DWP calls on pensions to embrace not just comply with tough climate change rules

Pension schemes face a significant challenge over the next twenty years. Whether they see that challenge as complying with a series of edicts from Government , or as an opportunity to tackle the risks of a changing climate, may decide  Britain’s contribution to the global threat to our planet.

The long-term nature of pension scheme investment and the weight of money tied up in pension funds, means that our pension system is the key that can unlock a deceleration and eventual reversal of the destructive change brought about by global warming.

There are two schools of thought as to what is meant by “opportunity”. To some, ESG is a speculative strategy that involves ditching stocks with a high carbon footprint and purchasing equity in companies that do the planet little harm.

The consultation makes it clear that this kind of opportunism is not what the Government is after. It quotes Baronness Stedman-Scott speaking  in the House of Lords last February

“ This does not mean that it is for the Government to direct schemes or set their investment strategies. The Government never have directed pension scheme investment, and do not intend to. Our clear view is that the amendments do not permit us to do that”

It also quotes Therese Coffey in October, speaking in the Commons

The Bill will bring transparency for the first time about what is happening with individual investments. This Government are not in favour of trying to force divestment of different elements of fossil fuels and similar.”

Guy Opperman , introducing the new consultation on the regulations, makes it clear that the Government’s proposed approach is not about pushing climate risk about and around  the financial system but using the system to reduce and eliminate climate risk.

Addressing trustees that are sceptical of the government’s direction or pace of change, he said:

“To these trustees I say that the world is changing, the challenges are changing. You need to change.”

The issue of reducing the fundamental risk (rather than transferring it) is written like a watermark through the various documents published by the DWP yesterday which build on earlier consultations and introduce the regulations which will turn the high level aspirations of the Pension Scheme Act into business as usual.

Opperman insists that meeting this challenge is now part of the fiduciary duty

Failing to ensure climate risk, the most systemic risk facing financial services, is properly considered is – in my view – a failure in trustees’ duty to protect members.

So what does this mean in practice for our pension schemes and those who manage them?

Here is the DWP’s  published  consultation on climate risk regulations and guidance as well as non-statutory guidance on how to apply the Task Force on Climate-related Financial Disclosures, following on from its August consultation. The new consultation closes on 8 March, suggesting that climate change is a risk that will not work to the usual timescales of the pensions industry,

Various pension schemes and industry participants had pleaded for an exemption from the climate regulations on the grounds that they are closed or invested primarily in gilts or hedging instruments, or asked for the size threshold to be increased to £10bn.

But the DWP does not mince its words in the response, saying while it notes the view

“that an asset-based threshold is a relatively broad-brush approach to defining the scope of our proposals”

it believes that

“the alternative approaches floated by respondents would likely be as blunt or blunter whilst typically more complex to apply”.

It questions the logic of assuming that government bonds and hedging instruments are not exposed to climate risk and notes that models are emerging to take account of this, concluding

“It is right that large schemes which provide for the retirement of many thousands of savers should be subject to our requirements, irrespective of whether they are open, closed, fully or under-funded and regardless of how they are invested,”

Where there are concessions

The department has given way on a few other points. Among others, trustees will have to select at least two emissions-based metrics, one of which must be an absolute measure of emissions and one which must be an intensity-based measure of emissions, as well as one additional climate-related metric.

However,

“trustees will be required, as far as they are able, to obtain the data required to calculate their chosen metrics on an annual basis – rather than quarterly”, the DWP says.

The change was made because many respondents to the previous consultation had pointed out that underlying companies only report their greenhouse gas emissions annually, and so quarterly reports by investors would add little value. Similarly, trustees will now only need to measure performance targets once a year.

The DWP has also extended its “as far as they are able” provision to the calculation and use of the trustees’ chosen metric, rather than just the collection of data.

Scenario analysis is, compared with the August proposals, now slightly less onerous as well. Trustees will now only need to conduct scenario analysis of at least two scenarios in the first year and then every three years thereafter, instead of annually.

They will in the intervening years have to do an annual review of their scenario analysis and

“carry out fresh analysis where they consider it appropriate to do so”,

which the DWP says is likely to be the case if there is:

• a material increase in data availability
• a significant/material change to the investment and/or funding strategy
• the availability of new or improved scenarios or events that might reasonably be thought to impact key assumptions underlying scenarios; or
• a change in industry practice/trends on scenario analysis

Trustee Knowledge and Understanding

Trustees should also prepare for training on climate risk. The DWP has added to the proposals on governance and will require trustees to have

“an appropriate degree of knowledge and understanding of the principles relating to identification, assessment and management of climate change risks and opportunities to properly exercise their functions”.

Elsewhere, the government is now no longer considering consulting on Paris alignment and ‘implied temperature rise’ at this point, the consultation notes, acknowledging that there are methodological challenges in doing so.

“As there is still uncertainty and inconsistency between the methodologies used to measure ITR, it is our view that now is not the time to consult on making it mandatory for trustees to measure and report their ITR… However, we still recognise the potential benefits of trustees working out the ITR of their portfolios. We have therefore included the option of a portfolio alignment metric within the draft statutory guidance accompanying our proposals on metrics and targets,”

The DWP is putting its foot down on the accelerator

The timetable for implementing these new rules looks to be accelerated. The DWP has  brought forward the planned review for schemes not yet in scope revisiting whether climate governance and reporting obligations should be introduced for those schemes in the second half of 2023.

Some DB schemes which have swapped managing their own liabilities by “buying in” the insurance  bulk annuities, will be exempted from reporting on the buy-in.

And trustees will be please by the decision to require that trustees conduct scenario analysis once every three years rather than annually, although schemes must still do their first scenario analysis in the first year that the regulations apply to them.

Inevitably there are going to be tensions with data availability here, so it is helpful that the regulations acknowledge that trustees may need to take a proportionate approach, although I predict much debate around what may or may not be required in practice.

But the radical change is in the introduction of new “metrics” and “targets”

The most radical sections of the new regulations are the metrics and targets section of the Statutory Guidance

One of the more difficult aspects of the new rules will be the performance targets,  even if these must now ‘only’ be reported annually.. Trustees will need to think hard about how the targets they set align with their fiduciary duties and what is in the best financial interest of their scheme members.

Trustees will have to gather information on the total green house gas emissions produced by companies within their portfolio and report on their intensity, explaining why the numbers are as they are.

They will have to choose one of three targets set by the DWP

1. There is an obscure target that Trustees can adopt known as “climate value at risk” which I profess not to fully understand.
2. Trustees can also choose to report on the Implied Temperature Rise of their portfolios
3. Or they can simply report on the quality of the data they are receiving from external sources (the fund managers or directly from companies they invest in)

Will it work?

The DWP reckon these new rules go further than any country has gone so far, to manage climate risk within pensions. So we appear to be in unchartered waters. But there is a comparison that can be made – one that strangely – can be made with France.

Torsten Bell of the Resolution Foundation has pointed out that the Banque de France has recently published a paper looking at how laws adopted following the Paris agreement affected the choices of French investment firms. Uniquely in Europe, France required insurers, pension funds etc. to report annually on their exposure to climate risks.

Comparing firms within France to French firms based abroad (not subject to the legislation), the research finds that affected firms chose to reduce their investment in fossil fuel companies by 40 per cent.

While better reporting and stewardship (rather than divestment) may be the desired outcome of this consultation, this suggests that the approach being adopted by the DWP, may well be the right one.