty. But trustees must be really nervous about picking winners. If a fund has basically underweighted or got out of oil and gas, there is a risk that later down the line the oil and gas industry does really well, and then the beneficiary comes back and says, 'My pension pot is very low because you divested me out of oil and gas, I am suing.' What is the risk of that?
Stuart O'Brien:The risk of being sued as a trustee of a Defined Benefit (DB) scheme is rather different to a trustee of a DC scheme, because for a DC member, the size of their pension is directly correlated with their investment returns or forgone investment returns. For DB it is not like that, the DB member receives his or her pension exactly at the level promised as long as their employer remains solvent. If investments don't perform in a DB scheme it's the sponsor that has to put its hand in its pocket to meet any funding shortfall, so logically it's going to be that entity that should be upset with trustees that have approached their investment strategy in a way that the sponsor was not comfortable with.
In a DC scheme members bear investment losses directly. But you have to draw a further distinction between default funds and member chosen, or self-select, funds. The vast majority of DC members will be invested in the scheme's default fund and more than likely will never have looked at a single piece of pension correspondence they have been sent. They have just assumed that the trustees are looking out for them and making prudent investment decisions on their behalf. There is a very real prospect that these members could bring claims against trustees who have not taken proper factors into account in deciding how to invest that default fund.
That is the key though: you can only test what was a prudent investment decision at the time it was taken.
If, on the advice received, trustees have a genuine, reasonably held belief that there is a material financial risk of overexposure to carbon and they take the decision to tilt the portfolio away from that, I think it is quite hard ten years down the line for a member to say, 'That was an irrational decision which should never have been taken.' The law requires trustees to be prudent not prescient.
What will further protect trustees is that they should be transparent about what they are doing. The protections for the trustees are to go through a rational decision-making process, be transparent, and not necessarily worry that every decision will not yield the maximum level of return.
Personally, I think the risk of being sued for having made a positive decision to tilt away from carbon is a much lower risk than having not thought about any issues at all, and just stuck with a market capitalisation-weighted index. In other words, the claim trustees should worry about is not, 'You thought about this and you made a decision that turned out to be wrong', but, 'You never thought about this at all', and that is a much bigger risk.
Part one of this roundtable, can be read here