Climate change could impact sponsor cash flow and longevity

The ECPA divides climate risk into two broad categories: macroeconomic risks affecting whole economies and business sectors, and specific risks to businesses, as well as opportunities.

“We contend that — while the future is clearly uncertain — at a practical level a careful consideration of the impact of the specific risks and opportunities (physical, liability and  transitional) on an employer’s future cash flows and likely longevity is possible, and this should be reflected by practitioners in their advice to trustees and sponsors in a proportionate way which reflects the likely impacts on the specific business,” the report explained.

“We also contend that understanding how management may have considered broader macroeconomic risks in their forecasting is also important — but recognise that the possible spectrum of outcomes may be very broad.”

Macroeconomic impacts could produce both supply-side shocks resulting in price volatility, and demand-side shocks including reduced disposable income, and business investments negatively impacted by uncertainty and financial losses following “climate disasters”.

Specific risks pertinent to scheme sponsors could include physical effects such as reduced income from tourism and hospitality businesses, and material risks such as infrastructure lost to floods.

Insurance companies will face additional liability risk, while other sectors will incur substantial transition costs where their product range needs to be modified to comply with new regulations.

The ECPA therefore argued that covenant practitioners should develop and expand their existing market and sectoral analyses to include climate change impact assessments, cautioning that “umbrella” analyses that have too broad a focus might miss “specific risks and opportunities to which sponsors might be exposed”.

“Once practitioners have an overall understanding of sectoral dynamics, they can consider how associated climate risks or opportunities may impact on a specific sponsor,” the report explained. 

“A key element of this analysis is to consider how these climate-related issues may impact upon a sponsor’s competitive market positioning — and, in turn, its potential profitability and longevity.”

It argued that “robust sectoral analysis” will inform on what climate-related risks are relevant to specific sectors and why, how changing regulatory environments will impact sponsors, and how competitive analysis might shift, “including which companies might be expected to be “winners or losers” as a result of climate change impacts”.

This information must be included in covenant assessments, it continued. Scenario analysis might, for example, show “tension” between scheme funding and sponsor investments, such as where investment required to meet the challenge of climate change results in sponsor cash constraints.

“Trustees should therefore consider identifying and quantifying/modelling the climate-related issues, not only as they might impact the sponsor’s business, but also how those risks might manifest as additional funding strain that the employer must cope with and solve, or how opportunities might lead to increased profitability benefiting the covenant,” the report explained.

“When formulating their investment and funding plans, trustees should also consider the interaction of climate-related issues on scheme assets, liabilities and covenant strength under different potential scenarios covering the short, medium and longer term (recognising covenant time horizons), and identify integrated contingency plans and responses to these different scenarios.

“Considering how covenant and other risks might crystallise in combination may also inform both mitigation plans and decision-making time horizons.”

Karina Brookes, chair of the ECPA, said: “Our members are seeing the impacts of climate change feed into the performance of sponsors right now. Transitional risks, for example, are affecting both the free cash flows and — potentially — the longevity of sponsors where demand for their existing products may atrophy over time, or where substantial investment in [research and development] is needed.

“But, as the paper emphasises, many sponsors are successfully addressing the impacts of climate change, and a number will secure market-leading positions through innovation in response to regulatory and demand shifts.”

Brookes explained that the paper sets out “clearly and systematically how our member firms can consider climate change in their work”, and advise trustees and sponsors on how it might be reflected in scheme funding and integrated risk management plans.