The hot debate on climate risk and pension investments: Does practice stack up against the law? (Investor Report)
ClientEarth and ShareAction established a project in 2015 which set out to clarify the legal obligations of UK pension fund trustees and their asset managers to assess and manage climate and carbon-related financial risks (“climate risk”).
Through this process, we engaged with the legal and investment communities to promote discussion and gain feedback on how climate risk features in the investment decision-making process of pension funds. This report sets out the responses from these interactions, and our legal analysis where considered relevant.
Climate change poses potentially significant financial risks to pension funds and their members.
According to the Economist Intelligence Unit, a scenario of 6°C warming could lead to a present
value loss of US$13.8 trillion of manageable financial assets, roughly 10% of the global total
(i.e. total stock of assets held by non-bank financial institutions).
At the same time, if the investment system does not take steps to move towards a low-carbon economy, then it could be left with as much as US$100 trillion in “stranded” fossil fuel assets by
2050, according to Citigroup. A recent report by the University of Cambridge Institute for Sustainability Leadership, “Unhedgeable risk: How climate change sentiment impacts investment”, argues that the systemic nature of climate risk means that a portion of the risk is unhedgeable for individual funds and that avoiding such risk will require system-wide approaches, such as strong regulation.
Trustees’ legal duties require them to address material financial risks to the fund. They need to show that they have taken appropriate advice, equipped themselves with appropriate knowledge
and considered relevant issues during the investment decision-making process.
Pension fund trustees can delegate investment powers to asset managers, but trustees retain supervisory and overall strategic decision-making powers. That is to say, trustees will retain ultimate responsibility for the acts or defaults of their asset managers if they have not taken all reasonable steps to satisfy themselves that their asset managers: have the appropriate knowledge and experience to manage scheme investments; are carrying out their work
competently; and are exercising their powers of investment in accordance with the law.
The prudence test should also be understood as requiring that trustees and their asset managers
are aware of good practice within the pensions and investment sectors. This may mean learning
from those who are showing leadership in these sectors, for example, by incorporating publicly
available information on climate risk assessment into their financial risk assessment practices, or are at the very least considering whether they should take similar action. Indeed, the actions of industry leaders, particularly post-Paris, should have sent a strong signal to trustees that the financial risks associated with climate change should be factored into risk assessment practices.
Growing numbers of mainstream investors are recognising that climate risk is likely to be financially material to investment portfolios. The direction of travel for climate change policy and the projected implications of climate change itself clearly indicate that climate risk needs to be managed now in order to prevent serious future financial consequences and/or detriment to portfolio value. Trustees, on the other hand, often interpret their legal and fiduciary duties narrowly, prioritising short-term financial return over the serious financial risks that climate change poses to assets, investments, pension pots, and the wider economy.
