We're delighted to feature this guest blog post from Michael Bushnell of Lincoln Pensions. Michael recently joined Simon Jones for an episode of our podcast Hymans Robertson On... where they discuss how climate risk can be considered when evaluating sponsor covenant. You can listen to the episode here.

Now over to Michael...

Employer covenant is the single largest credit exposure for many (if not all) defined benefit pension schemes; it is certainly the hardest to diversify away from, with residual exposure remaining for all but the best funded and hedged schemes.

Yet, the possible impact of climate change on these sponsors is routinely ignored by Trustees and advisers as they look to the long-term future of the schemes they support. Why is this? I see three clear reasons: because trustees do not know where to start in setting out the parameters of the problem; because the information needed to assess the problem is not available; and, because the problem seems too far in the future to warrant material focus.

The parameters of the problem

Complex problems can most readily be understood by breaking them down into addressable issues and comprehensible assumptions. The existing framework of information on the impact of climate change, which is largely split between 2 paragraphs of high-level description or 50 sides of detailed modelling, is simply not conducive to this process of breaking down the issues. 

However, there are some principles that should likely be followed in all cases. For each given employer covenant, the analysis of climate change impact needs to reflect a modern business’s interconnected nature and clearly sets out what regions, materials, companies and markets are critical in its operations. Broadly, information should be available to trustees, investors, management and other stakeholders to identify how those key ‘pinch points’ might be impacted by risks as climate changes and society responds.

At Lincoln Pensions, we illustrate this by distilling information into a world-wide ‘heat map’ which identifies key physical and transition risk areas for a given business under high warming and low warming scenarios. But to do this, we have to dig through significant amounts of third-party information and have built a bespoke model to identify risks, an approach which is not feasible for many.

Availability of Information

Given information is currently lacking or highly dispersed, information provision must be reformed if stakeholders are to effectively assess the exposure of companies to climate risk.

New information provision will help bring out new understanding and behaviours but driving this flow will require pressure from regulatory or legislative frameworks. Sadly, optional standards (which would be the preferred approach of many) are unlikely to make a material difference; who can be surprised that management teams do not want to be the first to disclose that they are highly exposed to a warming world? 

Without regulatory or legislative prescriptions in the right forms, the triple pressures of conformism (not being the nail that stands out), wilful-blindness (not wanting to confront the problem) and short-termism (not wanting to deal with things beyond the horizon) will likely lead to very limited and slow-moving change.

Proximity of climate risk

Viewing climate change as a ‘far-future’ problem is the most pernicious of the pressures on companies and stakeholders, leading those who are concerned to leave the problem to later generations, and giving an excuse to those wishing to do nothing.

However, we should not believe that a ‘shift’ in climate (a chronic change, like slowly hardening joints) cannot also encapsulate climate ‘shocks’ (acute change, like sudden, sharp pain in a knee one morning). 

The ‘shift’ in climate is the risk most often discussed, as it is the form that is revealed by models and temperature tracking over time; but ‘shocks’ (tail risks that are hard to capture through modelling) may also arise and materially alter the world in short order. These could take the form of inundation of land in the Netherlands, closed ports in southern China due to changed storm paths, or drought in Canada affecting grain production. The key is that they may not be foreseeable, and they need not arise on the timescales that modelling suggests. 

COVID-19 provides a parallel. Modelling may indicate risks (in this case of a global pandemic) sit ‘in the tail’ of probabilities, but this does not mean the risk cannot arise suddenly, and painfully.

The current pandemic also provides a warning, that in a world emerging from lockdown, we may forget our climate goals in the scramble to normalise. It is beholden on all stakeholders to keep pushing for the reductions in emissions, the new technologies and the new social norms that will be needed to keep the impact of climate change to the lowest level we can. And the best placed of all stakeholders to understand and influence this might be pension scheme trustees, with a very long-term obligation to members, ties to a single covenant, and a funding regime that guides funding now for risk that they see arising in the future.

To protect members and their benefits for the long term, trustees of all schemes should use their position to understand sponsors’ exposure to climate risk and their plans to adapt and, if trustees remain concerned, ask for funding to mitigate the risk like they would any other.