Responsible response to climate change (Sponsored)

Dec 02, 2019
Pension schemes will have to adapt and alter investment strategies in the face of climate change.

Pension scheme trustees and investors are likely to be exposed to many of the risks posed by climate change. These include risks related to the transition to a lower-carbon economy and risks related to the physical impacts of climate change. There are five main areas of risk for pension schemes according to Denis Lyons, Head of Defined Contribution Investment at Aon. These relate to litigation, physical, transition, market mispricing and mortality.

“There is a greater sense of global urgency, along with wider awareness around climate change, that has led to a new wave of litigation,” he says. “To date, almost 1,000 climate change-related court cases have been filed in over 25 countries relating mainly to a failure of fiduciary care. Since 1997, there has been over a 20-fold increase in the number of climate change-related policies and laws in place around the world. Growing public pressure on governments and companies to fulfil their commitments to the Paris Agreement and reduce greenhouse gas emissions mean that litigation risks are likely to grow.”

Physical risk can arise from climate and weather-related events such as heatwaves, droughts, floods, storms and sea levels rising. “These events can potentially result in large financial losses, impairing asset values and the creditworthiness of borrowers,” says Lyons. “The damaging effects of climate change are already evident with more erratic weather patterns, more severe weather events and greater environmental degradation. Increasing physical damage from climate change will naturally act as a drag on economies and impair market returns. “The broad-based drag on investment returns will make it more challenging for pension funds to meet their financial goals,” he notes.

Transition risk

Changes in regulation that require a shift away from fossil fuels and reduced greenhouse gas emissions will lead to a period of adjustment, which will initially raise production costs due to the imposition of stricter environmental standards. This transition risk will be amplified by new green technological innovation, which will accelerate the replacement of older industrial technologies and raise the threat of stranded assets. The longer-term outlook is more positive, however. “We expect the shift to a green economy to have tangible positive environmental and social impacts that spill over into stronger growth in a new green economy,” says Lyons.

Environment-related risks are regularly mispriced by markets. “Capital markets are poor at pricing in externalities, especially when public goods such as the environment are involved,” he explains. “Firms do not have to meet the full cost of their production. Instead, some of the costs of emitting greenhouse gases are borne by society. While carbon pricing has been introduced in some countries to moderate this problem, there has still not been a comprehensive effort to properly measure and fully reflect the costs.”

Carbon bubble

Markets also tend to focus on short-term considerations rather than long-term trends, which leads to climate change risks being too heavily discounted. The key risk identified by Lyons is the creation of what he terms a “carbon bubble”. This is where assets exposed to carbon or environmental risks are overpriced by markets now and will have to be repriced sharply downward as ever-more onerous environmental regulations and legislation are brought to bear.

Mortality risk relates to humans dying as a result of climate change. The net effect on mortality depends on what horizon you look at. In the short-term, there may be a decrease in mortality due to, for example, warmer winters. In the long-term, however, there is increasing evidence to suggest that the negative impacts are likely to outweigh the positive.

The World Health Organisation estimates that between 2030 and 2050, climate change is expected to cause 250,000 additional deaths each year around the world. The European Commission Joint Research Centre provides further evidence that an additional 152,000 people could die each year in Europe by 2100 as a result of climate change. This increasing uncertainty causes difficulties for pension funds in estimating the longevity of their members and, as a result, a further difficulty in estimating funding plans and the returns required.

A responsible investment strategy

Pension schemes can help mitigate and adapt to climate change risks by taking steps to integrate responsible investment considerations into their investment strategies, potentially including climate aware investments. According to Lyons, trustees should define their beliefs in relation to climate change and its risks; review their investment strategy and consider adjusting it to take climate change metrics into account; review and engage with managers to ensure that they are acting in a manner that is aligned with their beliefs and objectives; and update formal policy documents, such as the ‘statement of investment policy’ principles.

Many Irish schemes are adopting a “wait and see” approach until IORP II legislation is transposed into law, he adds. But environment, social and governance (ESG) principles have already been widely adopted in the ‘master trust’ market. “A recent survey of UK Master Trusts showed that 12 out of the 31 trusts reviewed adopted an ESG policy for their default fund, and a further 16 will consider this further and may adopt ESG in their default strategy in the next two years,” Lyons points out.

“Aon’s Global Responsible Investment team has worked with our preferred index provider to design an ESG and low-carbon screen equity index, which will shortly be incorporated into the full range of multi-asset funds and lifestyle strategies used in the Aon Ireland Master Trust,” he continues. “We will filter the investment universe to positively tilt towards companies with a lower carbon footprint and we will exclude coal companies. We will exclude manufacturers of tobacco products. We will exclude companies with involvement in controversial weapons such as anti-personnel landmines or cluster munitions. And we will exclude companies that violate the UN Global Compact. These are companies involved in serious violations of fundamental norms, who have proven unresponsive or have failed to address their behaviours within a reasonable time.”
Denis Lyons is Head of Defined Contribution Investment at Aon.