Michael Bushnell, Managing Director at Cardano Advisory, explains how UK pension trustees can turn imperfect climate scenario analysis to their advantage.
The murmurings of UK pension scheme trustees and their advisors engaged in climate scenario analysis to meet their Task Force on Climate-related Disclosures (TCFD) reporting requirements has recently reached a crescendo, with critical reports on the benefits of partaking from groups such as the DC Investment Forum prompting a swift response by The Pensions Regulator (TPR).
It goes without saying that the requirement for trustees to understand the possible impact of climate risk means climate scenario analysis and TCFD reporting will not be going anywhere. With a fiduciary duty to ensure the long-term provision of member benefits, TPR has made it clear that the impact climate change can have on member benefit security is a critical area to get to grips with.
In the last couple of years many trustees have made great progress from a standing start. However, if climate scenario analysis is going to have an impact, it must also be meaningful. Critically, this centres on the need for data that is understandable and coherent in its findings; that is relevant to a scheme’s expected timescales and circumstances; and that drives practical improvement.
Understandable and coherent
Already, TPR has highlighted some principles which we know from experience can make scenario analysis more meaningful, promoting strong narratives and ensuring trustees understand the practical impacts of a scenario. When done correctly, covenant can be a great reference point for framing the climate scenarios:
- What is happening in practice in a world that is Paris aligned at 1.5°C warmer, 2.5°C or even 4°C?
- In these scenarios, how will life change and economies and businesses be impacted?
Through demonstrative scenarios and consideration of tail risk, volatility and uncertainty can be taken into account, enabling trustees to better visualise the practical impact on their covenant, assets and members.
Such scenarios don’t necessarily need to be complex new models, but instead can be relatively simple counterfactuals. An example could include what would happen if extreme weather severely impacted 10% of the scheme’s global equity or credit holdings in a given year, and the potential impact on scheme cashflow and journey plans.
Having considered the need for understandable and coherent data, let us now turn to the importance of it being relevant to the circumstances.
An immature scheme, or one expecting to run on, may well benefit from a 50-year or 100-year stochastic model of its assets and liabilities as a tool in strategic decision making.
In such cases, successful scenario analysis will measure the likelihood of achieving the scheme’s plans, allowing for uncertainty and trustee actions into the future. Where analysis of the covenant shows significant variation in possible outcomes and meaningful downside possibility, we must ask ourselves if it is reasonable to assume that these will be smoothed over in the scheme’s broader investment holdings or member liabilities.
Conversely, where a scheme has a high expectation of closing and passing liabilities to an insurer in the near term, a 50-year model is unlikely to be of practical use. However, it is easy for trustees to think there is no other option, leaving them to adopt a shallow ‘by the numbers’ approach.
Instead, trustees should consider options to support their longer-term modelling such as contingency planning or workshops addressing the exposure of covenant, assets, and liabilities to climate risk in the near term. Relevant questions should include:
- Is investment or covenant risk concentrated in specific regions?
- What would it take to disrupt the trustees’ plans? Is such an event plausible?
- Does one risk, such as asset values falling as markets price in increased capex, increase the exposure to another, such as lower affordability as a sponsor invests in new machinery?
While this requires a change in focus, the endpoint remains the same – an integrated assessment of the risks to the scheme from climate change over timescales relevant to the scheme.
Driving practical improvements
This leads us to the third requirement of good scenario analysis, driving practical improvements.
These should include improved understanding of real-world risks and correlation, practical ways to monitor both sponsors and markets for the emergence of such risks, a clear understanding of how the trustee would respond to risks, and concrete plans to mitigate risk in advance through changes in investment, hedging or funding strategy.
However, a ‘by-the-numbers’ approach to climate scenarios is less likely to drive these improvements, in much the same way that ‘one-size-fits-all’ clothing is less likely to be a good fit.
Trustees are best placed to know what good outcomes look like for their own schemes, when they are given the tools to do so. Instead of just more of the same, they should be seeking better tools from their advisors, many of whose professions have questioned the current approach. Trustees should also ensure they are willing to make the most of the output, embedding it in their strategy and governance.
In this way, trustees can turn imperfect climate scenario analysis to their advantage, as an opportunity to protect members and continue to lead the industry forward.