The Law Commission's 2014 report on fiduciary duties in the investment chain concluded that trustees are required by law to balance returns against risk, and not simply to maximise returns. Pension scheme trustees may take account of any risk which could have a financial impact on their investments, and must take account of risks that are financially material.
As evidence of the risks posed by climate change mounts up, the practical consequence of the law is that trustees will be in breach of their duties should they fail to consider this as part of their investment strategy. At the very least, this requires them to understand whether climate change presents a financially material risk to the circumstances of their scheme.
None of this should come as a surprise to pension scheme trustees. In its investment guidance for trustees of both defined benefit (DB) and defined contribution (DC) schemes, The Pensions Regulator specifically mentions the need for trustees to consider sustainability - and, potentially, climate change. The government will also soon be enacting legislation requiring trustees to specify in their statement of investment principles how they take account of financially material considerations including those arising from environmental, social and governance (ESG) considerations, amongst other things, as well as their policies on the stewardship of investments.
Our recent report, based on research from Leeds University, found that, to date, pension schemes which have engaged in climate risk management have been driven, at least at the outset, more by general environmental values than by considerations of the financial impact of climate risk - and that this is consistent with there being low levels of understanding amongst trustees of their duties in this area.
Trustees therefore need to recognise the importance of having a proper governance structure around their approach to climate risk. This is not without its challenges, including a lack of regulatory clarity and methodological issues, but these potential barriers cannot be used as an excuse not to engage with this issue by trustees.
Broadly, the climate risk actions that trustees can take focus around four areas:
- investment strategy - for example, putting a climate change policy in place, or incorporating climate change into the fund's investment beliefs;
- strategic asset allocation - for example, diversifying assets across sources of climate risk, investing in low carbon assets or even full portfolio decarbonisation;
- selection and monitoring of fund managers - for example, considering the trustees' choice of investment manager's qualifications to address climate risk and considering climate change in investment mandates and monitoring; and
- stewardship activities - for example, direct engagement with investee companies and policymakers, and developing proxy voting guidelines which reflect the fund's climate risk stance.
The extent to which any of these actions is appropriate will vary according to the circumstances of each scheme.
However, the essential initial step for every group of trustees is to understand the implications of climate risk in the context of their scheme. In practice, this means that trustees should, as a minimum:
- talk to their investment consultants about whether, and if so how, climate change risk is currently built into their recommendations and what the rationale is for their approach;
- ask their investment consultants and/or asset managers to explain what, if any, measures the managers currently take to address climate risk;
- discuss, as a trustee board, their own beliefs on climate risk;
- develop a written policy on climate risk, either on its own or as part of a wider ESG policy, to give clear guidance on how climate risk should be taken into account when investment decisions are made; and
- follow that policy every time that a new investment manager is appointed and monitor compliance by requiring each manager to report regularly on how climate risk is built into that manager's decisions.
Beyond this, trustees can make their own judgment, based on the size and nature of their scheme, on how proactive they need to be in their approach to climate risk, just as they do for any other risk-based governance process.
Trustees must also consider the need to take account of climate change risk when assessing the employer covenant. If climate risk is relevant to a scheme's investments, then it is just as relevant to the sustainability of the employers which support that scheme.
It is worth noting that, whilst climate risk is only one of a number of potential ESG considerations, it is mentioned specifically in the forthcoming legislation. This defines financially material considerations as including, but not limited to, "environmental, social and governance considerations (including but not limited to climate change) which the trustees of the trust scheme consider financially material". The government's justification for this is that "the systemic and cross-cutting nature of climate change means that it should be retained as a named factor for consideration".
A practical consequence of this is that, whilst there may be no difference in law between trustees' duties in connection with climate change and their duties in relation to other ESG considerations, there will inevitably be a greater focus on climate change. This is compounded by the fact that members are more interested in climate change than other ESG factors. As a result, best practice in this area is expected to evolve rapidly, and trustees will need to keep up to date with these changes.
Carolyn Saunders is a pensions expert at Pinsent Masons, the law firm behind Out-Law.com. Carolyn contributed to a recent report on climate risk and investment co-authored by DWS, Grant Thornton, Redington, the British Antarctic Survey, Bloomberg New Energy Finance and Pinsent Masons.