30th September 2020
Kyla Taylor is a lawyer in our climate finance team, focussing on pensions. She looks at different legal strategies to improve the way institutional investors, like pension schemes, integrate climate-related financial risk into their decision-making. We took five minutes to find out more about her work, and the role that pensions can play in the fight against climate change.
As things stand, our planet is on course for temperature rises of 2 – 4°C by the end of the 21st century, with catastrophic consequences. In order to reduce these effects as much as possible, global efforts need to limit temperature rise to 1.5°C in accordance with the Paris Climate Change Agreement. Every country needs to play its part. The UK has committed to becoming 'net-zero' by 2050. In order to achieve this, the UK economy will need to reduce its greenhouse gas emissions by around 50% by 2030. That’s just ten years away. The clock is ticking, and we will only succeed if government policy, finance and business align in an unprecedented way.
The pensions industry is a major part of our financial system. Pension schemes are big, institutional investors with lots of money invested in global financial markets, often in a variety of different sectors and companies. This means that they have tremendous power to steer and influence financial flows and market behaviour towards achieving climate goals.
Pension schemes have tremendous power to steer and influence financial flows and market behaviour towards achieving climate goals.
Pension schemes around the world have different legal obligations to take action on climate change depending on their jurisdiction. ClientEarth monitors the actions of large pension schemes around the world, but at the moment, we have a focus on UK pensions because of the value of the UK market, and the UK's position as a major financial centre. In 2021 the UK is hosting the United Nations Climate Change Conference (COP26), and holding the G7 Presidency. In these roles it has the opportunity to show leadership and set a global agenda on climate.
It’s also worth noting that within the UK there are lots of different types of pension arrangements with different legal structures. Whilst we closely observe developments across the whole pensions industry, a key focus, particularly for our current pensions campaign, is on funded workplace pensions.
Simply put, UK pensions are generally provided in three ways – by the government, through employers in workplace pensions, and in personal plans arranged by individuals with a pension provider.
Of those three categories, government pensions are governed by statute, personal plans are governed by a contract or by trust, and workplace pensions can be governed by statute, contract or trust.
Personal pension arrangements include things like Self Invested Pension Plans, known as SIPPs. We definitely want to encourage people with personal pensions to make sure that they have thought about and talked to their investment managers about climate risk. However, the majority of people have pensions (including group personal pension arrangements) which have been set up through their employer and have less direct engagement with how their pension is invested. We want to make sure they are able to have these conversations with their pension provider when it comes to climate risk.
The state pension and most public sector workplace pension schemes, such as the NHS, teachers and the civil service (although not the Local Government Pension Schemes) are different, because they are unfunded. This means that there is no fund of assets which is separately invested in financial markets, and from which pension benefits are ultimately paid. Contributions paid by members of these schemes effectively go to the sponsoring government department. These contributions are not invested to build up a fund from which pension benefits are then paid. Instead, the sponsoring government department pays benefits to pensioner members as and when they fall due. As these are government-backed schemes, it’s still important to monitor government action, but these schemes are not invested in funds more likely to be involved in financing climate-wrecking industries. The exceptions to this are Local Government Pension Schemes, which do have funds invested in the same way as private sector schemes.
UK pension schemes do have legal requirements to take action on climate, but it’s not as straightforward as saying they must act, or refrain from acting, in a certain way.
There are different types of pension arrangements in the UK with different legal structures and related legal obligations. As a general premise however, a pension provider needs to look after the best interests of its members, and to balance returns on investments against risk in order to provide members with a pension. In doing so, they should be considering and acting on any financial risks to the pension scheme.
Climate change is a financial risk and, regardless of the type of pension arrangement, all pension schemes are exposed to climate-related risks. Therefore, all of them should be taking action.
Climate change affects the financial system in two key ways, known as physical risks and transition risks.
Physical risks are extreme weather events and changes in the climate. This year has already seen multiple examples of physical risks, starting with record-breaking temperatures and months of severe drought fuelling a series of massive bushfires across Australia. Events like these impact the economy in diverse ways. Basic examples include disrupting businesses, destroying food production and interrupting supply chains. This impacts the ability of businesses to make a profit, and the functioning of the economy at large, which can have profoundly negative impacts on the investments and financial returns of pension schemes.
Transition risks arise as a result of efforts to transition to a low carbon economy. These efforts lead to inevitable changes in policies and regulations (such as the changes we have seen in the Pension Schemes Bill recently), as well as behavioural changes, such as consumer choices and demands. These changes impact how industries and the economy operate. They will be felt particularly where there is a failure to prepare (at both a governance and business level) and when changes happen suddenly with less time to react and adapt. There are already examples of oil and gas companies – who recognise the shift away from fossil fuels – writing off assets in recognition that a proportion of the oil they would have produced will remain in the ground.
There are strong arguments that pension schemes face system-level risks because of climate change. This is because pension schemes invest across financial markets, which means that they are exposed to the whole economic system and any changes that take place within it.
Because our pensions are dependent on financial markets, the health of our pension savings are impacted by all of these risks.
Pension providers are required to consider climate change risks in their investment and risk management strategies. But how they approach it, the tools they use to engage with climate change issues and the conclusions they draw can differ.
Sometimes, a provider may decide that acting in their members’ best interests and delivering their pension benefits means staying invested in seemingly undesirable companies. In certain circumstances, this can be effective: a provider may decide to retain its holding in such a company because, as an investor, they have some power to require companies to change (particularly when they work with other investors). For those companies whose primary business means that they have the potential to transform in line with a zero carbon future, pension providers have the financial power to influence and push for those changes more rapidly. As long as that pension provider is using its power forcefully and strategically, holding on to a stake in the company may be more effective than allowing that stake to be sold to someone with no interest in advocating for positive change.
We want to see a change not just in what pensions are investing in, but how they are investing. Climate change risks affect all pension schemes and we want to see structural and behavioural change across the industry. These changes are underpinned by existing legal imperatives and will become increasingly robust with future regulations.
We want to see pension schemes forming and acting on robust, strategic climate change policies which seek to ensure that the scheme is resilient and able to adapt and indeed contribute to the transition to a zero carbon economy.
Taking a cursory risk assessment approach is not enough to protect people’s pensions from climate change risks. We want to see pension schemes forming and acting on robust, strategic climate change policies which seek to ensure that the scheme is resilient and able to adapt and indeed contribute to the transition to a zero carbon economy.
The legal structures already exist for pension schemes to do this. Consequently, we would like to see much stronger direction, accountability and enforcement action from regulators to ensure that genuine change occurs, and at pace. We want to see those providers who are taking their obligations seriously celebrated, and to make sure the industry works collaboratively to share best practice.
We also want pension schemes members to have proper access to this information in a clear and transparent way. Pension providers are stewards of their members’ money, acting on their behalf. Many members want to engage with their pensions and, in particular, with environmental social and governance factors.
If these changes take place, we will see a transformation across the industry, meaning lots of pension members are benefitting, rather than a situation where change is only happening when individuals move their own savings to a specific type of ethical fund. Using the law will target the heart of the problem. It can take a bit more work, but it really is one of the most powerful tools you can use to create systemic, long lasting change.