Responsible Investment – my lightbulb moment

By now, most people in the pensions industry accept that a climate emergency is looming, and that mitigating the risk of catastrophic events requires a massive redeployment of capital.

UK pension fund trustees and their advisers have also been inundated with regulatory requirements to consider climate change, to have regard to the impact of climate risk in making decisions, and to report that they have done so.

But the guilty reality is that, for the large majority of UK pension assets – the £1trillion plus held by closed DB schemes - the dots are not being joined.

Closed DB schemes are often on a journey to insurance buy-out and are increasing their allocation to low-risk assets in the meantime. Given trustees’ responsibility to their own scheme, their primary fiduciary duty to make their own members’ benefits secure, and the fact that their holding in growth assets is both small and temporary, many trustees understandably feel that the direct impact they can realistically have on changing the outlook for climate change is limited.

This is especially the case as “impact of climate risk” is often interpreted as managing the impact of climate change on the scheme’s investments, as opposed to the impact that a redeployment of their capital can have on changing the outlook for climate change.

Worse, the capacity on trustee agendas to focus on responsible investment is instead being crowded out by TCFD reports and other compliance requirements – which if anything is having the effect of turning people off the subject rather than turning their attention to where it really matters.

As CEO of LCP, I am happy to lend my energy and support to addressing LCP’s own carbon footprint. We also now have around 100 consultants working with the energy industry to deliver a faster, better energy transition for all. Combined with our strong position as advisers to institutional investors, we are making great strides in optimising the interface between institutional capital and the energy transition. Indeed, our purpose as a business is to “fuse human expertise with powerful analytics to shape a more positive future”. But it remains the case that very little of the capital needed to drive the energy transition is coming from UK closed DB schemes.

I have recently had my “lightbulb moment” to begin to join the dots. I appreciate that I will be far behind others, including colleagues at LCP, who will have reached a similar realisation years ago. Nonetheless, I am humbly sharing these thoughts in case they help others who are at a similar stage in their journey to mine, to use their influence collaboratively in order to make a real difference.

Joining the dots

It’s becoming increasingly clear to me that if pension scheme assets are going to be part of the climate change and energy transition solution, this will require more than the current actions: we need a radical re-interpretation of trustees’ fiduciary duty, in two dimensions:

• Time horizon. Clarification that fiduciary duty includes consideration of members’ best financial interests over the remainder of their lifetime so that DB trustees can legitimately think beyond buy-out. It would be up to the trustee board to decide how much weight it wishes to place on this consideration relative to others.
• Macro versus micro. Clarification that trustees may have regard to the real-world impact of their investment decisions, not just the impact that external ESG factors have on their scheme’s investments. This is relevant not only because those real-world impacts will take place over their members’ lifetimes, but because they will have an impact on the stability of financial systems - and thereby the security of pensions - long before the worst impacts of climate change (if left unchecked) may be felt.

With these changes, the logic flow to support legitimate changes in behaviour will be as follows:

• Step 1: A shift from being driven by regulatory reporting to a focus on real world impacts. For example, the scientific analysis projecting that by 2100 around three quarters of the population may not be able to live comfortably in the same habitats as their 2023 counterparts, the fact that when average temperature rise, extremes get dangerously extreme, and the acknowledgment that a global transformation to a low carbon economy is expected to require investment of $4-6 tn pa¹. That’s a massive change to capital flows which will impact on financial markets for everyone, regardless of the priority they personally place on addressing climate change.
• Step 2: To meet the re-interpreted fiduciary duty, trustees will be able to look beyond the financial performance of the pool of assets they directly control. They will be able to consider how, with better engagement and stewardship, their investments give them the ability to influence the corporate behaviour of their investee companies, and also to influence governments and financial services regulators to re-align the incentives within financial markets. Those trustees will realise that they cannot do this on their own, but through collaboration with other institutional investors and asset managers.
• Step 3: Trustees will rightly continue to include an allocation to safer assets such as government bonds within their investment strategy. Who can be criticised for lending to their government, right? But what if the pensions industry, with its newly interpreted fiduciary duty, were to make a condition of its vast lending to the government that the money is used to shape a more positive future? And if that government doesn’t play ball, even consider lending to a better-aligned government instead, and hedge the currency risk?
• Step 4: When it does come to buy-out, trustees would favour insurers who invest sustainably and commit to use their own influence to bring about positive change, thereby increasing the chance that the worst effects of climate change – both physical and on the stability of financial markets - are not felt during their members’ lifetime.
• Step 5: How will trustees be judged in hindsight compared to the status quo? Imagine two trustee boards in identical situations, each managing a very well-funded pension scheme. The first prioritises getting their scheme to buy-out as soon as possible. The second also gets to buy-out, maybe a couple of years later – but in the meantime the trustees have done all they can via their investment strategy and engagement to re-align the incentives within financial markets to shape a more positive outcome for the planet and people. The change that I am advocating will judge the second board more favourably than the first. And that’s a big difference from the status quo.

My goal is simply to encourage a constructive debate on these issues. This is not a lecture to anyone on how they should invest their pension scheme assets. But let’s be open about the fact the current trend of increasingly onerous compliance reporting requirements is not going to be of much help to the planet and society unless it is also accompanied with a re-interpretation of trustee duty to support meaningful real-world action.

This article was originally published in Professional Pensions on August 31st 2023