Episode 1: What should pension schemes be doing about ESG?

Episode 1: Transcript

Raj Mody:

Welcome to this first ever episode of PensionsCast. This is a new podcast from PwC, focused on a wide variety of pension issues. In this one, we will be talking about the new climate change requirements for pension schemes. I’m Raj Mody, and I am your host. I am a pensions partner at PwC.

We are, by now, all aware of the risk that climate change presents, we've seen some very bold statements like “it is unequivocal that human influence has warmed the atmosphere, ocean and land”. And we've had the UN Secretary General talk about a “code red” for humanity.

Well, what does this all have to do with pension schemes? As one of the largest investor groups in the UK, they obviously need to consider their approach to ESG issues and in any case, unsurprisingly, legislation has come to force them to do that. I am delighted to be joined today here in our virtual studio with Liz Ramsaran, and Patrick Iddison from the PwC pensions team. Liz is a solicitor, and Patrick, an actuary.

Liz, let's start with you, could you please talk us through the new climate-related requirements for pension schemes and what exactly it means in practice?

Liz Ramsaran:

Thanks Raj. This year we've seen perhaps the world's biggest step towards dealing with climate change and pensions. The UK is the first major economy to introduce climate disclosures and reporting requirements for pension schemes, and these have applied to the largest schemes since October 2021 and will apply to smaller schemes soon enough.

Under The Pensions Regulator’s Combined Code, which is expected to come into force in summer 2022, the majority of schemes will need to factor ESG, including stewardship considerations, into their governance and in particular, the new governance requirements of the own risk assessment and effective systems of governance that schemes will have to comply with.

There are also increasing calls from lobbyists and parliament on trustees to set net zero targets and the Work and Pensions Committee has recommended that the Pensions Regulator provides guidance on net zero alignment for trustees, but it's just worth bearing in mind that there are significant legal barriers for trustees in considering ESG, and that's particularly in light of their fiduciary duties.

Raj:

Well, we will definitely come back to that legal barrier issue, but I am taking away from what you've said that there are a lot of different parties involved in this agenda and they are all coming at it with their own angle. That leaves people responsible for running pension schemes with quite a lot to digest. So, how is that actually going, Patrick? What are your thoughts on that?

Patrick Iddison:

Hi Raj, we are seeing a lot of trustees, and some trustee advisors as well, actually struggling with these requirements. One common issue is around scenario analysis. The scenarios have been set out in a lot of detail in the reporting requirements, but trustees really need to spend the time to understand these requirements, understand these scenarios, and think about how the implications of rising temperatures, rising sea levels, all these things that, frankly, we're very worried about, what the impact will be on their own schemes.

Part of that is that sustainability has become a profession in its own right and there’s climate change specialists, who can work with trustees and work with trustees’ existing advisors to prepare them for these reporting requirements. It's not to say that it's like a tick box exercise or anything that can be wrapped up in a matter of days or weeks.

We feel that it's a two to three year journey for full implementation of the Task Force's recommendations and putting in place a credible commitment to net zero. It doesn't sound great, but the good news is, these aren't new issues. There are other industries which have gone through these changes before, and are going through them now. With pensions, the timescales are a bit more accelerated, but these experiences of other industries will really help trustees and their sponsors in facing this challenge.

Raj:

It's a good point you make, Patrick, in terms of the fact that we've got more than 25 COP events behind us, but it's only relatively recently, as Liz was saying earlier, that ESG issues, in a formal way, have hit the pensions agenda. Liz, just coming back in, Patrick has talked about the challenges that go with trying to get your head around all the different scenarios that have to be computed, what are the other challenges that you're seeing trustees and sponsors face?

Liz:

Thanks Raj. The main thing that we're hearing from trustees is really the role of asset managers and also concerns around their fiduciary duties. One of the big issues trustees are also having is data. There is a slight issue that there's not a consistently held understanding of what key terms in ESG actually mean, and as a result data that is being passed through to trustees isn't really consistent, and that then has an impact, because it means trustees aren't able to carry out the metric testing and the scenario analysis with any sort of clear degree of certainty, or consistency.

There's also a bit of a concern within the financial services industry that some providers are “greenwashing” investment portfolios, which perhaps looks good on the face of it, but isn't actually helpful to the net zero journey. What we are seeing is increasing calls for green taxonomy, a common framework for determining which activities can actually be defined as environmentally sustainable, as well as better quality of data in order to carry out that scenario analysis and metric testing.

Over the next two years, we are expecting to see more clarity, we are expecting to see that from Europe and within the UK. And what we are also seeing is the whole financial services sector really starting to align with the taskforce for climate and financial disclosures. That consistency will really help schemes in terms of meeting their reporting obligations and their journey towards net zero.

Raj:

Yes, but I suppose when you put all of that together, you've got the pensions industry having to tackle issues around data, as you've said, issues around greenwashing and what ESG compliance actually means in practice, and all of those points mentioned earlier around getting their heads around the scenarios.

I've heard a number of pension scheme managers say, ‘well, this is not necessarily something that we, the pension scheme managers, should be focusing on, this should be up to the investment industry, and the asset managers themselves, to resolve.’ Patrick, is that a fair stance to take?

Patrick:

It's reasonable, I think I get where that viewpoint is coming from, and a lot of trustees that manage schemes, who are not yet subject to the reporting requirements, are expecting they can rely on the asset managers to adjust their approach in the future, and then those trustees will just follow suit. And that's fine, where there's a limited budget or a reluctance to start a detailed project on ESG, but it does come with the potential flaw that many schemes, as you know, will have very diverse portfolios, and various different asset classes so the trustees do need to form their own views, and their own ambitions, on climate.

We don't expect, though, that in the short term, all asset managers will report on ESG in the same way, that's another thing that trustees need to look out for, and there will still be work to be done once all information has been received.

Finally, I'd say that trustees really need to consider all of the risks and opportunities relating to ESG, not just passing it over to the asset managers. That requires consideration of wider governance issues and also looking at the impact that ESG factors will have on the strength of the sponsor’s covenant.

Raj:

Right, and that brings us neatly back to the previous point actually about their legal responsibilities. Let's just try and tackle that one, and Liz, I'll bring you in on this. So you do hear a school of thought that says, particularly from pension scheme managers, that we get these ESG issues, but you hear trustees saying, ‘but I've got a wider responsibility, a fiduciary responsibility, really simply just to pay the members benefits as they fall due, and maximise the return on the asset portfolio, and that's that’. So how does ESG fit in, can you square that off for us?

Liz:

I can try Raj! I think it's a fair comment and we are seeing this, as you say, quite a lot from trustees, that they are seeing their fiduciary duty, which is broadly to act in the best financial interests of members, can be at odds with taking into account ESG factors. I think a lot of this comes from previously-held beliefs that ESG was very much a non-financial factor, and generally the rules are that trustees can consider financial factors, but are only able to consider non-financial factors in very limited circumstances. And from that trustees have started to form the view that it's very challenging to think about climate and ESG more generally. I think though we have moved away from that, when you look at the body of evidence around the financial impact of climate.

And in particular there are transitional risks that trustees need to bear in mind, as well as physical risks, and also remember there are opportunities here as well. So when we think about looking at financial interests of members, it's a bit more nuanced than that simplistic view we are hearing, and in particular, it's not just looking at returns, but it's also looking at balancing risk. That's always been the case, because if we weren't able to balance risk, schemes wouldn't have been able to hedge effectively. As we know a large majority of schemes do use hedging as part of their investment strategy.

So when we’re considering ESG, it is actually within trustees’ fiduciary duties to consider the risks presented by climate. And if they don't do that, I think there's a real question as to whether they're complying with their fiduciary duties at all.

Raj:

That's a really neat way of bringing it together, that you're saying essentially that you've got this overall duty, and although ESG has been called out as a topic within that, it's really part and parcel of your overall duty, accepting that there are some specific ESG requirements that are now on the table and disclosures you've got to meet, but I like the way you brought that together. Thank you very much for that.

Patrick, I am just going to bring you in on one final question, which is that for this episode so far, we've been talking about the institutional situation for defined benefit schemes. We haven't really looked at it through the lens yet for defined contribution schemes and what individual members of those schemes are doing and what they think about ESG issues. Do you have a take on that topic?

Patrick:

We are seeing a lot of DC members really applying pressure to their pension schemes. We are seeing pressure from all factors, be that social, be that environmental, be that governance. On the other hand, we are also seeing the trustees of DC schemes and the employers reaching out to members, being proactive and trying to present them with fund options that align with their beliefs, and give them a wide range of choice so that ESG factors can be presented to members.

It is for the same reason that Liz was mentioning earlier, there is a fiduciary duty for these trustees, but even when there's not trustees, even when it's a Group Pension Plan, employers are considering ESG comprehensively and a lot of that has to do with the commitments that the business as a whole is making. These firms want to make sure that the pension scheme is in line with that as well, and there's not a big disconnect there.

Looking at the ‘social’ in ESG, we see a lot of DC funds that can be tailored to members’ own beliefs. A really interesting example we're seeing coming onto the market is pension funds that are in compliance with Sharia law. Another thing we're seeing that's really the market adapting to what members are demanding, is funds which exclude investment in certain industries.

Raj:

It's obvious that this is coming to both defined contribution and defined benefit schemes, like it or not. But we've covered a lot of ground there, so let's wrap up now.

That draws us to the close of this first episode of PensionsCast. Thank you so much, Liz and Patrick, for a wide ranging discussion and thank you to our listeners for tuning in. Please do get in touch with any of us, if you have any questions or comments, or would like to discuss any of the content further.

Finally, don't forget to subscribe to what will be a series of podcasts, so you can keep up to date with future episodes.

Thank you very much everyone. Please tune in again soon.

Participants

• Raj Mody
• Liz Ramsaran
• Patrick Iddison