‘Net zero greenhouse gas emissions by 2050 or sooner’ is often associated with the Paris Agreement from the Conference of Parties (COP) 21 in 2015. ‘Net zero’ itself means emissions are at least equal to absorbing an equivalent amount from the atmosphere. Since 2015 the global momentum around climate change awareness, and commitments from different governments (including the UK) on what needs to be done, has grown exponentially. Governments, such as the UK, recognise climate change is an existential threat and that there is a moral case stemming from the UK’s history as a major contributor to greenhouse gases.

International Energy Agencies (IEA) Global Energy Review 2021 estimates that CO2 emissions will increase by 5% this year, despite a respite in 2020 due to COVID-19. And, with COP26 due in Glasgow in November (of which NatWest are proud sponsors), climate change and restricting emissions as soon as is feasible, remains a hot topic.

There are a number of initiatives and benchmarks focused on this goal. To name but a few:

• The United Nations-convened Net-Zero Asset Owner Alliance representing $6.6trillion of assets
• The United Nations-convened Net-Zero Banking Alliance representing $29trillion of assets
• ​Net Zero Asset Managers Initiative managing over $37trillion of assets (in aggregate)
• Soon to be launched Net-Zero Insurance Alliance from seven world leading insurers and reinsurers
• Paris Aligned Investment Initiative representing $34trillion in assets
• Ahead of COP26, Glasgow Financial Alliance for Net Zero (GFANZ), brings together over 160 firms (responsible for $70trillion) from net zero initiatives across the financial system
• Institutional Investors Group on Climate Change (IIGCC) who launched a ‘Net Zero Investment Framework’
• Climate Action 100+ who launched a Net-Zero Company Benchmark

Over the past few years pension schemes have been on a significant ‘ESG’ journey. From understanding ‘Governance’ which many see as core to existing fundamental credit analysis, to building on the ‘Environmental’ side in line with a number of initiatives and disclosure improvements, and ‘Social’ being the least developed but very much with a renewed focus; particularly given impacts relating to COVID-19 and previous investments in social housing and essential services such as hospitals. The ESG approach and reporting requirements have evolved over time and vary from negative to positive screens, to engagement and stewardship through to the ‘net zero’ debate and whether portfolios can meaningfully evidence this.

Whether an asset owner targets net zero by either 2035/2040/2050 etc., this is not expected to be a portfolio cliff edge adjustment, but more akin to a glide path over time. That said, it is unclear if there will be a future market ‘Minsky Moment‘ should pricing of non ESG-friendly assets collapse leaving future “stranded” assets (in a situation where ESG related externalities and risks were not adequately priced in).

For pension schemes, whether that means changing their approach from the bare minimum according to the regulations (which we explain here) or leading from the front of the pack, an increase in ESG and climate risk-specific integration remains top of agendas.

Whilst there is a growing number of pension schemes (including the Church of England and National Grid pension schemes) that have committed to cutting portfolio carbon emissions to net zero by 2050 or earlier, BT Pension Scheme’s public goal of achieving net-zero emissions across all three scopes of 1, 2 and 3 by 2035 is arguably the most ambitious.

Many UK defined benefit (DB) pension schemes have spent the last 24 months significantly improving their ESG-related portfolio level data, to allow for scenario analysis (per the regulation) and an increasing amount of scrutiny around how they can effectively decarbonise their portfolios.

In terms of recent pension regulation, 2019 saw UK pension schemes update their Statement of Investment Principles to include ESG considerations and stewardship policies, whilst 2020 saw focus on asset manager alignment and incentivisation relating to trustee investment policy (including ESG risks and performance). From 1 October 2021, implementation statements and online publication requirements apply. For DB schemes over £5bn in size, climate-specific scenario analysis and reporting on the risks of climate change to their investments is required by October, albeit reporting on Scope 3 emissions in the first scheme year won’t be required given the practical difficulties in doing so. With time, as more companies report their Scope 3 emissions, this will flow into the climate metrics to support evaluations.

There are a number of schemes that have committed a lot of resources to understand and take action on ESG risks however, in reality, the sheer volume of data and lack of consistency across asset classes stemming from different corporate disclosures and jurisdictions, remains a challenge. There are also a number of initiatives trying to help address this; from the Partnership for Carbon Accounting Financials (PCAF) which aims to measure a portfolio’s carbon emissions to the Science Based Targets initiative (SBTi) or Transition Pathway Initiative. Disclosure needs to increase, but in a more standardised or harmonised way.

Whilst the UK Government intends to make TCFD disclosures mandatory across the UK by 2025, pension schemes are one of the first. Simultaneously, the bottom up approach of companies reporting will feed into their analysis, highlighting the interdependent nature of ESG on many financial market participants. In addition to TCFD, a number of voluntary but important flagship initiatives such as the UN Principles for Responsible Investment Reporting and Assessment framework, to the Stewardship Code, require reporting but for slightly different metrics or different methodologies making it difficult to repurpose data. This has also led to schemes relying heavily on investment consultants and also needing to upskill teams/add specialist hires in this space.

Given this complexity, institutional investors are building out their ESG analysis, which goes beyond the ‘carbon numbers’ that will be incorporated when available.

Whilst it’s not new news that the quality of ESG data varies greatly, when thinking of ‘net zero’ targets as building on ESG related work and reporting, it remains a commendable target for pension schemes but one that is difficult to evidence. Whilst much of the above focuses on DB schemes, the same themes apply to defined contribution (DC) (including in relation to any DC default fund), albeit with marginally different timelines. There are also many different ways of achieving such a target, across scope 1, 2 and 3 emissions, and the extent to which carbon offsets are used – so the devil really is in the detail. In addition, it remains to be seen how pension schemes interpret the “as far as they are able” regulatory language caveat.

Whilst reputational risk is just one part of considering the extent to which a pension scheme will aim for net zero (either publicly or privately), the role of private sector capital in the UK’s ambition and path to net zero by 2050 will continue to be scrutinised.

Notes

[1] https://makemymoneymatter.co.uk/2021/06/02/the-worlds-first-net-zero-pension-summit/

[2] Pension Schemes Act 2021