Julius Pursaill says aspects of the 2021 climate change regulations and guidance have not helped the pensions industry
We should all warmly welcome the Department for Work and Pensions (DWP) minister Viscount Younger’s statement to the Lords on 24 April confirming a post-implementation review of the 2021 climate change regulations.
In particular, the statement's acknowledgment that current models suffer from material limitations and need development to ensure they are decision-useful is a move in the right direction.
Cushon has said for some time that official scenarios and the modelling based upon them are not decision-useful.
We believe that aspects of the regulations and guidance have not helped the pensions industry, or the beneficiaries whose savings we steward. Indeed, we believe they create a risk of material customer detriment, so we look forward to contributing to the discussion which will help deliver the DWP review.
What do we hope for from this review?
First, that the gap between the predictions of integrated assessment models and the predictions of climate scientists on the scale of impacts on GDP and asset values will be closed. When fiduciaries are told that the financial impacts of climate change will be modest, is it any wonder that investment strategies remain largely unchanged as a result? The upside (in terms of reduced risk or increased return) is inevitably modest and the potential short term opportunity costs loom large in proportion as a consequence.
A more realistic view of the likely impact of climate change on asset values will arguably lead to material changes in investment strategy, both to mitigate downside risks but also to capture investment upside.
Is the modelling gap too large to comfortably close?
While the closing of the gap will indeed prove uncomfortable for many fiduciaries (and their advisers), there are signs that economic models are themselves moving to close it. A recent paper from a Harvard economist predicts GDP damage of 12% at 1 degree of warming by basing a damage function on global temperatures rather than local temperatures. Tipping points and feedback loops are still not embedded in the modelling, so we clearly need to go further.
Second, that modelling actually produces decision useful scenarios. Much of the relevant impact is likely to be felt at sector and position level, albeit with geography playing an important role. While geographic impacts may lead to asset allocation changes, the most decision useful output is likely to cover the impact of transition and physical risks on sector and position level exposures. This will require multiple methodologies to capture transition risks and detailed location data (including that of the supply chain) overlaid with geography-specific climate stresses like water scarcity, extreme heat and hurricanes to capture physical risks.
Third, depending on what scenarios are considered most likely by trustees, we would hope to see carefully considered risk mitigating investment strategies emerge.
Take two obvious scenarios, likely to be of interest to trustees: a successful transition to 1.5 degrees of warming and a delayed and disorderly transition to between 2.5 and 3 degrees of warming.
In the first scenario, one might hope to see exposure change to reflect that successful transition – exposure to renewable energy, to supportive technologies and to natural capital. Careful thought will have been given to stranded asset risks.
In the second scenario, one might expect to see exposures to climate adaptation assets like flood defence being added, alongside protection against the inevitable inflation that supply chain disruption will cause, protection from the most serious physical risks of climate change and, again, exposure to natural capital assets.
How trustees choose to create exposure to opportunity and mitigate downside exposure will depend upon which scenarios (or combination of scenarios) they think are most likely. There is no single "all-weather" portfolio that will deliver portfolio resilience under very different scenarios.
Most of all we hope that decision-useful scenario analysis reveals to policymakers that they cannot rely on private sector capital alone to drive a successful transition. Unless fiduciaries are convinced that a successful transition is a likely scenario, they may prove unwilling to allocate to transition assets. Only a sufficiently supportive policy framework will convince them and ensure private sector capital swings behind a successful transition.
In the absence of credible model outputs and decision-useful scenarios to review, fiduciaries are inevitably left without any pressing reasons to take action and no clear roadmap to follow to mitigate any risks they may suspect lie in their portfolios. As we see the impact of climate change on the economy on an almost daily basis, whether that be inflation impacts of failed harvest, or European shipping delays caused by flooding, or the halting of production caused by water scarcity in China, this review cannot come quickly enough.
Julius Pursaill is strategic adviser at Cushon
