Just as net-zero pledges have become universal in the multi-employer DC pensions sector, cracks are beginning to appear in the industry’s ability to deliver on the promises that have been signed up to.
That was one of the key takeaways from a Corporate Adviser round table on ESG in DC Pensions last month.
Advisers and providers gathered to debate the fourth edition of Corporate Adviser’s ESG in DC Pensions Report 2021, which showed 2021 was the year that DC pension providers embraced ‘net zero’ — with all 21 major master trust and GPP providers committing to Paris-aligned targets for reducing carbon emissions on their default portfolios. The majority of asset managers working across this sector also now have firm net zero commitment in place.
The universal nature of the net-zero pledges made might suggest it is ‘job done’ and the journey towards net zero pensions will progress in an orderly fashion, but consultants and advisers said this was far from the case, with significant challenges set to come home to roost in a matter of just a few years.
In the vast majority of cases these providers have pledged to be net zero by 2050, with interim targets to halve emissions from their portfolios by 2030 or sooner in some cases.
Meeting these 2030 targets while protecting members’ returns will be one of the more immediate challenges. Redington global head of sustainable investment Anastasia Guha pointed out that in order to halve emissions from their default’s portfolio, schemes are typically looking at a 7 per cent year-on-year reduction in carbon intensity, something that is certainly not happening yet.
Tight targets
“It’s getting harder and harder to imagine how we’re going to get to this target in just eight years, when the global economy
continues to increase carbon emissions. In the real world economy we have never reduced the amount of carbon we produce — even in 2020 when Covid effectively stopped the economy,” said Guha.
Lane, Clark & Peacock partner Nigel Dunn pointed out that there has been race to announce net zero ambitions over the last year or two.
But he says this is only part of the picture. “What we’ve really been looking to understand from providers is what their plans are for meeting these targets.
“I don’t think many people know yet exactly how they are going to get there.” This he said applies to companies working across many sectors, not just pension providers and asset managers.
Legal & General head of DC investments Veronica Humble agreed that these stretching near-term targets are key. She pointed out that 2050 commitments are relatively easy to make, as it is still a long way out. “2030 is a bit more tangible, and those making 2025 commitments need to be looking at how they are going to be reducing carbon emissions today.”
Delegates at the debate agreed there was likely to be increased scrutiny of these interim targets, which for some providers will be reached before 2030. Guha pointed out that two-thirds of the members of the UN Asset Owners Alliance had set targets to reduce emissions by 2025.
“These are very stringent targets, that are about reducing the emissions from underlying investments, not meeting these targets by financial engineering within the portfolio.”
Some panellists questioned whether timescales for meeting these targets might start to slip.
Guha flagged concerns that progress is not happening as quickly as anticipated: “There are starting to be noises around decarbonisation pathways in the high emitting sectors.”
Review and rethink
This could prompt asset owners and trustees to rethink investment strategies — for example on whether more robust divestment is necessary to meet net-zero targets, or whether a new approach to engagement is needed.
Those attending the debate agreed that there may be the need to re-evaluate current ESG strategies, particularly in relation to net zero goals.
In recent years there has been significant debate around the benefits of divestment versus engagement —with some arguing that engagement may be a better way to drive real world carbon emissions downwards.
Asset managers such as LGIM have been strong proponents of this view —where this stewardship is backed by a robust ‘name and shame’ approach for companies failing to engage or publish transition plans, with the ultimate sanction of divestment.
This approach has also been promoted by the government and pensions minister Guy Opperman, as an effective route towards net zero — though it does of course mean that pension schemes and asset managers remain invested in fossil fuel companies, airlines and mining conglomerates, for example, in order to wield boardroom leverage.
However some on panel said these extensive engagement programmes had yet to deliver substantive gains when it comes to carbon reductions.
Guha, who has previously worked in engagement programmes in her former role at the UN PRI, said: “Engagement programmes may have delivered results on a range of issues, but not for carbon reduction.” She asked: “If we have to drive down carbon emissions in companies across the globe, what needs to change in the way we work and our engagement process to make that happen?”
She flagged concern over the commitment of signatories to Climate Action 100+, a group set up to co-ordinate shareholder action and drive change on climate change. Of all the alphabet soup of coalitions, pledges, standard setters and alliances in the field of climate transition – Corporate Adviser’s ESG in DC Pensions Report identified 229 such organisations signed up to by asset managers and providers in the UK DC space – ClimateAction 100+ has been seen as one of the most respected.
“This is one of the largest engagements we’ve seen, it is focused on one subject with the biggest polluters in the world,” said Guha. “There have been some wins, but out of 167 companies you probably get less than 10 per cent that are meeting the campaign’s benchmark targets at the moment.”
She said that some asset managers are failing to hold boards to account when they miss these targets year after year. “At what point do these become more robust conversations?” She said that at present this engagement campaign was “creaking” and far from a clear success.
Tilt questions
Others on the panel thought there was an argument for stronger engagement programmes, targeting company boards. Dunn pointed out that many net zero strategies have relied heavily on tilts — where passive indices are weighted towards companies with favourable ESG characteristics and away from those with poorer ratings.
The ESG in DC Pensions Report found 19 out of 21 pension providers deploy ESG tilts or screening overlays on their default, compared to just five master trusts doing so three years ago.
Dunn said these may not always be effective. “We’ve got this rush of providers going into tilted passive strategies. But these tilts are based on data, and there is not always good disclosure around these issues. In the UK there is relatively good disclosure, but only about half the companies in the US report on this sort of emissions data. When you go to the Far East it’s even less.”
Hymans Robertson head of DC investment Callum Stewart said tilts may have a part to play in the net zero journey, but he expressed concern that the industry’s focus on costs was placing too much emphasis on this single approach.
“I see this shift towards passive approaches, and I think it’s symptomatic of an industry that is too heavily focused on costs and charges and not on overall outcomes for savers.” He said this is inhibiting innovation and leading to “suboptimal investments strategies”.
“We are not directing capital as readily into solutions like illiquid investments that should absolutely be a part of default strategies to help deliver net zero goals.”
Dunn said tilting strategies could reduce emissions on pension portfolios but added that this will be “completely useless” in terms of tackling climate change if schemes end up invested “in a collection of wind farms and other green assets” while the major polluters carry on as normal, but with different owners.
Hold the index?
Being fully invested across the market and focusing on stewardship and engagement activity could drive more meaningful change, said Dunn, with pension funds “getting lifted [in terms of reduced carbon intensity] in line with the broader economy. Some of our clients have certainly taken the view that this is the way forwrd,” he said.
This though may have potential consequences for hitting 2030 targets, particularly if engagement programmes are slow to deliver results.
Current political and economic headwinds may also not be helping. A recent report by BlackRock forecast that ‘green’ equities were likely to outperform ‘brown’ stocks over the next few years, possibly in part due to the need of pension schemes and asset managers to meet net zero targets.
But at the same time, many oil producers and gas companies have seen revenues soar and share prices rise after surging demand post Covid lockdown. This situation has been exacerbated by the current political crisis in the Ukraine, and further sanctions on Russia.
Steve Herbert head of benefits strategy at Howden Employee Benefits & Wellbeing said this is inevitably leading to some climate scepticism. “You would always expect this, but perhaps it has come slightly sooner than expected with soaring gas and oil prices.”
Climate scepticism
He said this has led to questions being asked as to whether pension schemes could be losing out, on short term gains at least, by pursing aggressive net zero strategies if these mean lower weightings to these sectors.
Consultants and advisers face challenges when it comes to understanding the different approaches pension schemes are taking towards carbon reduction.
Barnett Waddingham associate and policy & strategy lead Amanda Latham said: “One divergence in approach is whether we are thinking about carbon emissions today or carbon emissions in future. This is one of the things I think we’re starting to see differentiated in the approaches of different asset managers.”
As she pointed out, those taking the former approach may be investing in equities with relatively low carbon emissions today.
“Others may be much more focused on the transition and providing finance to companies to enable them to decarbonise as we move into the future.” This could see them holding investments that have far higher emissions today — particularly in companies in the energy, airline or mining sectors.
This issue is likely to be thrown into sharp relief by the new Task Force on Climate-Related Financial Disclosures (TCFD) regulations, which from this year require pension schemes with assets of £5bn or more and authorised master trusts to make standardised reports as to how they are assessing and managing climate-related risks in their portfolio. Pension schemes with assets of £1bn or more will be brought into this regime from October this year.
Could this create perverse incentives, whereby schemes that are focusing more on future transition — with the potential to deliver more significant long-term carbon savings — appear to be heavier polluters today when TCFD reports are analysed and compared?
Advisers did not think this was an immediate problem. However all agreed that there was a need for better metrics around this, in order to avoid such market distortions. There was agreement that global standards on carbon accounting could make a significant different, but TCFD was an important first step.
Humble said that in her experience consultants and clients are aware of many of the nuances within this debate. “The important thing is to get the plumbing in, in terms of TCFD and see how this changes the landscape.”
As she pointed out it is not only pension schemes that will be reporting this data, regulation will require UK-listed companies to disclose more detailed information about their own carbon emissions, all of which will help pension schemes and asset managers build more robust ESG strategies.
Charlie Goodman a partner at Employee Benefits Collective said TCFD reports are not going be looked at in isolation. “There’s a lot of complexity and nuance in this, and there is going to be even more going forward.”
He added that advisers need to be careful about the promises they are giving members, in terms of ‘greener’ pension and net zero goals. “If schemes fail to meet targets and deliver on these goals we lose a lot of trust and that could really derail a lot of the good work being done.
“Employers are starting to ask these questions. We’re just trying to make sure we’re guiding people down that path, and keeping them comfortable with what is going on, in terms of broader ESG guidelines and more specifically the transition to a lower carbon economy.”
Offsetting concerns
When it comes to meeting net zero goals those attending the event expressed some hesitation around the use of carbon offsets.
Stewart said: “Fundamentally I think these will not be part of the real world solution, but that’s not to say they can’t be useful or helpful in different ways.”
He said high quality carbon offsets can help improve biodiversity, for example. “So there’s an opportunity to improve and meet wider sustainability goals. I would see this as an additional activity within a core portfolio, rather than an alternative to reducing the carbon intensity of investments.”
The panel agreed that offsets may have more of a role to play in future, particularly as a more robust market develops to assess their quality. Direct air capture, for example, where carbon is permanently removed from the atmosphere and stored underground rock formations, may be a more effective solution that forestry or planting trees, but is prohibitively expensive for widespread adoption at present.
Ultimately delegates agreed that pension schemes were now firmly on a journey towards net zero, and had an important role to play in helping transition the economy to a lower carbon future.
But while there was agreement that this was the right journey to be on, and that the trajectory is broadly supported by members, there was less consensus about what this might entail in the next few years in terms of portfolio construction and investment strategy — to ensure environmental goals are met, while still maximising member returns.
