Will Martindale, Group Head of Sustainability at Cardano, says trustees are enthusiastic in their embrace of TCFD, despite its shortcomings.
In a matter of days, more than 1,300 of the UK’s largest companies will be obliged to start disclosing financially material climate information in line with the recommendations set by Taskforce on Climate-related Disclosures (TCFD).
British businesses with over 500 employees and £500 million in turnover join pension funds with £5 billion or more in assets – and asset managers and insurers with a premium listing – in producing an annual report that explains how they are managing the risks and opportunities presented by climate change.
Speaking at the time the reporting requirements were announced, Energy and Climate Change Minister Greg Hands said: “If the UK is to meet our ambitious net zero commitments by 2050, we need our thriving financial system, including our largest businesses and investors, to put climate change at the heart of their activities and decision making.”
But there are those that believe the UK government’s decision to force investors to report under TCFD ahead of the companies in which they invest left pension funds – which started reporting last October – without the necessary data to quantify and reduce the climate risks in their portfolios.
Will Martindale, Group Head of Sustainability at fiduciary manager and pension provider Cardano, has been on the front-line helping pension funds to implement their disclosure requirements and says this has been made more challenging by a lack of data from investee companies, particularly on Scope 3 (supply chain) emissions.
“The data isn’t perfect but trustees understand and accept that, and it shouldn’t stop us going forward. However, we would like to see regulators either encourage or enforce the disclosure of Scope 3 emissions by companies,” he says.
Martindale shares an example he gives to clients of the importance of accessing emissions data across the supply chain.
“Take two car manufacturers, one making its own tyres while the other outsources to a tyre manufacturer. The one that makes its own tyres will have higher Scope 2 emissions than one that outsources, but obviously no cars are going to be sold without tyres. To properly compare companies, we do need to start seeing Scope 3 emissions that investors can rely on.”
The data challenges do not end there, particularly for those investing in what Martindale calls “hard-to-reach” asset classes, or with allocations to government debt.
He says: “There are still conversations around how to measure the carbon emissions of a country including emissions associated with private actors. There are challenges around disclosure for infrastructure; some private equity investments; and real estate investments particularly those outside of UK, Europe and North America. There’s not the quality of data that we’d like.”
He would also like to see greater consistency and transparency from the data and ratings provided to pension funds by third-party providers on whom they are highly reliant.
“While data quality is improving, and the research and analysis by these providers is high quality, the disclosures aren’t fully regulated yet. Pension schemes are a product taker and while we are doing our best to scrutinise those disclosures, it’s a challenge for a pension scheme portfolio that may have exposure to anything north of 500 different companies to verify the information they receive.”
Martindale notes that the Securities and Exchange Commission (SEC) is proposing to mandate US companies to report in line with the TCFD which would make the disclosures the “global norm”.
However, he adds: “It is six and a half years since signing the Paris climate agreement and the SEC proposals are still subject to consultation with the Republican Party opposed to the proposals. There will likely be further political wrangling.”
Sense of enthusiasm
Challenges notwithstanding, Martindale says Cardano’s clients have accepted the TCFD reporting requirements with “a sense of enthusiasm about understanding the risks and opportunities associated with climate change and doing so in a in an established and sophisticated way”.
When advising pension funds on compliance with TCFD he starts by establishing an internal governance framework.
“While it’s not strictly an obligation of the regulations, we have worked with clients in establishing a governance policy on what we call climate change risks and opportunities. This helps trustees decide who oversees education and resources, and how they delegate climate change decision making.”
Once governance is in place, the next step is to establish the possible global warming scenarios against which targets can be set.
The regulations require TCFD reports to include at least two scenarios for carbon equivalent analysis covering a 1.5 degree Celsius increase in global temperatures, which is aligned with the Paris Agreement, and a 2 degree increase which is considered more likely based on recent reports from the Intergovernmental Panel on Climate Change.
However, Martindale says Cardano encourages trustees to include a third, based on a 3 degree increase in temperature, which they call a “hot-house” scenario.
“Although we’re optimistic that that scenario is unlikely it does help give trustees a full breadth of understanding across different climate change scenarios.”
In terms of metrics to inform disclosures, Cardano uses enterprise value including cash (EVIC) which is the measure set out in the EU benchmarks.
EVIC identifies greenhouse gas emissions per market capitalisation of a company including debt at year end. No deductions of cash or cash equivalents are made to avoid the possibility of negative enterprise values.
Martindale says: “That metric allows us to aggregate pension funds’ equity and fixed income positions to give them a sense of their portfolio’s carbon footprint.”
Cardano is also looking at measuring pension schemes’ alignment to the Paris Agreement, a step suggested as part of the Department for Work and Pensions’ consultation into climate reporting last October.
Martindale says that recognition of the need for severe emissions cuts by 2030 may encourage pension funds to move beyond net zero 2050 targets.
“Once trustees start to consider target setting, it would seem logical to align with the Paris Agreement and set interim targets based on emissions reduction by 2030 from 2019 levels.
He continues: “The schemes we’ve been working with over the past few months have tended to adopt a 50% emissions reduction target by 2030 as part of their commitments to net zero by 2050.”
A sellers’ market
For asset owners to comply with TCFD there needs to be enough suitable investment vehicles. Mature defined benefit pension schemes that are part of a liability-driven investment strategy which relies on asset matching tend to lean towards fixed income.
Cardano favours sustainable bonds that “provide an efficient solution for pension funds looking to hedge interest rate risk across liabilities while investing sustainably”, says Martindale. “Investing in green bonds ensures that capital is supporting progress towards climate change targets. This is relevant both to UK pension funds considering their approach to TCFD target setting and for those in the EU hoping to obtain article 8 or 9 classification under the Sustainability Financial Disclosure Regulation (SFDR)”.
However, accessibility and liquidity remain relatively low for buyers, and Cardano reports “there is no doubt that the sustainable bond market, at least for now, remains a sellers’ market”.
Martindale says that while that picture is improving, it is incumbent on investors to use their stewardship power to influence behaviour across the investment universe and encourage greater issuance of sustainable bonds.
“We advise [clients] to be universal owners. They tend to have broad exposure to the economy as a whole and some of the biggest levers for change involve using their influence either through new capital allocations or through collaborative stewardship and policy engagement. This will encourage companies that have typically been high carbon and high polluting companies to change their business models and change their business model rapidly.”
He adds: “There are wider portfolio benefits in having lower carbon economies in which we can invest. We are starting to work on some ESG tilts in strategies to align with sustainability goals, improve sustainability reporting and that increase issuances of sustainable bonds.”
Playing catch up
While the UK gets to grips with TCFD, the government is planning the next set of disclosure requirements. Its proposed Sustainable Disclosure Requirements will cover a wider range of environmental risks and impacts, but will also include product-level labelling rules for green funds, similar to Europe’s SFDR.
Martindale says that while the EU should be applauded for pioneering labelling for ESG funds, the UK’s decision to create its own framework gives an opportunity introduce more flexibility that allows asset owners to invest in and engage with high carbon emitting companies as part of an ESG strategy.
He says: “It’s really important that the regulatory framework allows for allocations to high carbon companies, as long as there is a clear stewardship objective and that allocations are made on the grounds that the company is transitioning [to net zero] at a pace consistent with the Paris Agreement.”
Martindale adds: “That would give us the confidence in investing in a product that seeks to achieve positive change rather than simply divesting from high polluting companies.”
Cardano has recently appointed Sustainalytics to support its stewardship and engagement activities with an engagement overlay service for fiduciary and defined contribution clients, while schemes on an advisory-only basis able to opt in.
“Stewardship and engagement are still not fully understood within the investment community. There are additional stewardship activities we think are necessary within our portfolios and the broader economy which go beyond those provided by third party managers,” says Martindale.
Additional activities include engaging with a company when it contravenes an ‘established norm’, for example engaging in illegal deforestation, directly or through its supply chain. Sustainalytics will also undertake thematic engagement where the goal is not necessarily financial, but rather alignment with investor priorities.
“The goal with thematic engagement is about making an impact or being more sustainable. For example, we might ask Sustainalytics to engage with a company on low pay. There may be evidence that higher paid workforces are more productive, but that’s not necessarily our driving force here. We are approaching this from first principles that it is the right thing to pay a workforce enough to them to live and to feed their children.”
Whether on engagement or disclosure, Martindale says progress on sustainable investing can be described as “a lot done, more to do”.
“Our sustainability efforts will continue apace, because it is the right thing to do for investors, companies and the planet,” he adds.