Countries have agreed in the Paris Climate accord to limit the increase of global temperatures to a maximum of 1.5°C. To achieve this goal, countries will need to move towards climate neutral economies, in which net-CO2e emissions are reduced to zero by the year 2050. If we are not able to reduce greenhouse gases and limit our emissions, the world is looking at a 3 to 5°C increase in global temperature compared to 1.5 centuries ago.
The concentration of greenhouse gases is increasing. In fact, according to the World Meteorological Organization, there is no sign that the increase is slowing down. Meanwhile climate change effects are becoming more and more noticeable. For example, the difficult to reverse process of melting polar ice or white, dead coral reefs. Extreme weather patterns that lead to catastrophic hurricanes or forest fires, as we have recently seen in Australia, are increasingly common. These climate change related events do not only affect humans and the environment, but also local and global economies.
Pension funds and climate change
Climate and pension funds are closely linked. Climate change has far reaching consequences for pension funds investments while pension funds investments are effecting climate change.
Risks, opportunities and solutions
If the transition towards a climate neutral global economy happens abruptly, we can expect transition risks to increase. Transition risks such as the depreciation of assets that become unusable (for example oil reserves) and increasing risks due to CO2 pricing. These risks are related to climate change effects and are expected to decrease as we finalise the transition.
Besides transition risks, climate change leads to physical risks. These are extreme weather patterns, rising see levels or droughts. These risks can have far reaching consequences for firms and governments in which pension funds invest.
Climate change does not only pose a risk to pension funds investments, but it offers opportunities as well. Given the social demand to move towards a clean economy, new markets are expected to emerge. Markets in which pension funds can invest while at the same time have a sustainable impact. Furthermore, there is a need for financing climate change solutions knowhow to which pension funds could contribute.
Effective climate policy
An effective climate policy focusses on preventing any additional global warming and helps with the adaption to physical risks which leads to climate change resilience.
Developments surrounding these topics are moving fast. This means that is up to pension funds to take a proactive stance by tracking these climate change related developments and translate them to investments opportunities. While this is not an easy task, it is of great importance, especially given the fact that pension funds as of now are mainly focussing on CO2e reduction.
VBDO has researched whether and to what extend the 50 largest pension funds incorporate climate change into their investments decisions. The research shows that almost all pension funds (88%) have integrated a climate policy into their investment model. This means that climate change has finally entered pension funds boardrooms. For comparison, as of 2017 less than half (42%) of these funds had a climate policy.
When we zoom into these policies, we see that most of the pension funds (38%) have a general designed climate policy. 28% of the funds are mainly focussed on transition risks and the reduction of the investments portfolio CO2e emissions. Which is not surprising given the fact the focal point in climate change agreements or guidelines such as the EU taxonomy for sustainable activities are transition risks and CO2e reduction.
Less attention to physical risks
While transition risks gets the most attention, pension funds are less focussed on the adaptation to physical risks. It is safe to assume that adapting to physical risks in not an easy endeavour given the diverse consequences, which are location- and context specific and can influence each other. Consider, for example, the effects of increasing temperatures on changing weather patterns or extreme flooding’s. This leads to the conclusion that same areas are being threaten by diverging consequences in the absence of adequate actions. Which is being reflected by the fact that only 22% of the pension funds are addressing physical risks and the need for adaptation through engagement.
Risk models are being developed to analyse the effects of physical risks on the investment portfolio. Such models will lead to a more efficient market place and help pension funds to protect their investments portfolio by making it more resilient to climate related physical risks. But we have to remain critical of these models and ask ourselves the question: To what extent do these globally used models incorporate or integrate location- and context specific risks?
When it comes to reporting by global financial institution on climate risks, the Task Force on Climate-related Financial Disclosures (TCFD) framework is utilized. TCFD focusses on CO2e reduction as well as physical risks. Although the framework is set up to analyse the consequences of climate change on the financial sector, it does not look at the impact that the financial sector is having on the changing climate.
Climate at portfolio level
Climate resilient portfolio: possible perverse stimulus
Physical risks can me analysed on the asset level. This does take place, for example, on real assets such as real-estate and infrastructure, but it could be applied to multiple asset classes. This form of adaptation is utilized to protect investments from physical risks. Which is proactively being done by larger pension funds in terms of asset under management such as ABP and PFZW.
A variety of standards do exist to measure the sustainability of real assets. Most of the pension funds (69%) who are actively investing in real-estate utilize these standards. However, the underlying assumptions and criteria of these standards are only focussing on transition risks and not climate change resilience, though we do see some development in that area. One being GRESB’s use of specific module to analyse climate resilience.
Climate resilient habitat: contributing to the solution
Although it is understandable that investors are mainly fixed on the reduction of physical risks to the investments portfolio and creating climate resilient assets, it is safe to argue that this is simply a form of symptom management. In the long run this will not save the patient.
Solutions to climate change problems will eventually not only contribute to the resilience of the natural habitat, but also the global economy. Logically we can assert that even the most well protected firms or buildings will not be able to function in locations which are not climate resilient.
In that spirit we should expect pension funds to take their responsibility and their financial interest and utilize them to contribute to climate change solutions. Moreover, their climate policies focal point should be a resilient natural habitat.
The good news is that as of now the means and knowhow to tackle climate related risks are being developed. For example the Global Center of Adaptation has been working since 2018 with countries and firms on the solutions to climate change adaptation. Scientist are contributing to the knowledge and are presenting inspiring solutions and project to the Netherlands as well as the world on how to adapt. Besides public investments, we will need private investments as well, to realise these solutions. Now more than ever, it is up to pension funds to emphasise climate change risks in their climate policies and become part of the solution.
In the face of the facts that is climate change, pension funds cannot afford to limit their response to only reducing financial portfolio risks. To become climate resilient, they will need to be part of the solution. This requires a broad approach to climate change. It’s focal point should not only be financial risks and opportunities, but also mitigation as well as adaptation and impact that leads to real solutions.