Why covenant assessment should be front and centre of your TCFD report
As we continue down the path of climate-related financial disclosures, it is crucial for pension schemes to embrace a more comprehensive and forward-thinking approach.
Climate in covenant is here to stay
Since I first started advising pension schemes on covenant nearly ten years ago, I have seen a real shift in how this potentially seismic risk to schemes is viewed. The world is waking up to the climate emergency and there’s increasing pressure on individuals and companies alike to drive change; it’s time for the world of pensions to catch up.
Every scheme will be affected to some extent. Some will see their sponsor’s entire business scrambling as changing policy rules make existing products redundant. Others could see significant asset value wiped overnight in a greenwashing scandal. But for many, it will be less overt - sponsors will most likely be balancing the cost of shifting to renewable energy and sustainable waste management with meeting demands for cash from the scheme, lenders and shareholders.
As engagement picks up pace and regulators increasingly focus on reporting, everyone is racing up the sustainability curve. When there’s so much new and changing information out there, it can be challenging to know what to do with it all.
Cutting through the noise - timing timing timing
Whilst we need to be alive to what risks are out there, it’s determining which ones are material and getting a sense of when they might bite - that’s when we can start to form a meaningful plan.
The Regulator’s Funding Code really reinforces this need. The length of journey plan and amount of investment return will now be reliant on an assessment of the prospects and resilience of the covenant. To give a view on a business’ prospects, timing is key. You need to understand what significant risks the covenant is facing and when those might crystalise, alongside any corresponding mitigating actions.
The world is changing so quickly, it’s very difficult to say precisely when a risk might materialise, but that doesn’t mean we need to sleepwalk over the precipice. If there are early warning signs, let’s identify them now and monitor them. Monitoring is a key aspect of a scheme’s risk management process, so why wouldn’t we include climate risk? An early warning system helps us protect cities from extreme weather events - it’s going to help us protect members’ benefits too.
What’s the strategy?
Let’s take a company fitting and replacing gas boilers that has a DB pension scheme. The scheme is looking to buy out by 2035 - what’s the key risk?
Current regulations point to no gas boilers in new homes from 2025 and a full phase out in all homes by 2035. Monitoring Government and regulatory announcements like the Energy Security Bill issued last year, annual future energy scenario modelling, and the upcoming ‘Future of Heating’ decision will give us an early idea of if and when those timelines might change. And if they don’t, we can start to visualise the impact - how the company’s revenues and the scheme’s ability to rely on the employer covenant could decline materially over the next 10 years. Understanding this means we can ask the all important funding questions around investment risk, cash needs and the ultimate end game strategy.
We are combining our climate, covenant and sector expertise with digital tools to do just this. We’re visualising the possible impact of covenant risks on the scheme’s journey plan and modelling how alternative strategies could influence members’ chances of getting their full benefits.
The climate problem isn’t going away and whilst we can’t say for certain exactly how the next few years are going to play out, it is time to make sure you cut through the noise and respond early to protect members' pensions.
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