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A Revolution that No one can Afford to Miss out on

Celene Lee, Investment Principal at Buck, says UK pension scheme trustees should treat new climate disclosure rules as the start of a large-scale and ongoing transformation.

UK pension scheme trustees may feel they already have enough on their plate. But from this year, the job is about to get even bigger. New regulation within the Pension Schemes Act 2021 imposes ESG disclosure requirements on certain defined benefit (DB), defined contribution (DC) occupational pension schemes and master trusts.

From 1 October 2021, broadly, DB schemes with more than £5 billion in assets must have effective governance, strategy, risk management, measurement and objectives in place to assess and manage the impact of climate risks in their investment portfolio.

Trustees must meet these governance requirements and publish a Taskforce on Climate-related Financial Disclosures (TCFD) report and have it made publicly available.

From October 2022, DB schemes with more than £1billion in assets will fall under this regime, with the rest of the schemes expected to follow in future years. That may seem like a long way off, but there is plenty of work that needs to be done. And the time to start is now.

Where do we start?

There are three key things trustees must understand to prepare for this new responsibility. The first is to understand that their scheme is not alone. Perhaps more importantly – and this has not been well communicated – is that addressing TCFD requirements is not only an issue for pension schemes.

Similar climate-related disclosures are also expected to be adopted by asset managers, life insurers and pensions providers regulated by the Financial Conduct Authority (FCA). In many cases, both UK-listed companies and large private companies are also captured by similar requirements set out by the respective regulatory regime.

It could mean that a sponsor is having to do much of this work themselves, but many schemes have found that their sponsor is keen to work with their scheme to align their efforts.

Real-life decisions

The second thing to understand is that these disclosures demand something far more tangible than schemes have been required to provide in the past.

This means going beyond just paying lip service on the subject of ESG. Training is likely to be the starting point for many trustees to understand the language in order to translate the scheme’s ESG investment beliefs into a real-life investable mandate. This means aligning ESG beliefs with available ESG investment products and solutions to support the ESG journey. It is a rapidly evolving journey as asset managers are also changing what they offer to investors.

Getting this part right is absolutely crucial. ESG beliefs which are not supported by the appropriate investment solutions available could mean investors are breaching their other requirements, such as constructing a diversified investment portfolio and taking into account financially material considerations. Research carried out by MSCI in 2020 suggests for example that, for investors to be targeting net zero by 2050 and restricting global warming to 1.5 degrees Celsius above pre-industrial level, the MSCI ACWI Investible Markets Index would have to be reduced by 90% of the investible companies, which would make for a much more concentrated portfolio than the index.

The investment beliefs enshrined in the statement of investment principles (SIP) must be applied to the investment approach. They have to be practical and investable, as the scheme is no longer being asked to disclose beliefs, but report upon actions.

It’s all about the data – and the data set is flawed

The third step is to prepare for the ESG journey. As regulation and markets evolve, this is going to be a multi-year marathon, as well as a sprint to achieve near-term compliance. In order to translate their beliefs into actions, schemes must be able to measure their objectives to be confident that, when reported, their numbers are meaningful.

Some schemes have access to an ESG dashboard that collates information on risk and assists their measurement and reporting. Climate change metrics only address the ‘E’ in ESG, and then only one element of it. Other issues under ‘S’ and ‘G’ – tobacco, armaments, alcohol or even animal testing – may also be considered important within the trustees’ investment beliefs and trustees will need to prioritise.

Some of these things are more easily measured than others. There is more data available for listed markets, for instance. But potentially less is available for other asset classes, such as a number of alternative investments, or private markets.

Then there is the matter of Scope 3 emissions. Recent draft guidance from The Pensions Regulator has confirmed that trustees are not required to report on Scope 3 emissions in the first year they fall under the new requirements. What are Scope 3 emissions and why is this an issue? Many companies measure and report their Scope 1 and 2 emissions, which relate to greenhouse has (GHG) emissions either directly come from their own manufacturing process or indirect emissions consumed by the company such as the use of electricity and heating. With Scope 3 emissions however, it’s the emissions produced by the companies up-stream and down-stream activities that are considered, all the way across their supply chains. They are not emissions ‘owned’ by the company itself, but rather by suppliers or customers, and can arise from the process of transporting components, for example.

Why is it an issue? Because Scope 3 emissions outside of a company’s direct operations can often be many multiple times of that of Scope 1 and 2 emissions. Moreover, measuring Scope 3 emissions accurately or having direct influence over supply chain continues to be an important challenge for companies.

Eventually, the more investors understand the disclosures and requirements they face, the more they will understand that solving the climate risk challenge goes far beyond disclosures. This is only the first step.

The danger of greenwashing

On face value, the UK’s green credentials are pretty good compared to some nations. We are responsible for only about 1% of global GHG emissions, whereas the US, China and India make up over 50%. However, this does not allow for all the emissions produced in shipping goods to our market.

Currently, trustees are only required to report Scope 3 emissions “as far as trustees are able”. However, ESG accountability is developing. It confirms that the global supply chain is not so simple – or transparent – as we might like to believe.

Headline numbers do not provide a true indication of who is the greenest. While disclosure is incredibly important, it is also crucial to understand the data. But perhaps it is even more important to understand the imperfection of the data we have access to now.

The TCFD requirements set out in the Pensions Scheme Act 2021 cannot be governed by a ‘set and forget policy’, but will require constant recalibration instead.

The time to start is now

Legislation is already in place which means trustees must produce a SIP, setting out their policies on financially material ESG considerations (including climate change). Schemes with less than £1 billion in assets are not immediately affected by these rules, but processes will have to adapt as more information becomes available. It takes time to close the knowledge gap on ESG data and there is a danger that if schemes wait until they must report, they will fail to report the right metrics and lead to the wrong kind of investment actions due to lack of understanding on the potential flaws of the data.

ESG is not a passing fancy for the regulator but a regime change happening on a global scale. The same regulations are being pushed out in Europe and beyond. Inevitably, this will have an impact not just on climate disclosures, but cost of capital, asset flows, and therefore fundamental risks and returns not captured just by looking at history.

Change often happens via a slow evolutionary process, but ESG is a revolution on a large scale. Even if there are no immediate requirements for some investors, there is no excuse for complacency. One of the largest changes of the century is currently taking place and we all need to be prepared.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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