The environment and economic impacts of climate change pose many long-term challenges, and trustees and investors are likely to be exposed to many of the risks this global threat entails. In this whitepaper, Aon's investment experts discuss these risks and how investors can mitigate them.
The environment and economic impacts of climate change pose many long-term challenges, and trustees and investors are likely to be exposed to many of the risks this global threat entails. This includes risks related to the transition to a lower-carbon economy (transition risks) and risks related to the physical impacts of climate change (physical risks).
Trustees are facing increasing scrutiny and legislative pressures from regulatory boards regarding climate change.
In the UK, the Department for Work and Pensions announced that pension funds will need to expand their Statement of Investment Principles (SIP) by 1 October 2019 to show how they take account of financially material considerations, including climate change, over the appropriate time horizon for the scheme. The Pensions Regulator has also stated that trustees should assess financial materiality of Environmental, Social and Governance (ESG) factors, including climate change, as well as be familiar with manager stewardship policies and, where appropriate, engage.
Climate change scenarios
Pension schemes need to be prepared for the climate change hazards that lie ahead. Scenario analysis is an essential tool for understanding and navigating these risks successfully.
Our climate change scenario analysis helps pension scheme representatives understand the possible implications of climate change and prepare for the substantial risks and opportunities it poses.
Read our paper Climate Change Challenges here for more information on the climate change scenarios and their impact on funding risk and asset allocation.
The IPCC Reports
The Intergovernmental Panel on Climate Change (IPCC) published a report in October 2018 highlighting that urgent and unprecedented action is needed to limit global warming. The conclusion of the report is that it is still affordable and feasible to tackle the problem, but the action required lies at the most ambitious end of the pledges made in the 2015 Paris Agreement.
The report also warns even half a degree of warming beyond the threshold, to +2.0°C of warming, will significantly worsen the intensity of storms, forest fires, drought, floods and extreme heat.
Figure 1 illustrates some of the IPCC findings. It shows that the effects from climate change become more pronounced the further global temperatures rise above 1.5 °C.
What are the climate change risks to trustees?
The five main areas of climate change risk are:
Fiduciaries have a duty to take account of financially material environmental risks. Increasing legislation, policies and law suits relating to climate change are likely to add to financial and reputational risks.
There is a greater sense of global urgency, along with wider awareness around climate change, that has led to a new wave of litigation. To date, almost 1,000 climate change related court cases have been filed over 25 countries relating mainly to a failure of fiduciary care. Since 1997, there has been over a 20-fold increase in the number of climate change related policies and laws in place around the world. Growing public pressure on governments and companies to fulfil their commitments to the Paris Agreement and reduce greenhouse gas emissions mean that litigation risks are likely to grow.
This can arise from climate and weather-related events, such as heatwaves, droughts, floods, storms and sea levels rising. These events can potentially result in large financial losses, impairing asset values and the creditworthiness of borrowers.
The damaging effects of climate change are already evident with more erratic weather patterns, more severe weather events and greater environmental degradation. Major events during 2018 included:
- The UK saw some of its worst storms, such as Storm Callum and the ‘Beast from the East’ which caused property subsidence issues, as well as experienced a summer drought.
- The deadliest and most destructive wildfire ever recorded in California. This is the second year in a row that California has set a new record for wildfires.
- Torrential rains leading to catastrophic flooding across much of Japan.
- Mass flooding during the seasonal summer monsoon months in India’s Kerala.
- Prolonged summer drought conditions over much of Northern and Central Europe.
Read our Weather, Climate & Catastrophe Insight paper for further information here.
The impacts from physical risks, from higher global temperatures and extreme weather, can cause global supply chain disruptions or increase insurance costs. Increasing physical damage from climate change will naturally act as a drag on economies and impair market returns, as capital needs to be redirected to replace or repair assets. The broad-based drag on investment returns will make it more challenging for pension funds to meet their financial goals. Figure 2 illustrates the increase in average global economic losses due to weather events, as well as all other causes.
The shift towards a lower-carbon economy can cause political, technological and market changes.
The United Nation’s Principles for Responsible Investment (PRI) have recently reported that investors are not prepared for the implications of ‘inevitable policy responses (IPR)’ to climate change. Policies that make up the IPR can be split into four categories:
All of these contribute to large political, technological and market changes.
Changes in regulation requiring a shift away from fossil fuels and reduced greenhouse gas emissions will lead to a period of adjustment that will initially raise production costs due to more onerous green standards being imposed. In addition, new green technological innovation is likely to accelerate the replacement of older industrial technologies, raising the threat of stranded assets. Decreasing costs of ‘green’ technology and a growing certainty of long-term physical damage caused by climate change will drive this shift. Longer term, we expect the shift to a green economy to have tangible positive environmental and social impacts that spill over into stronger growth in a new green economy.
Changes in regulations could influence trustee decisionmaking. For example, future regulation may force pension funds to progressively reduce their exposure to carbon intensive assets. Aon’s climate change scenario analysis helps trustees consider the short, medium and long term risks posed by projecting both assets and liabilities.
Market mispricing risk
Environment related risks are often poorly understood and are regularly mispriced by markets. More frequent and severe climate events could eventually lead to market corrections that can reduce the profitability and viability of certain investments.
Risks are mispriced for two reasons:
- Capital markets are poor at pricing in externalities, especially when public goods, such as the environment, are involved. Consequently, firms do not have to meet the full cost of their production; instead some of the costs of emitting greenhouse gases are borne by society. While carbon pricing has been introduced in some countries, in an attempt to moderate this problem, there has still not been a comprehensive effort to properly measure and fully reflect the costs.
- Markets have a clear tendency to focus on short-term considerations rather than longterm trends, which leads to climate change risks being too heavily discounted.
A key risk is the creation of a “carbon bubble”, where carbon intensive assets are valued without taking the impact of climate change into consideration. More than two-thirds of today’s proven fossil fuel reserves cannot be used before 2050 if current climate change agreements and pledges are to be achieved. This has the potential to cause widespread investment write-downs, as current and future reserves of oil and gas are labelled “unburnable”, and the market begins to pro-actively re-price assets exposed to carbon or environmental risks. This will pose threats, as well as opportunities, depending on preparation for the market change.
This is the risk of death to humans caused by climate change.
The net effect on mortality depends on what horizon to look at. In the short term, there may be a decrease in mortality due to, for example, warmer winters. In the long term, however, there is increasing evidence showing that the negative impacts are likely to outweigh the positive.
The net effect on mortality depends on what horizon you look at. The World Health Organisation estimates that between 2030 and 2050, climate change is expected to cause 250,000 additional deaths each year around the world. The European Commission Joint Research Centre provides further evidence that an additional 152,000 people could die each year in Europe by 2100 as a result of climate change.
This increasing uncertainty causes difficulties for pension funds in estimating the longevity of their members and as a result, a further difficulty in estimating recovery plans and required investments.
Pressure on trustees to address these risks
The UK pension market faces increased pressures from the government, environmental organisations and activists to tackle climate change. Research conducted by Pinsent Masons in 2018 found that only 5% of the UK’s largest pension fund managers have a specific policy on climate change in place, despite 74% being aware of the risks climate change poses to pension funds.
A few of the key challenges posed to UK pension funds recently have been:
- The House of Commons Environmental Audit Select Committee (EAC) in 2018 asked the trustees of the 25 biggest UK pension schemes to explain how they manage the risks posed by climate change in their pension schemes.
- ClientEarth, a legal environmental campaign group who successfully sued the UK government over air pollution, wrote to the 14 pension schemes ranked “less engaged” by the EAC, telling them that their current failure to address climate change risks could result in litigation.
- The Institute and Faculty of Actuaries issued a risk alert to raise awareness around the financial risks posed by climate change. All actuaries, regardless of their industry, were asked to consider the implications of climate change on their work, actions and decision making. In their report, they state Aon’s climate change scenario modelling is “the most useful report published to date”.
Planning for the future
Pension schemes can help mitigate and adapt to climate change risks by taking steps to integrate responsible investment considerations into their investment strategies, potentially including climate aware investments.
To address the risks discussed in this paper, there are several steps that pension fund trustees can consider.
Here are a few we recommend:
- Define your beliefs in relation to climate change and its risks. - Undertaking a survey of individual stakeholder views is often an effective tool to reach a consensus on climate change objectives.
- Update your formal policy documents (SIP and Responsible Investment policy). - Various documentation is required by regulation, but a written policy is more likely to be followed in practice.
- Assess the risks and consider the potential impact on assets and pension scheme funding levels. - Climate change scenario analysis can help illustrate the possible impact on future outcomes for your pension fund.
- Review the investment strategy and consider adjusting the strategy to consider climate change metrics. - Produce green investment portfolios that are well positioned to take advantage of the transition to a low carbon economy, while mitigating the risks of ongoing climate change.
- Review and engage with your managers - It is important to ensure your investment managers are acting in a manner which is aligned with your beliefs and objectives.
Climate change is a clear existential threat which has an impact on pension funds’ return and risk outlook and funding levels. Aon’s Responsible Investing Team can help you assess the risks and act now to position for a more robust portfolio in the face of these risks.
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