Posted by Frances Lawson
Pension fund trustees and fund managers can no longer ignore the risk that climate change poses to their investments, particularly in the longer term. That was the conclusion of a high-level seminar this week to mark the two-year anniversary of the Law Commission report ‘Fiduciary Duties and Investment Intermediaries’.
The report found that many pension fund trustees and managers were under significant misapprehensions about their fiduciary duties and the extent to which the current law allows them to factor environmental, social and governance issues into their investment decisions. Subsequent research has revealed that similarly, many trustees and fund managers are both unaware of the extent of the risk that climate change may pose to their investment portfolio, and of their need to assess it.
Specifically, the Law Commission report found that many in the pensions sector believe their duty is to maximise returns in the short-term, and that the law does not permit them to look to longer-term horizons, nor to take account of “non-financial” considerations.
The legal duties on pension fund trustees derive from the trust deed itself, statute and the common law. The trust deed commonly states little more than that the purpose of the trust is to provide a pension, although there may be other express terms that trustees need to give effect to. The statutory duties are derived from the Pensions Act 1995 and the Occupational Pension Schemes (Investment) Regulations 2005.
The relevant provisions of the Pensions Act 1995 are as follows:
The ability to delegate the discretion over investment decisions to fund managers (section 34(2));
The requirement to take all such steps as are reasonable to ensure that, in the case of delegation, the fund manager a) has the appropriate knowledge and experience to manage the investments of the scheme, and b) is carrying out his work competently (section 34(4));
The inability of trustees to exclude or restrict liability for the actions of fund managers unless they have complied with the previous requirement (section 34(6));
The duty of trustees to have prepared, maintained and from time to time revised a statement of principles (SIP) governing investment decisions pertaining to the scheme (section 35). The SIP must include their policy on the following: a) the kinds of investments to be held; b) the balance between different kinds of investments; c) risk; d) the expected return on investments; and e) the realisation of investments.
The duty to have regard to the need for diversification of investments (section 36(2)(a));
The duty to have regard to the suitability of the scheme of investments proposed (section 36(2)(b));
The duty on trustees to obtain and consider proper advice on the question of whether the investment is satisfactory, having regard to the above duties and the principles in the SIP (section 36(3)).
The requirements under the Occupational Pension Schemes (Investment) Regulations 2005 are as follows:
The investment of scheme assets to be in the best interests of beneficiaries (reg 4(2));
The powers of investment to be exercised in a manner calculated to ensure the security, liquidity and quality and profitability of the portfolio as a whole (reg 4(3));
Scheme assets to be properly diversified (reg 4(7)).
As for the relevant common law duties, they can be summarised as follows:
Duty of impartiality between beneficiaries;
Duty to consider relevant considerations and ignore irrelevant considerations;
Duty not to fetter discretion;
Duty not to act under the dictation of another.
Climate risk is relevant to the exercise of trustees’ and fund managers’ duties in two key regards. First, the Paris Agreement and the objective of limiting warming to “well below” 2 degrees Celsius puts the international community firmly onto a low-carbon, non-fossil fuel pathway for the future. It is estimated that, in order to have any chance of meeting that objective, 60-80% of remaining fossil fuel reserves will need to remain underground. Even if carbon capture and storage technology is fully deployed (which does not even appear very likely), approximately 45% of reserves will still be “unburnable”. This makes the value of fossil fuels highly susceptible to significant losses in value in the years ahead. Consequently, continued investment of members’ money in fossil fuel extraction and related activities is risky and looks set to become ever more so.
The second respect in which climate risk is relevant to the exercise of trustees and fund managers duties relates to its systemic nature. Not only is climate change likely to wipe off much of the market value of fossil fuels, it is predicted also to have impacts across the whole economy at global and national levels, and therefore to affect the financial sector as a whole. Climate change-related weather events have already caused major losses in many regions of the world, and are likely to increase in frequency and gravity, affecting the economy and financial sectors across the globe. On a trajectory of 5 degrees of warming, losses are estimated at around US$7 trillion. Given that current estimates place the world on a 4-degree pathway, losses of this scale are entirely possible.
It follows that the contention that pension fund trustees and fund managers should not be considering and assessing climate risk is unsustainable in law, and is premised on an unadapted and narrow interpretation of the legal duties above. Specifically, the duty to obtain specialist advice requires trustees to obtain advice as regards climate risk given the wealth of evidence that climate change poses such a risk, and particularly given the dearth of knowledge in the sector about it. The fact of climate change posing a risk to the financial sector means that it must be considered as part of the SIP. The duty to act impartially as between beneficiaries requires trustees to give equal importance to the long-term needs of younger beneficiaries who will require their pension in 30-40 years’ time, as they do to older beneficiaries whose retirement will be far sooner. This is because climate risk is of a far greater threat to the investments of younger beneficiaries. Research indicates that pension fund trustees and managers are often excessively focussed on maximising short-term returns.
The requirement of prudence in trustees’ duty of care, meanwhile, and the standard of care being that of the ordinary man, also call for consideration of climate risk. This is because arguably, the ordinary man will tend to take a longer-term view in respect of investment decisions, and will consider a wider range of factors than if the standard was of the ordinary businessman. The duty of trustees to retain oversight of fund managers’ activities, and not to act under the dictation of another, requires the former to ensure the latter is considering climate risk, and doing so adequately.
At present, much of the pensions sector is “behind the curve” when it comes to factoring climate risk into their pension decisions. Although the English judiciary is, by nature, conservative, it is foreseeable that in the next ten years, a pension fund portfolio could lose money due to a failure to consider climate risk, and that a legal case could be brought against trustees and/or fund managers for their failure to adequately consider this. Considering climate change in the investment chain is therefore not about taking a risk; it is an essential means for trustees and fund managers to cover their backs and avoid a risk of being found liable for losses to the fund that could have been prevented.
You can keep up-to-date with all updates by following @6pumpcourt on Twitter.