Gilts, stewardship and addressing climate risk

At LCP, we recognise stewardship as a vital tool in an investor’s armoury. Traditionally, stewardship, which is responsible management of investments to promote long-term value and sustainability in the interests of the investor’s beneficiaries, has focused on equities and, more recently, corporate bonds. But what about gilts?

Within the Defined Benefit (DB) pensions landscape, as funding levels have improved and schemes de-risk, our clients' portfolios now consist of larger allocations to gilts. These clients and other gilt investors may be asking what stewardship looks like for them. We believe policy advocacy, ie the process of influencing public policy, is a key part of gilts stewardship.

The power of DB pension schemes

There has traditionally been a misconception that gilt stewardship is not possible. However, gilt investors can engage with the UK government, analogously with the company engagement undertaken by investors in corporate debt.

Some people might query whether investors can influence the government, particularly DB schemes, which need to hold gilts, arguing that – without the threat of divestment – engagement carries no weight. We would challenge this view. Pension schemes have choices on how to hedge interest rates and inflation risks (eg swaps, insurance solutions or even overseas government bonds). As we showed at our investment conference last year, if you exclude the Bank of England, pension schemes are the largest lender to the UK government. Furthermore, when we looked at forward gilt issuance projections, the UK government is likely to face a funding shortfall, giving potential gilt purchasers even greater influence. All of this means that pension schemes wield a significant voice. But how to wield it most effectively?

In the case of DB pension schemes, gilts are predominantly held with Liability Driven Investment (LDI) managers. We believe trustees should be ensuring that their scheme’s money is held with LDI managers who are engaging appropriately to address systemic risks that they are exposed to.

What is a systemic risk?

A systemic risk is one that could cause the collapse of an entire financial system, or entire market, as opposed to the risk associated with any one individual market participant. Systemic risks cannot be easily diversified away, given their broader impact on the wider economy. They are best addressed at a systems level, ie through policy or regulation. Hence, they are an important target for gilts stewardship.

Geopolitical risk, biodiversity loss, and antimicrobial resistance are all examples of systemic risks, and climate change is another.

So how can trustees’ LDI managers take action to mitigate climate risk? One way is to send a clear message to the UK government about the importance of clear and consistent policies on climate action that are sufficient to meet the UK’s climate targets.

How have we helped our clients?

We wanted to understand how well LDI managers are acting to mitigate climate risk on our clients' behalf and to raise standards across the market.

We had a series of conversations with asset managers and reviewed publications of industry groups to understand typical and leading practices in relation to engaging with the UK government on climate change.

Working collaboratively with five major LDI managers, we developed a set of “best practice principles”, setting out our views on what “excellent” climate policy advocacy looks like. Some key principles were as follows:

• Managers should articulate a transparent view of what they want to see from climate policy. This view should be aligned with the latest climate science, encourage governments to set clear, credible, and consistent net zero plans, and highlight where policy ambition and implementation fall short of what is needed to meet governments’ climate commitments.
• Managers should develop and implement a strategy for engaging on climate policy and make a summary of it publicly available.
• Managers should engage with a diverse range of stakeholders – eg government ministers, regulators, the Debt Management Office (DMO) – and utilise a variety of methods to engage them. For example, public statements, bilateral conversations, or collaborative activity.

We then used our principles as a template against which to assess the LDI managers.

Our assessment of LDI managers

We have now completed our initial assessment of the five LDI managers. We found that there was a range in how effectively managers were doing this work, and how strong or weak managers were in different aspects of climate policy advocacy. We discuss a few of our key findings below:

• We found that, generally, the managers have been reluctant to comment on the UK government’s net zero plans. We believe the underlying reason for this hesitancy is that managers are unwilling to be seen to be taking a 'political side'. However, asset managers have a fiduciary duty to serve their clients’ best interests, which includes mitigating risks that they are exposed to, such as climate change. Therefore, we believe that conducting an analytical assessment of the government’s policies to reduce emissions versus the reductions required according to the latest science, and advocating for improvements to address any shortfall, is in line with their fiduciary duty, and can be presented in an apolitical manner.
• We found that LDI managers’ strategies and governance frameworks relating to climate policy engagement currently tend to be quite rudimentary and not clearly disclosed publicly. Clearly this is an evolving area, the processes in place are in a nascent stage, and we would expect to see improvements over time.
• On the plus side, it was pleasing to see that all five firms are doing some climate policy advocacy, are liaising with a range of UK government and regulatory bodies and have dedicated resources in this area - albeit to varying degrees.

We have fed back our suggested improvements to the five managers and our analysis is available for interested clients. We will keep our principles and assessments under review, updating them as market practice evolves.

What actions should you take?

We recommend that our clients with LDI mandates review our assessment of their manager and engage with their LDI manager to encourage improvements in the areas we have identified.

Of course, it is not just LDI managers who are able to influence the government. Large asset managers who do not manage significant gilt assets still have substantial influencing power due to their importance to the UK economy. We suggest that all our investment clients keep systemic climate risk on their agenda and ask all their managers how they seek to influence government policies.

If the answers received are not in line with their expectations of managers in this area, clients should encourage managers to improve, or investigate alternative investment options.

In summary, it is our view that, not only is gilts stewardship possible, but it has the potential to play a significant role in addressing the systemic risks that our clients are exposed to, including climate change. We encourage our clients to use stewardship across their asset portfolio to mitigate such risks and will continue to help them to do so.