The world is in the throes of a major energy crisis, centred on Europe and a horrible war, but augmented by huge shifts in global demand. Energy sits at the centre of plans for the world to transition to a more sustainable economic system, but with just over seven years to go until pledged 50 per cent carbon reductions in portfolios, and a new broom through Whiitehall, have events changed the calculations for the pension sector in terms of its net zero ambitions?
From a regulatory point of view, the ESG and sustainability juggernaut continues its seemingly inevitable progress.
In June, former Work and Pensions Secretary, Thérèse Coffey MP, in a foreword to a consultation on climate and investment reporting, made the following assertion. “From October this year more than 80 per cent of UK members will be invested in pension schemes which are helping to limit the climate risk to their members’ retirement incomes.”
The consultation response added some significant details. It said: “Policy proposals, draft regulations and draft statutory guidance will require [schemes] to calculate and report a metric setting out the extent to which their investments are aligned with the Paris Agreement goal of pursuing efforts to limit the global average temperature increase to 1.5˚C above pre-industrial levels.”
It did offer some leeway to schemes under £500m. They are no longer subject to the requirements to select and calculate a portfolio alignment metric with immediate effect. They must still report on their selected portfolio alignment metric in their Task Force on Climate Related Financial Disclosures (TCFD) report for the scheme year which has just ended.
Trustee target
An accompanying guide for trustees updated in July goes into all sorts of important details as well. For example, the guide asserts that growth assets are more sensitive to climate risks than income producing ones but then adds the not particularly startling observation that “some sectors (for example renewables and electric vehicles) and assets (such as green infrastructure) will benefit from the low-carbon transition”.
But this, also from the guide, is more assertive. It says: “Asset managers’ climate competence should be factored into manager selection and be monitored post-appointment. Trustees should also ensure that investment consultants demonstrate a robust track record in assessing and addressing climate risk and have adapted their core services to include consideration and discussion of long-term risks and opportunities”.
It goes on to suggest that signatory status and reporting against the Principles for Responsible Investment PRI and 2020 UK Stewardship Code are key indicators of this track record for both managers and consultants.
This might give an impression that the journey to a transition is uncontroversial. But the roiling political and to a degree financial industry debates shows that is not quite the case.
ESG challenge
For example, ESG has become close to a swear word for some on the US Republican right, attributing a raft of evils to it, not least energy inflation. Nevertheless, and perhaps titled in response, the Inflation Reduction Act has now passed into law with a huge raft of measures, including $369bn for energy security and sustainability. It has been suggested that it could cut emissions by 37 to 41 per cent by 2030 and makes it more likely the US will meet its Paris targets.
In the UK, the Conservative leadership contest saw proposals to go more slowly on net zero, especially from rising star Kemi Badenoch while Liz Truss’s main energy bill proposal has been to remove the green levy from fuel bills. However, despite a few populist swerves, the net zero target remains.
Kirk kickback
We have also seen kickback came from within the sustainable finance industry as well. The now former global head of responsible investments at HSBC Asset Management Stuart Kirk made a searing critique of many of
the assumptions regarding sustainability, central bank models, the workload required by regulations, the implications for green and brown stocks and what he saw as the very bright prospects for GDP and continued market growth meaning in his view, that the world could afford many of the adaptions.
At an FT conference Kirk argued global warming was already priced into asset valuations, and argued the UN Intergovernmental Panel on Climate Change’s (IPCC) own projections showed a temperature rise of 3.6 degrees by 2100 would mean a loss of 2.6 per cent of global GDP. This was trivial he argued, as global growth would probably be between 500 and 1,000 per cent by then.
The UK pension industry did not engage with his challenges in detail. But two academics certainly did. Noël Amenc, associate professor at Nice-based EDHEC Business School and Frédéric Blanc-Brude, director of the EDHEC Infrastructure Institute in an open letter questioned Kirk’s ‘theoretical and empirical consistency’.
“You may be right or not that climate stress test models are useless. But the conclusion that climate risk does not exist is yet another fallacy. Unknown unknowns are a thing.”
They said: “Institutional investors see their very existence in many jurisdictions as conditioned by their ability to take the non-financial consequences of their investment into account”.
Ukraine and beyond
Europe is facing an unprecedented energy crisis albeit one widely trailed for at least a year in newspapers such as the FT and since autumn by global thinkers such as the economic historian Adam Tooze. They were predicting a post-pandemic energy crunch long before the Russian invasion of Ukraine made things more acute.
That has brought new debates and arguments to the fore regarding the status of gas and oil, the efficiency of battery storage, the resilience of the grid in the UK, and that fact that spot prices are largely set by gas even at times when renewables are supplying the energy.
But that does bring one huge and significant question to the fore – do real world events and a backlash among at least a few finance professionals, challenge the seeming regulatory inevitability of climate targets and sustainability in the pensions industry? The answer is mostly no but there are nuances.
XPS, for example, now draws a line between ‘net zero’ and ‘net-zero aligned’ for schemes.
XPS head of ESG research Alex Quant, writing in a recent note regarding net zero, says: “As relatively few companies are currently operating at net zero, we do not consider it appropriate for pension schemes to build a diversified net zero portfolio today.
“Whilst it is possible in theory to create a net zero portfolio immediately, by excluding the worst emitting sectors, this would lead to very different risk characteristics compared to the market index, and also remove exposure to those sectors with the most significant scope for change. This is an area where pension schemes have the power to influence change by utilising their engagement and voting rights through their investment managers.
“On a more practical level, investing in these sectors, such as energy and utilities, is critical for achieving real world change. As well as exclusions at a sector level, achieving net zero today would likely require disinvesting from emerging markets. This misses a significant opportunity as it is in these markets where the most investment is required to deliver successful global outcomes. Finally, a net zero portfolio today would also likely rely on purchasing and surrendering carbon offsets which comes at a direct cost to the scheme, at odds with its broader objectives. A change in emphasis towards an approach focusing on reducing gross emissions sustainably over time is fundamentally important – less ‘net’, more ‘zero’.”
He does go on to suggest that by using this approach net zero is achievable by 2050.
Tom McPhail, director of public affairs at the Lang Cat says: “Whatever the political climate,
we need to press ahead with transparency and accountability around the ESG impact of retirement investments. We need to be able to measure this stuff and we need to be able to give people agency and control. So we should definitely press ahead with the requirements to measure and report.
“Even if politicians were to scrap the net zero target for now, we’re still going to need to track the ESG impact of pension investments, so I’d argue in favour of keeping calm and carrying on.”
Target rationale
Callum Stewart, head of DC investment at Hymans Robertson says that targets are less for individuals and more for corporates, governments, asset managers and other institutions and their advisors to influence and take action.
“For example, there is lots of scope for the energy sector to punch above its weight to make progress towards global net zero goals. This sector has benefited from rising commodity prices and profit so should be well placed to invest for the future.
“The role of various stakeholders is to hold them to account and drive the change. The sector really needs to demonstrate commitment to change. We need investment in technology, storage, grids and renewable generation, particularly given it can take a number of years to bring new projects to the market.
“For trustees, there may be pressures in terms of ongoing costs for running their schemes so this is where we, as advisors, need to be a supportive force to help them prioritise and focus on the really meaningful areas to push e.g. holding asset managers to account on stewardship, or putting in place meaningful and achievable targets and considering incremental progress rather than root and branch overhaul.”
His preference is not to overly regulate on climate change matters and to leave time for the TCFD governance and reporting frameworks to bed in.
CanScot Solutions principal Robert Reid says a lot of conversations tend to get to the matter of returns very quickly and when asked, he suggests ‘we simply don’t know’.
Member choice
Reid says: “When it comes to master trusts, I think members need to ask ‘am I getting to pick sustainable funds that suit me or am I being shoved into the default fund that someone else picked and they consider sustainable?’ Are you giving the people the choice on sustainability or are you expecting people to trust someone else to do it. Given the amount of greenwashing that is about, I am not sure that one flies. We are all having this heavy journey into sustainability and impact, but the general public aren’t.”
Fiduciary return
PTL managing director Richard Butcher discussing the challenging context says: “The bottom line is it doesn’t change anything particularly substantive.
“Trustees’ only driver is their fiduciary duty: to invest to get the best return commensurate with the risks for the benefit of the beneficiaries. When it comes to risk, they have to consider short, medium and long term – all of course in the context of the duration of the liabilities.
“All the ESG and sustainability rules did was codify a set of very specific long term financial risks. Trustees should have been considering long term and these specific risks already although I accept not all were. Those risks still exist and still need mitigating – so nothing in the mechanical process has changed.
“That said, I think the current environment may change a trustee’s assessment of what
the risks and mitigations look like. A European war, the economy in dreadful state, massive national debt, high inflation and energy costs are all factors we probably didn’t build into our model. Once we do, we might find certain assets become more or less attractive to us.”