Part 3 of 4

Pensions in a Changing Climate

Part 3: Strategy & Risk Management

This is the third of a four-part report assessing the world’s 100 largest public pension funds responses to climate change and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). The parts cover specific areas from the survey and follow the structure of the TCFD core recommendations. The full report has been split into 4 parts:

  1. Global Ranking, Key Findings & Regional Performance (here)
  2. Governance & Communication (here)
  3. Strategy & Risk Management (below)
  4. Metrics & Targets (to be released autumn 2018)

Using AODP survey data, this part explores the performance of the world’s largest pension funds on their approach to strategy and risk management. To ensure you receive the following parts, please get in touch with Peter Uhlenbruch, AODP Investor Engagement Officer, on peter.uhlenbruch@shareaction.org to be added to the AODP mailing list.

Key Findings

This section presents three key findings relating to how the world’s 100 largest pension funds have responded to climate change in their strategy and risk management practices. These findings cover the following areas: identification of risks and opportunities, scenario analysis, Paris-aligned investment strategies, coal policies, relationships with asset managers, and company engagement.

Finding 1: Climate-related risks are largely unidentified and unassessed by global pension funds

1.1. 87% of the assets managed by the world’s 100 largest pension funds have not been assessed for systematic risks associated with the low-carbon transition

Our data reveals that 87% of the assets invested by the world’s largest 100 pension funds, equivalent to 9.8 trillion USD, are yet to have undergone assessment for systematic risks associated with the low-carbon transition. As such, the overwhelming majority of assets managed by global pension funds may be exposed to a range of physical and transition climate-related risks, posing material financial risks to members and beneficiaries.

Figure 1: Climate-risk assessment: Proportion of pension funds by collective AUM*

Figure 1: Climate-risk assessment: Proportion of pension funds by collective AUM

*Representing combined assets of world’s 100 largest pension funds (~$11 trillion USD).

Figure 2 shows that in cases where investment portfolios have been assessed for climate-related risks, transition risks (including stranded assets, regulatory developments, expected carbon liabilities, technology, market, and reputation) are more likely to be considered than physical risks.

Figure 2: Climate-risk assessment: most common approaches

Figure 2: Climate-risk assessment: most common approaches

1.2. Almost one fifth of funds are already carrying out climate scenario analysis

In June 2017, the TCFD recommendations encouraged organisations to undertake forward-looking climate scenario analysis to better understand the range of climate-related risks and under a range of plausible global warming outcomes. Given the uncertainty around how climate-related risks and opportunities are expected to materialise, scenario analysis is recommended as an invaluable tool available to help organisations better understand their risk exposure.

Our data shows that 18% of the world’s largest 100 pension funds have performed climate scenario analysis. This proportion is effectively double compared against the insurance sector (10%). A further 10% of pension funds are considering performing scenario analysis, indicating that the industry is making some progress in this area, however the majority of global pension funds appear to be taking no action.

Figure 3: Scenario analysis: Performance by pension funds

Figure 3: Scenario analysis: Performance by pension funds

Figure 3 above illustrates that the majority of funds who undertake climate scenario analysis are doing so against multiple scenarios, including a less than 2 degree scenario, as is recommended by the TCFD. Some funds have undertaken scenario analysis under just one scenario.

Part II of this report series discussed qualitative feedback from survey participants regarding challenges around implementing the TCFD recommendations. Scenario analysis was identified as the most common challenge, particularly in terms of a lack of guidance and clarity regarding how investors are expected to undertake climate scenario analysis and incorporate the findings into real actions such as asset allocation and investment decision-making. In our Winning Climate Strategies report, we reviewed a variety of approaches by leading asset owners on climate scenario analysis.

We acknowledge that ‘fit for purpose’ climate-risk assessment should represent a holistic approach capturing both forward-looking and historical approaches. With respect to the use of backward-looking data for risk assessment, we will discuss carbon footprinting in part IV of this series.

1.3. Stranded assets are the most commonly identified climate-related risk, while renewable energy is the most commonly identified opportunity

The heat-map below visualises which climate-related risks and opportunities are most commonly identified by pension funds (darker shades represent more frequently identified risks/opportunities). The most common risk identified is around regulation, policy and stranded assets, while the most common opportunity identified is around renewable energy.

Figure 4: Climate-related risks and opportunities: Most commonly identified*

Figure 4: Climate-related risks and opportunities: Most commonly identified

* Darker shades represent risks/opportunities most commonly identified.

** Acute physical risks refer to the impact of specific events, for example flooding. Chronic risks refer to risks that develop over a longer term, for example changes in temperature and precipitation leading to drought, land degradation etc.

A qualitative assessment of pension funds’ responses to this topic reveals that asset owners are commonly viewing risks and opportunities in terms of their potential impact on asset allocation. Some funds, for example, have identified the high exposure of assets held in fossil fuel dependent sectors to a range of transition risks, including expected policy developments and stranded assets. Other funds have identified the physical risks (both acute and chronic) facing their investments across asset classes, also factoring in exposure across supply chains. On the opportunities side, some funds have identified a range of opportunities across asset classes expected to emerge from the low-carbon transition.

As a proportion of total pension funds, only 30% identified climate-related opportunities, while 36% of assessed funds identified climate-related risks.

Finding 2: The vast majority of pension funds are failing to align with the Paris Agreement

2.1. Only 10% of pension funds have a policy to align their investment portfolio with the goals of the Paris Agreement

Figure 5: Aligning with Paris: Taxonomy of climate policy approaches across world’s 100 largest pension funds

Figure 5: Aligning with Paris: Taxonomy of climate policy approaches across world’s 100 largest pension funds

Just 10% of funds have formally adopted a pledge to align their investment portfolio with the goals of the Paris Agreement (to limit global temperature rise to well below 2 degrees of warming relative to pre-industrial levels). A further 25% of funds have adopted a formal climate-specific investment policy, while 18% of funds have a broad ESG or RI policy that contain no specific reference to climate change.” The remaining 47% of the world’s 100 largest pension funds have no policy in place at all. As such, the majority of funds have no formal policy to manage the range of financially relevant climate-related risks and opportunities.

2.2. Climate-related policy commitments cover a range of topics, with coal exclusion lagging behind more popular approaches

Figure 6: Climate policy commitments: Most popular policies

Figure 6: Climate policy commitments: Most popular policies

Of the 35% of pension funds who have adopted a formal climate-related policy, coal exclusion is among the least common policy commitments. Company engagement is the most popular policy commitment, followed by low-carbon investing, engaging with service providers (including fund managers), policy engagement and coal exclusion. Low-carbon investing will be explored in further detail in part IV of this report series.

2.3. Despite pension funds commonly identifying stranded assets as a major risk, 85% of funds are not taking any action on thermal coal

Only 15% of pension funds have developed a formal policy commitment to exclude or phase out the most polluting fossil fuel companies from their investments. The majority of these policies focus exclusively on thermal coal, while some pension funds have broadened their policies to also limit exposure to the oil and gas sector (targeting companies who provide no information on how they intend to respond to the low-carbon transition).

Figure 7: Coal exclusion policies

Figure 7: Coal exclusion policies

The UN’s recent IPCC report has stressed the urgent need for stronger policy actions to avoid catastrophic climate change, concluding that coal must be phased out of the global energy mix by 2050 to stay on a 1.5°C pathway (relative to pre-industrial levels). Our data shows that 85% of pension funds have no formal policy on investments in thermal coal, and potentially exposed therefore to stranded asset risks. Though pension funds tended to identify stranded asset risks as the most common climate-related risk (see finding 1.3), this awareness is yet to be translated into formal policy commitments.

Our analysis of funds’ responses reveals that pension funds are taking a variety of approaches in their coal exclusionary policies. For instance, exclusionary thresholds applied as a proportion of revenue vary between 20% and 50%. This shows that work still needs to be undertaken on formalising approaches and developing a harmonised taxonomy relating to the exclusion of thermal coal assets.

The Global Coal Exit List provides a database of companies who derive more than 30% of revenue from coal, or who produce more than 20 million tonnes of coal annually, or operate more than 10,000 MW of coal-fired capacity. AODP recommends that pension funds adopt this list as a minimum reference point for developing exclusionary thresholds for investments dependent on thermal coal.

2.4. Majority of pension funds yet to factor climate-related issues into asset manager relationships

Our data indicates that the vast majority of pension funds provide no information on how they require their asset managers (whether internal or external) to incorporate climate-related issues into their investment decision-making. This is true both for how pension funds are selecting asset managers, and also how they monitor and evaluate performance with regard to climate change (see fig 8). Considering the extent to which pension funds often outsource investment decision making to external asset managers, these gaps are concerning.

Figure 8: Climate-related monitoring and selection of asset managers

Figure 8: Climate-related monitoring and selection of asset managers

Our Winning Climate Strategies report reveals how leading asset owners are taking charge and applying creativity in their relationships with their external asset managers around climate-related issues. Some examples include undertaking comprehensive climate-related due diligence, systematically integrating climate-related issues into monitoring of performance, and in some cases allocating pre-determined carbon budgets asset managers are required to invest within.

Finding 3: Around half of global pension funds undertake company engagement on climate change

3.1. Climate-related company engagement largely limited to improving disclosure

The most popular company engagement theme identified in our research related to improving climate-related disclosure. As figure 9 illustrates, half of disclosure-related engagements relate to improving TCFD-aligned disclosure. This reflects our finding from Part II, that pension funds who have supported the TCFD recommendations are also incorporating the framework into company engagement practices. It is encouraging to see the TCFD being used as an engagement framework, and we expect to see broader use by pension funds in the coming years. However, our data shows there is room for pension funds to broaden the scope and quality of their company engagements by also challenging companies on how they are actively managing climate-related risks and opportunities across their business (see figure 10).

Figure 9: Company engagement: General climate-related disclosure vs TCFD-aligned disclosure

Figure 9: Company engagement: General climate-related disclosure vs TCFD-aligned disclosure

Our research shows that leaders are engaging with companies on disclosure as well as topics such as decarbonisation pathways, scenario analysis, climate-linked remuneration, and withdrawing from controversial trade associations. This finding is also supported by our Winning Climate Strategies leading practice research. While improving disclosure is important, leading practice company engagement also focuses on driving actionable outcomes, such as building Paris-aligned business models and strategies.

Figure 10: Company engagement: most popular themes

Figure 10: Company engagement: most popular themes

3.2. Company engagement: The escalation gap

Only 35% of those pension funds that do undertake climate-related company engagement have established an escalation strategy in case of engagement failure. Escalation processes ensure that engagement is meaningful and impactful by leveraging shareholder influence to take further action against companies if they do not show sufficient progress. Examples of common escalation approaches are outlined in figure 11, which include voting on climate-related shareholder resolutions followed by filing/co-filing resolutions, divesting, or setting time-bound engagement objectives.

Figure 11: Company engagement: Escalation approaches in case of engagement failure*

Figure 11: Company engagement: Escalation approaches in case of engagement failure

*refers to % of funds who engage with companies on climate change.

3.3 Pension funds more likely to undertake climate-related company engagement than insurers

Our data shows that roughly half of global pension funds are undertaking company engagement on climate-related topics, which is a much higher proportion than found in the insurance sector (30%).

Figure 12: Company engagement: Pension funds vs Insurers

Figure 12: Company engagement: Pension funds vs Insurers

Industry perspective on being ‘universal owners’

The UN’s recent IPCC report outlined the magnitude of climate-related impacts between 1.5 and 2 degree global warming scenarios. Meeting the minimum requirements of the Paris Agreement by limiting warming to 2 degrees will be met by significant economic disruption from both physical and low-carbon transition impacts of climate change. As the report outlines, “climate-related risks to health, livelihoods, food security, water supply, human security, and economic growth are projected to increase with global warming of 1.5°C and increase further with 2°C”. As such, institutional investors need to be aware not only of how their portfolios are exposed to these risks, but how their asset allocations are currently aligned with the goals of the Paris Agreement.

A number of pension funds have indicated in their survey responses to AODP that they are approaching the issue of climate change from a ‘universal owner’ perspective. These funds have recognised that their investment portfolio is spread across asset classes, sectors, and regions, and therefore represent a ‘slice’ of the global economy. These funds also realise that their portfolios are exposed to the same climate-related risk and opportunities facing the global economy. This perspective has caused some funds to work towards better understanding the full range of climate-related systemic risks (both at physical and transitional levels) and opportunities they are exposed to. These funds are also building ‘systems-level’ responses such as portfolio-wide decarbonisation or low-carbon investment targets that seek alignment with the goals of the Paris Agreement to curb global warming to 2 degrees or under.

Conclusions & Recommendations

The UN’s recent IPCC report highlighted that the actions taken in the next 12 years will determine whether the worst consequences of catastrophic climate change can be averted; rising sea levels, lack of food security, increasing frequency and intensity of weather events. These consequences would cause a surge in climate-related economic losses, which have already increased by around 2.5 times in the last 20 years, totalling $2.9 trillion USD. In order to mitigate these effects, the international community will need to put into place significant measures to accelerate the low-carbon transition. Whichever pathway the transition takes, there will be material impacts on pension funds’ investment portfolios.

Our research shows the vast majority of the world’s largest 100 pension funds have inadequate strategies and risk management processes with respect to climate change and its implications. This is the third instalment of a four-part series outlining the results of the survey. We have highlighted a number of recommendations relevant for this section.

FOR REGULATORS

Clarify trustees’ duties in respect of managing climate change as a material financial risk

Throughout this report series and our Winning Climate Strategies report, we have found that robust regulation plays a key role in driving better disclosure and management of climate-related risks and opportunities. Though recent years have seen some promising progress in this area, we believe regulators must do much more to prompt a stronger response by clarifying trustees’ duties in respect to reporting and managing climate-related risks.

FOR MEMBERS/ BENEFICIARIES

Challenge your pension fund to make a pledge to align its investment portfolio with the goals of the Paris Agreement

Our research has shown pension funds members only have a 1/10 chance of being in a fund that has formally committed to aligning its investment portfolio with the goals of the Paris Agreement. We believe members can play an important role by using their influence to challenge lagging pension funds to improve their performance on managing climate-related risks and opportunities.

FOR PENSION FUNDS & TRUSTEES

Improve identification and assessment of climate-related risks across the investment portfolio

Our data shows the vast majority of assets managed by the world’s largest 100 pension funds have not been assessed for climate-related risks. Pension funds have a responsibility to their members to ensure that their investment portfolios have undergone rigorous identification and assessment processes for both climate-related physical and transition risks. A number of tools are widely available to help asset owners assess their exposure to climate-related risks in their equity and fixed income portfolios.

Escalate engagement with investee companies on climate-related topics

We believe if pension funds are to effectively contribute to the low-carbon transition they must do more to hold the companies they invest in to account on climate-related issues. We support and recommend collaborative initiatives such as Climate Action 100+ as a convenient, yet powerful, forum for engaging with companies. For pension funds already engaging with companies on climate issues, we recommend broadening the scope of climate-related topics from disclosure to action (for example setting science-based targets, stress testing business models against a range of climate scenarios, installing decarbonisation pathways, or shifting capital expenditure towards more  below-two-degree pathway aligned enterprises).

Acknowledgments

ShareAction gratefully acknowledges the financial support of the European Climate Foundation, Finance Dialogue, Hewlett Foundation, and the KR Foundation for this project. These foundations kindly supported this project, but the views expressed are those of ShareAction. More information is available on request.

We would further like to thank the panel of experts who gave their time to provide guidance to inform this research project, and particularly the development of the methodology and feedback during the review process.

We also acknowledge the efforts made and time given to supply information by individuals who were nominated to represent their companies in this assessment.

Report written and produced by: Pavel Kirjanas, Felix Nagrawala, Sam Hayward, Peter Uhlenbruch, Amy Metcalfe, and Toby Belsom of ShareAction.

Find out more

This is the third of four related publications we will make between September and November 2018 to draw attention to the role of global public pension funds in managing the risks and opportunities of climate change. Contact Peter Uhlenbruch, AODP Investor Engagement Officer, on peter.uhlenbruch@shareaction.org if you would like to be notified about the next instalment of Pensions in a Changing Climate.