TCFD: considering climate risks to funding and investment strategy in an integrated manner
A core feature of the Taskforce on Climate-related Financial Disclosures (TCFD) framework is the identification, assessment and management of climate-related risks and opportunities. Many asset owners have so far focused on the risks and opportunities to their investments and ignored the other side of their balance sheet. However, that is starting to change.
The mandatory TCFD rules being introduced this October explicitly require trustees of large UK defined benefit (DB) pension schemes (with relevant assets over £1bn) to consider the impacts of climate change on their funding strategy as well as their investment strategy, including consideration of the ability of the sponsoring employer to provide ongoing financial support. Techniques for doing this are at an early stage of development and some trustees are sceptical of the value of such analysis. However, given the material financial risks posed by climate change, it is essential that pension scheme trustees understand and consider climate impacts in the round when making strategic decisions.
Climate scenario analysis: a case study
Scenario analysis is an excellent tool for this. It is opening up important conversations with DB trustees about the implications of climate change for their choice of long-term funding target, their journey plan to get there, and what could throw them off course.
At LCP, we consider three scenarios : a Paris Orderly transition where there is rapid and effective action to keep temperature rises well below 2°C and markets react smoothly; a Paris Disorderly transition with the same climate outcomes but accompanied by market shocks; and a Failed Transition where temperatures rise by 4°C by 2100. We use modelling developed by Ortec Finance and Cambridge Econometrics to illustrate the potential impacts on the economy and financial markets and hence on the pension scheme’s assets, liabilities and sponsor covenant. The modelling is accompanied by detailed narratives that bring the scenarios to life and deepen the trustees’ understanding of how climate change might unfold.
We recently carried out the analysis for a DB scheme sponsored by a telecoms company. It gave the trustees comfort that the actions they have already taken to significantly de-risk their investment strategy will also help to protect their funding position from climate risks.
Results of the analysis
The impacts under the Paris Orderly scenario were limited, although this is the least likely of the three scenarios. Of greater concern was the potential for market shocks over the next decade under the Paris Disorderly scenario. This could cause significant volatility in the scheme’s funding position, potentially affecting the timing of further steps to de-risk the investment strategy. It emphasised the importance of the work the trustees are already doing to understand the climate risk exposures of each investment mandate and ensure their investment managers are taking appropriate steps to mitigate the risks.
From the 2030s onwards, the most negative outcomes were seen under the Failed Transition scenario as the markets began to anticipate the severe physical impacts that would unfold over the rest of the century. By this time, the scheme is expected to have met its long-term funding target and reached a “low dependency” state, with no expectation of further contributions being needed from the employer. However, the analysis and discussion highlighted that the scheme would still face climate risks and could be dependent on the employer for further contributions if the funding position deteriorated as a result.
The sponsoring employer is relatively well placed for the climate transition and has emissions reduction targets that the Science Based Targets initiative has certified as being consistent with a 1.5°C pathway. Nonetheless, its business will still be affected by climate change. The analysis suggested that the biggest effects could come from lower GDP and consequent reductions in consumer demand, particularly under a Failed Transition.
This raised an important question: do the trustees want to rely on the employer covenant indefinitely, or should they aim to transfer the scheme’s liabilities to an insurer where the regulatory regime offers additional climate protection?
Next steps
The trustees will consider this question further in their next strategy review. In the meantime, they are putting in place a monitoring system to track how climate risks and opportunities are unfolding. It will include three sets of climate-related indicators: investment metrics, covenant metrics and economy-wide metrics that indicate progress towards a low carbon economy. In addition, a summary indicator of the overall level of climate risk (red, amber or green) will be added to the scheme’s main risk monitoring dashboard to ensure climate change is kept front of mind.
Outcomes
Through this exercise, the trustees have made good progress in meeting several of the TCFD requirements: having appropriate knowledge and understanding of climate change; incorporating climate considerations into their strategy; and integrating climate change into their risk management systems. It has also demonstrated the value of such analysis, even for a DB scheme with a relatively low risk investment strategy and a sponsor relatively well placed for the climate transition.
If you would like to consider climate scenario modelling for your scheme, or want assistance with meeting the TCFD requirements, please speak to your usual LCP contact.
A version of this article first appeared on the ESG Clarity website.