USS Overhauls Approach to Scenario Analysis Amid “Significant Limitations” 

UK pension fund’s TCFD report outlines plans to refocus its methodologies to better identify tipping points, including more short-term focus and integration of macro factors. 

Universities Superannuation Scheme (USS), the largest pension fund in the UK, has stopped conducting climate scenario analysis after identifying “significant limitations”, and is collaborating with the University of Exeter to develop a new approach.  

All pension funds in the UK are mandated to conduct climate scenario analysis at least every three years under the Task Force on Climate-related Financial Disclosures (TCFD) framework, unless there are significant changes in either the scheme or the climate.  

USS undertook scenario analysis for its 2022 TCFD report, but in this year’s iteration it noted that the trustee board has decided to review the scheme’s approach.  

Speaking to ESG Investor, Innes McKeand, Head of Strategic Equities and Head of the Net Zero programme at USS, said it took the opportunity to “pause for thought” and try and address the problems it has identified with undertaking climate scenario analysis.  

McKeand said one issue with scenario modelling currently is that it predominantly focused on long-term horizons. “It involves so many layers of data and assumptions that there is the potential to miss things like tipping points.” 

A tipping point, McKeand explained, arises when many different factors come together or variables reach a position or situation where the effects “go hyperbolic”. 

The theory is often associated with the risks of climate change, but can also apply to social aspects, with a tipping point describing the point of no return in different environmental, ecological or social conditions. A culmination of small additional changes can reach a “tipping point” where there are irreversible consequences for human populations, ecosystems, and the climate system as a whole.  

There can be negative or positive tipping points such as pioneering renewable technology to tackle climate change becoming economically viable and technologically mature due to incremental changes such as supporting policy, investment interest and societal changes.  

McKeand said because current scenario models are typically long term there was a danger climate risks that may affect financial returns could look like they there were happening gradually, but crystallise very suddenly at a tipping point. 

“We are testing new approaches to scenarios and we are coming to the end of phase one of our work with the University of Exeter on this,” said McKeand. He said USS is exploring scenarios which were shorter term and more actionable. “It’s hard to make appropriate investment decisions with a climate scenario analysis which is so long-term. If they were more actionable, then we might be getting somewhere.” 

McKeand said the work with Exeter involves climate scientists, system modellers and economists focusing on weather systems and what the policy response might be depending on various outcomes. 

“These are more realistic modelling scenarios than we’ve used in the past,” he said. 

Typical climate scenarios model long-term climate outcomes, then imply impact on GDP, which then implies impacts to asset markets. “There’s a very long and loose chain of causation in that logic.” said McKeand.  

He said shorter time horizons would be better at capturing the economic impacts of policy or politics for example. 

USS, which was established in 1974, has 528,000 members at had total assets of around £75.5 billion ($96.1 billion) as of March 2023.

Tipping points and macro drivers 

Other issues with current climate scenarios, highlighted in USS’ TCFD report, included an excessive focus on precise measurement, their limited use as an allocation input and inadequate modelling of physical risks.  

Its work with the University of Exeter will attempt to build in climate tipping points into scenarios, and better integrate climate factors with other macro drivers.  

USS’ work comes as a growing number stakeholders are voicing concerns with climate scenarios.  

Last month, Carbon Tracker warned retirement savings were at risk from flawed scenarios used by pension funds, and the Institute and Faculty of Actuaries raised concerns that economic models currently used to underpin climate scenario modelling by financial institutions often fail to adequately reflect the magnitude of the threat posed by climate change to our planet and society. 

Carbon Tracker’s report also highlighted the long-term nature of climate scenarios, which stretch out as far as 2100. It also noted that some pension funds found overall risk to an investment portfolio would be acceptable in 2100 where a 4.3°C increase in global temperatures is expected. However, scientists argue a temperature rise of this nature represents an existential threat.  

McKeand acknowledged there will always be limitations to climate scenarios.  

“They don’t give you the answers. They inform you of some potential future outcomes but there is an awful lot of uncertainty because you can’t fully predict what will happen with the climate, never mind the economic impacts and the human responses, and then the impact on asset prices.” 

He also said many net zero plans assume benefits from unproven technologies, such as carbon capture and storage (CCUS) or hydrogen. 

“You are relying pretty much on unproven technology, and so unproven economics, in the outer years. I haven’t yet seen convincing economics on carbon capture and storage, for example.” 

Outcomes from USS’ collaboration with the University of Exeter on climate scenarios are expected to be published in by October this year.  

USS said to address climate change effectively, it is necessary to work collaboratively with other pension funds, institutional investors, and policymakers.  

McKeand said USS could work with other pension funds and policy makers on its implementation of new scenarios. According to its TCFD report, USS plans to make the outcomes of this work public, contributing to the debate and helping other funds to tackle the same issue. 

In related news, a new report released by the Economics of Energy Innovation and System Transition (EEIST) has warned that pension fund net zero transition plans are dramatically underestimating the risks and opportunities presented by climate change. The report, led by the University of Exeter, calls on pension funds and other asset owners to adopt “decision-useful climate scenarios” – using plausible real-world narratives to develop and implement bespoke transition plans.  

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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