With recent research critiquing some climate scenario analysis used by pension scheme trustees for their annual climate reports, Mark Hill, The Pensions Regulator’s Climate and Sustainability Lead, explains what trustees can do to drive change. In April our Executive Director, Nicola Parish, highlighted concerns over the integrity of some climate scenarios and urged trustees and their advisers to think carefully about the narratives they applied to the scenarios they used and the outcomes produced. |
By Mark Hill, Climate and Sustainability Lead, TPR Since then, we’ve seen scenario models and analysis used by trustees drawn into further question with comprehensive reports by the Institute and Faculty of Actuaries and Carbon Tracker, The Emperor’s New Climate Scenarios [PDF] and Loading the DICE Against Pensions respectively, together with several media articles. These reports starkly highlight the limitations of current models and scenario analysis. 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. But this doesn’t have to be seen as a bad thing, it’s a timely opportunity to take stock and look ahead.
First steps Many trustees are only just taking their first significant steps on their climate journey and our review of TCFD reports found several areas for improvement, including climate scenarios, as well as identifying emerging good practice. But while there’s been progress, data and analytical gaps and imperfect models seem to present considerable challenges. It’s time to take a step back. We need to collectively consider what needs to be done to address the shortcomings in the available models and approaches to scenario analysis if we are to create truly decision-useful climate scenarios. Something I’m aware is being looked at by the likes of the UK’s biggest private sector pension fund, the Universities Superannuation Scheme. Only in this way will practice evolve at the pace required, gaps close and a degree of consensus emerge around climate scenarios. Following the recent criticism and concern, it’s clear a degree of revolution, not evolution is needed. Trustees need effective tools and approaches to adequately identify and respond to risks (and opportunities) to avoid savers being left exposed. Starting now, we need to help a new consensus emerge.
Insight v complacency Unlike other models and approaches trustees are familiar with, such as longevity and asset-liability models, the range of uncertainty in climate change model outputs is extremely large. Intuitively, the relatively minor reduction in the returns expected under if global temperatures increased by 4°C that some reports suggested did not seem consistent with established science. Scientific consensus suggests there would be catastrophic biodiversity loss, the collapse of the insurance sector, increased migration and potentially resource wars. In such a scenario, it’s expected the period between cataclysmic events would reduce and economic and social ecosystems would collapse. The potential impact underscores the importance of global efforts to keep temperature increase well below 4°C, including the UK’s transition to net zero by 2050. Hence, it’s essential trustees appreciate this reality and feel confident to question and challenge their advisers and the output from climate scenario analysis. Is the financial analysis consistent with the science? What are the implications of the narratives behind the scenarios? How are tipping points and other non-linear changes accounted for?
No ‘tick-box’ compliance Decision-useful climate scenarios are a key part of this. It’s well understood there are limitations with some elements of data, analytics and modelling. It’s likely there always will be. However, the decision usefulness of outputs will improve as industry knowledge and understanding develops. That said, the window for action is narrowing rapidly. Future change is unlikely to be incremental and some changes, for example, market re-pricing, could happen rapidly. TPR is committed to supporting and helping trustees as collectively, we face this uncomfortable reality.
What trustees can do The challenge now is to ensure the models used and the scenario analysis addresses a fuller range of real-world risks and uncertainties. Recent events have shown how climate risks can crystallise, compound with other risks and cascade. There is an urgency to protect savers.
Trustees do not need to be climate experts, but should:
have an appropriate level of knowledge and understanding of climate issues
undertake regular training and ask for additional training if they do not feel comfortable making decisions based on the information provided regularly review the climate-related capabilities of service providers and consider the need for additional advisers or specialist input be able to understand the narratives underlying their climate scenarios, the limitations of those scenarios and the assumptions made in their construction broadly rationalise the outputs from those scenarios for their scheme consider with advisers the use of stress testing and tail risk analysis to complement their climate scenario input to investment strategy decision making In the years where trustees are not formally required to undertake scenario analysis, we expect them to review their most recent analysis and consider undertaking more, in the light of the recent developments TPR has highlighted. Triggers for new analysis include the availability of new or improved scenarios or modelling capabilities or a change in practice or trends. Where trustees do not undertake new analysis, they should explain why in their TCFD report. We also expect trustees and their advisers to be mindful of industry developments and good practice. Last summer we ran a webinar with the IMF Financial Sector Assessment Programme (FSAP) team who presented on climate stress analysis they carried out as part of the UK’s quinquennial FSAP review. The team’s approach was based on assessing the implications of a climate “Minsky Moment” – a market tipping point and collapse. This work was a pilot and included areas where further development was needed. However, the output was insightful of an additional approach that could be used to complement longer term analysis and inform actions.
TCFD reporting year two Many of those will have completed scenario analysis, using exploratory climate scenarios which have been challenged recently. Where trustees have already completed their scenario analysis but not finalised their TCFD report, it would be useful for members if trustees provided additional commentary in their report on the analysis they carried out and how they expect it to develop. Where they have finalised their report, they can record additional comments in their board minutes and make them available to members. In both instances, trustees should consider if additional analysis or action is needed.
Influencing the debate Climate change transcends disciplines and requires more joined-up thinking between finance and science. One of the aims in our climate change strategy was to influence debates around pensions and climate change. The recent papers have been helpful, and we’ll look to encourage more debate ahead of the Department for Work and Pensions’ review of the regulations this year.
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