“Radical and Urgent Shift” Needed in Climate Scenarios – USS 

One of the largest pension funds in the UK has released details on four new climate scenarios developed in partnership with University of Exeter to better reflect real-world risks.

Universities Superannuation Scheme (USS), one of the largest pension funds in the UK, has said it feels a “false sense of security” with current climate scenario analysis, after it co-released a new report calling for a “radical and urgent shift” in the way they are conducted. 

The ‘No Time To Lose’ report outlines four new climate scenarios, developed by USS and University of Exeter, that “better reflect the real-world risks and opportunities that frame investment decision-making over the short and medium term”, such as extreme weather, geopolitics, financial markets, and technology.  

The new scenarios range from optimistic, with politics and economics working in harmony to drive rapid decarbonisation, to pessimistic, where a toxic political climate compounded by dysfunctional markets frustrates progress.  

Speaking to ESG Investor, Mirko Cardinale, Head of Investment Strategy and Advice, who leads USS’ climate scenario work, said it identified issues after doing its first climate scenario in 2022 under UK regulation which mandates that pension funds conduct them at least every three years.

“It sparked quite a lot of discussion between us [USS investment team], the investment committee and the board of trustees. We felt that there were some interesting findings, but also felt there was a lot that could have been done better.” 

According to Cardinale, while USS had “done quite extensive due diligence” to identify the best technology and provider for the analysis “there was quite a lot to be desired in terms of some simplifying assumptions”, such as long-term horizons and climate being isolated, rather than integrated with other macro drivers. 

The difference in projected returns across different climate scenarios, was not very large, he said, adding that this gave USS a “false sense of security” that even in the worst climate scenario, “we might only lose maybe 70 basis points per annum”. 

“The gap between the worst and the best global scenario felt overly precise, and perhaps potentially too optimistic,” he added.  

USS is now developing new scenarios with the University of Exeter after approaching the organisation. 

“[The University of Exeter] proposed a collaboration and we decided that it was a worthwhile initiative to come up together with a better framework that really addresses some of the shortcomings,” Cardinale said.  

The new climate scenarios will focus on including more shorter-term dynamics, geopolitics, development of new technologies, economic cycles and physical risks in detail, he said.  

“We want to really think about the narrative before thinking about putting precise numbers down, which obviously can be misleading if there are too many assumptions behind them.”  

Underestimation of financial risk  

In recent weeks there has been a groundswell of concern in the UK that current climate scenarios are not fit-for-purpose.  

Last week, The Pensions Regulator (TPR) published a blog from its Climate and Sustainability Lead Mark Hill discussing reports criticising the climate scenario analysis used by pension schemes.  

“These reports starkly highlight the limitations of current models and scenario analysis,” said Hill.

“They rightly question the validity of some published outcomes, which appear to seriously underestimate the financial risk from climate change and are at odds with the established earth and climate science.”  

The shortcomings with climate scenarios have been known for the past few years, according to Dr Nicola Ranger, Environmental Change Institute at the University of Oxford who is quoted in the USS/University of Exeter report.  

“We’ve long known that integrated assessment models do a poor job at representing the wide-ranging implications of climate change and severely underestimate the risks,” she said.  

“Yet, in the past few years, we’ve seen these become a mainstay in financial scenario analysis for climate change.” 

On why the such models continued to be used for scenarios, Cardinale said: “It may be because of the difficulty of the problem or trying to cut corners in scenarios by trying to find simplifying assumptions. In some ways, it is unavoidable because it’s impossible to model every possible uncertainty. But I think there is a balance to make between making assumptions and not taking the conclusion at face value.” 

Another issue, highlighted in the report, is policy makers and businesses approaching climate scenarios with conservatism and “political correctness”, making them reluctant to include subjective or controversial drivers of change such as migration or populist governments.  

Cardinale said: “If we think about the next five to ten years, there are some really important political events that will be key drivers for a certain type of climate transition such as the outcome of the Ukraine war and the presidential elections in the US.”

USS’ scenarios it has designed with the University of Exeter, describes what may happen if peace in Ukraine is achieved, or not, and what may happen with a Republican victory in the US, or if tensions with China continue, for example.  

The report also singles out climate scenarios from official body the Network for Greening the Financial System (NGFS) as having limitations for failing to capture key aspects of the real world.

“Official scenarios” are also critiqued in the report for being absent of asset pricing, when their output “somehow needs to be translated into the implications for asset prices using ‘expert judgement’”.   

USS did not draw upon NGFS climate scenarios for its previous climate scenarios analysis, although they are widely endorsed and used by regulators and central banks.  

Cardinale said there was an issue of some organisations using NGFS scenarios and taking the results at face value, as they were not designed by the NGFS for this use.  

“It’s a tool and if you understand its limitations, it is a tool that can be used.”   

In July, NGO Carbon Tracker released a report on the limitations of scenarios, illustrating potential flawed analysis from UK pension funds. It highlighted, for example, that Shropshire County Pension Fund had estimated that 2°C warming by 2100 would boost returns till 2030 by 0.05% per annum, while a trajectory leading to a 4°C increase by 2100 would only reduce annual returns to 2030 by 0.06% per annum in its 2020 TCFD report. The pension fund’s 2022 TCFD report changed the format for analysis, with the assumption of asset value of its portfolio modelled over 40 years under different scenarios.  

Shropshire Pension Fund used consultancy firm Mercer for both years to conduct its climate scenario analysis, which develops analysis built upon NGFS scenarios, with the key differentiating factor being the forward pricing-in stress tests. 

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