While climate change may have been considered in LGPS funds’ investment strategies for some time, climate risk is something that LGPS funds will have to consider in their covenant assessment and funding strategies too. As the government introduces measures embedding climate change into pensions’ law, we take a look at what’s coming next for the LGPS and what we can do to prepare. |
By Nicola Tait FFA, Associate and Actuary and Melanie Durrant FIA CERA, Principal and Actuary at Barnett Waddingham
What's coming? TCFD is primarily about governance. It also covers risk management and strategy, along with scenario analysis and metrics. With a range of potential climate scenarios and highly complex impacts reaching far into the future, implementing the new framework isn’t going to be straightforward, but the LGPS is well placed to meet the TCFD challenge. Although we are aware that some funds have started the journey to develop plans to quantify and address the risks of climate change as well as capitalise on the opportunities of the transition to net zero, there is a long way to go. The process of carrying out climate change reporting should lead to better-informed decision making on climate risks, while improved transparency throughout the investment chain (as companies and asset managers are also required to meet TCFD recommendations) should improve accountability and provide useful information to Pension Committees when making decision as investors. Ultimately, it will enable funds to demonstrate their journey to net zero. The Ministry of Housing, Communities and Local Government (MHCLG) is expecting to consult on proposed changes to the LGPS Regulations to bring in TCFD requirements soon. Their aim is for any new requirements for the LGPS to come into effect from 2022/23. It is expected that the proposed changes will take a similar direction to those made by the Department for Work and Pensions (DWP) in the private sector, but the consultation will enable stakeholders to help shape the framework for the LGPS. The Pensions Regulator has already published draft guidance on governance and reporting of climate-related risks and opportunities which they suggest decision makers at LGPS funds may wish to follow to improve the governance and resilience of their funds in relation to climate change, although it’s not yet law. This is helpful as funds begin to navigate their way through the new requirements.
Investment strategy
Funding
Discount rate However, climate risk is complex and whilst it is easy to imagine the various ways that climate change could impact an energy company, for example, it becomes less clear with other companies (such as those in the service or healthcare sectors). If the market cannot anticipate or agree on the impact, then it’s unlikely this will be priced in to today’s market value or return expectation – in particular where investors’ timeframes vary.
Long-term inflation As is the case for the discount rate, however, if the inflationary impact of climate risk is not being priced into the bonds in the market then this will have a knock-on effect on our inflation assumption – the impact of which is, again, unknown.
Longevity For example, it’s possible that in the UK, longevity might actually improve due to climate change. If winters are milder in future then that could mean fewer deaths. On the other hand, if our summers get too hot then that might not count for much.
Scenario analysis
a measured, orderly transition to a low carbon economy; We will be reviewing the MHCLG consultation to see what requirements are proposed for the LGPS and responding accordingly, so that we can best support you. In the meantime, however, we are already developing modelling tools as part of the 2022 valuation process, to allow us to consider these and other scenarios so we can help funds gauge the potential impact on their assets and liabilities. It makes sense to consider any scenarios as part of the triennial valuation process, and so we hope to see the MHCLG consultation soon. For some of our funds we are already working with the investment advisers to test climate risk as part of the investment strategy review in the lead up to the 2022 actuarial valuation. This may be based on the scenarios listed above, or alternatively we are able to run a stochastic model to simulate many different possible future outcomes.
Covenant Some areas are at greater risk of flooding and extreme weather events than others, affecting funds as a whole. Or local authority budgets may be affected by non-pensions issues surrounding climate change. This will all have an impact on covenant: how able and willing employers are to pay contributions to the fund. This should be considered and can be factored into the triennial valuation by means of the prudence allowance in the discount rate, or in some other way.
Governance and disclosure We understand there will be an aim for consistency in reporting across all funds and, based on the TCFD requirements, these are likely to cover:
describing risks, opportunities and impacts over the short, medium and long term
Next steps In the absence of the updated Regulations, there may be reluctance for funds to go too far at this stage. However, regulations or not, these risks exist and are something all funds should have on their radar and many will already be considering as part of the review of their investment and funding strategies. We expect MHCLG to consult on draft regulations soon, and we anticipate a similar approach to that taken by DWP, with the exception that it will apply to all LGPS Funds from the start irrespective of size. Due to the tight timeframes, we hope that there will be some initial flexibilities as funds get to grips with the new framework. We will therefore be well placed to support you in meeting the requirements. Additionally, BW are members of the cross-industry Pensions Climate Risk Industry Group (PCRIG) that has published guidance for pension schemes on how they can adopt the TCFD recommendations on climate governance and disclosure. We will, of course, keep you updated as and when further detail is provided for the LGPS. In the meantime, we are preparing to provide scenario modelling for funds before or as part of the 2022 valuation, should it be required. |
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