OUT-LAW ANALYSIS 8 min. read
05 Mar 2024, 10:37 am
UK pension scheme trustees should review how they undertake scenario analysis to ensure that their approach is sufficiently robust to enable them to align their investment strategies with their duties on climate risk and investing in climate action.
This is an essential issue not just for master trusts and large defined benefit schemes, but for all pensions schemes, including smaller ones that aren’t de-risked.
Scenario analysis is a valuable approach for assessing the potential outcomes of complex risks and opportunities. Unlike sensitivity analysis or stress tests, which typically focus on isolated variables or extreme conditions, scenario analysis takes a holistic view by examining how significant risks and opportunities could unfold over time. Each scenario has a specific narrative, providing context and depth to the analysis.
It is essential to understand that scenarios are not predictions. Instead, they are intentionally constructed to be plausible while diverging from conventional assumptions about business-as-usual trajectories. By envisioning and exploring alternative future paths, scenario analysis allows decision makers, regulators, beneficiaries and other stakeholders to gain a nuanced understanding of the diverse range of possibilities and the potential impact.
Scenario analysis also offers more than just a quantitative assessment of potential outcomes: it provides qualitative insights into the underlying drivers and dynamics shaping each scenario. This qualitative dimension enables decision makers to grasp the intricacies and implications of complex risks and opportunities, discerning subtle shifts and interdependencies that may not be captured by traditional analytical methods.
By immersing themselves in a spectrum of plausible scenarios, investors and other stakeholders can better anticipate uncertainties and develop robust strategies to prepare for transition and business transformation. Scenario analysis serves as a powerful tool for enhancing strategic planning, risk management and decision-making processes, empowering organisations to adapt and thrive in an ever-changing environment.
The Taskforce on Climate-related Financial Disclosures (TCFD) recommends using climate scenario analysis to explore a range of climate-related outcomes and analyse their financial impact in a structured manner, helping consider potential responses to different future states. In recent years, there has been a global movement where these recommendations have been translated into regulation, driving wider adoption by financial institutions.
By adopting [the Climate Financial Risk Forum’s] three-step approach and integrating climate scenario analysis into their risk management frameworks, financial institutions in the UK can enhance their capacity to identify, assess, and manage climate-related financial risks effectively
In the UK, the Financial Conduct Authority (FCA), under its Environmental Social Governance (ESG) Sourcebook, requires the pension providers it regulates to make annual disclosures consistent with the TCFD recommendations at both entity and product levels. In this regard, pension providers must, among other things, explain their approach to climate-related scenario analysis, providing quantitative examples where feasible, and illustrating how this analysis informs investment and risk decision-making. Product-level reports must also contain information such as the provider’s exposure to carbon-intensive sectors and the quantitative impact of climate change on assets across various scenarios.
The Occupational Pension Schemes (OPS) Climate Change and Governance Reporting Regulations in the UK also impose obligations on trustees of certain pension schemes to ensure effective governance concerning climate change. Such schemes include:
Trustees of these schemes must identify, assess and manage climate-related risks and opportunities, incorporating climate scenario analysis, and report in line with TCFD recommendations.
Trustees must conduct scenario analysis in the first year they are subject to the reporting regulations, and then every three years thereafter. During the intervening years, trustees must also annually assess whether it is necessary to carry out new scenario analysis to ensure they still have a current understanding of significant climate-related impacts on the scheme’s assets and liabilities. This assessment includes evaluating the resilience of the scheme’s investment and funding strategy under various scenarios.
If trustees determine that changes to a scheme's investment strategy, for instance, have not affected their understanding of these impacts and the resilience of the strategy, they are not required to conduct climate scenario analysis for that scheme year. However, trustees must provide a rationale for this decision in their TCFD report. If it is decided that conducting climate scenario analysis is necessary, guidance from the Department for Work and Pensions suggests that this interim assessment could be based on qualitative scenarios, or limited to higher-risk sectors or asset classes.
The adoption of climate scenario analysis is not solely driven by regulatory mandates – financial institutions increasingly recognise its value in strategic decision making. For pension schemes, it aids in fulfilling fiduciary duties by proactively managing long-term investment risks and opportunities associated with climate change and supports informed capital allocation.
As climate-related risk management practice evolves and capacity builds, regulatory disclosure requirements and stakeholder expectations are expected to tighten. Pension schemes and trustees must stay abreast of these expectations, enhancing their understanding of climate scenarios and the challenges associated with conducting scenario analysis.
The Bank of England’s Climate Financial Risk Forum offers practical guidance on how to use scenario analysis to assess climate-related financial risks to inform strategic and business decision-making. This work emphasises that scenario analysis is a dynamic, iterative and circular process that should be integrated into existing risk management frameworks to guide a robust strategic response to material climate-related risks and opportunities.
The approach to climate-related scenario analysis advocated by the Climate Financial Risk Forum can be broken down into three steps:
This initial stage involves identifying potential exposures to climate-related risks, building upon a materiality assessment. Financial institutions must pinpoint areas within their operations, investments and supply chains most vulnerable to climate-related impacts, encompassing both physical risks like extreme weather events and transition risks arising from policy shifts, technological advancements, and changing market preferences.
Following identification, financial institutions should develop scenarios to assess a range of potential outcomes. These scenarios may include reference scenarios based on established climate models or tailored scenarios reflecting specific regional or sectoral characteristics. Institutions can begin by posing 'what if?' questions to explore the potential implications of different climate-related scenarios on their business activities.
The final step involves evaluating exposure and financial impact under different scenarios. This assessment enables institutions to quantify potential losses or opportunities associated with climate-related risks, devising suitable risk mitigation strategies. By considering a variety of scenarios, institutions can better grasp the uncertainty surrounding climate-related risks, making more informed decisions to safeguard their financial stability and resilience.
By adopting this three-step approach and integrating climate scenario analysis into their risk management frameworks, financial institutions in the UK can enhance their capacity to identify, assess, and manage climate-related financial risks effectively.
Institutions across the financial sector, including large pension schemes, are making strides to enhance their capability to assess and tackle climate-related risks and opportunities. However, recent publications – including a blog by the Pensions Regulator, article by the Financial Times, and research by the Institute and Faculty of Actuaries – have brought to light several challenges and reservations regarding prevailing approaches to climate scenario analysis:
Firstly, there is a notable issue with understating risk due to the inherent uncertainty in predicting the pace of climate change. Certain climate scenario analysis frameworks have drawn criticism for their uniformity and tendency to offer an overly optimistic outlook on economic impacts across different scenarios. This discrepancy could potentially lead to a misrepresentation of the true extent of risks associated with climate change, leaving institutions inadequately prepared to address them.
Additionally, there is a persistent gap between climate science and economic and financial models, hindering a comprehensive understanding of the costs associated with climate change. This disparity makes it challenging for financial institutions to accurately assess the financial implications of climate-related risks, potentially leading to underestimation of the costs involved.
Regulators have also expressed concerns about the limited standardisation, robustness, and transparency in climate scenario analysis methodologies. The lack of consistency and reliability in these approaches undermines their effectiveness in informing decision-making processes within financial institutions, ultimately diminishing their ability to manage climate-related risks effectively.
Addressing these issues is imperative to enhance the credibility and reliability of climate scenario analysis. By improving standardisation, robustness and transparency in methodologies, organisations can gain a more accurate understanding of climate-related risks and make well-informed decisions to mitigate them effectively. This will not only strengthen the resilience of financial institutions against the impacts of climate change but also contribute to broader efforts to transition to a more sustainable economy.
Pension trustees in the UK have trust law investment duties, which include managing material climate-related financial risks and opportunities. In fulfilling this obligation, trustees must carefully evaluate the results of scenario analyses, including holding service providers accountable. Key considerations include:
To effectively perform these duties, pension trustees may actively seek expert guidance from professionals with expertise in climate risk and scenario analysis in an investment context. Collaborating with industry peers and stakeholders can also provide valuable insights and best practices. Additionally, trustees should prioritise ongoing learning and development by participating in regular training sessions and staying updated on evolving climate-related issues and regulatory changes.
Mark Baker
Partner
Through active engagement in scenario analysis, seeking expert guidance, and continuously improving risk management frameworks, trustees can lead the way toward a more resilient and sustainable future for pension schemes
Exploring alternative approaches, such as reverse stress testing, can further enhance trustees' ability to evaluate and manage climate-related risks effectively. Reverse stress testing entails identifying extreme scenarios and working backward to determine the conditions under which these scenarios would materialise. By incorporating such innovative techniques, trustees can strengthen their risk management frameworks and safeguard the long-term sustainability of pension fund investments amidst a shifting climate landscape.
Understanding and responding to the materiality of climate-related risks and opportunities is crucial for trustees managing both defined benefit and defined contribution pension schemes.
Even though defined benefit schemes typically invest in lower-risk assets such as fixed-income securities, like gilts and bonds, these assets will still be exposed to both physical and transitional climate risk. While scenario analysis is valuable for strategic planning, it should be integrated into a comprehensive framework rather than used in isolation. Pension schemes should establish climate risk management frameworks aligned with the four pillars of the TCFD framework: governance; strategy; risk and opportunity management; and metrics and targets.
Many organisations have made good progress establishing governance structures and measuring certain climate-related metrics – like their scope 1 and scope 2 emissions. However, there is often a lack of attention given to the materiality of climate impacts, limiting the potential for developing a robust strategic response. Pension schemes should undertake a thorough gap analysis comparing their current policies, processes, and operational practices with climate-related risk management regulatory requirements, international standards, best practices, and stakeholder expectations. This assessment can help identify necessary steps to close the gap and identify opportunities to strengthen institutional capability and capacity.
While trustees may vary in their approaches to climate scenario analysis, a fundamental shift across the sector can be achieved by consistently integrating consideration for climate-related risks into investment decision-making. The pensions sector is just beginning this transformation, where understanding and responding to climate-related risks and opportunities is becoming central to fiduciary duty.
As regulatory requirements tighten and stakeholder expectations evolve, trustees must remain vigilant, enhancing their understanding of climate scenarios and their implications. Through active engagement in scenario analysis, seeking expert guidance, and continuously improving risk management frameworks, trustees can lead the way toward a more resilient and sustainable future for pension schemes.
Written by
OUT-LAW NEWS
03 Nov 2023
