What the low-carbon drive means for UK pension funds

The value of US-listed coal stocks has fallen 90 per cent in the past five years. And that trend has nothing to do with ethics or moral obligation.

It is a hard and fast indication of an incremental erosion of value that has gathered momentum since 2011, driven largely by the advent of cheap shale gas.

This is not about social responsibility – it is not about achieving non-financial objectives or helping society, this is about taking a rational, clear-headed view of risk and adjusting your portfolio accordingly

Ian Simm, Impax Asset Management

Low energy prices and plentiful shale have caused significant value destruction across the sector, but additional pressure has come from stringent environmental regulations on air emission levels, making it near impossible to commission new coal plants in certain US states.

Turning up the heat

The movement to divest away from these stocks has reached new heights in the US over recent weeks.

At the beginning of September the California Assembly voted 47 to 30 in favour of state bill 185, known as ‘Investing with Values and Responsibility’, and mandated two of the state’s largest public pension plans – the $292bn (£187bn) California Public Employees’ Retirement System and the $191bn California State Teachers’ Retirement System – to divest from coal.

The bill requires the two public funds to liquidate investments in thermal coal companies on or before July 1 2017.

Where trustees make a determination to liquidate investments, they are required to “constructively engage with thermal coal companies to establish whether the companies are transitioning their business models to adapt to clean energy generation”.

However, under the bill, CalPERS trustees are not required to divest if doing so is deemed to be inconsistent with the board’s fiduciary duty to members – meaning the fund’s ongoing coal stock holdings will remain intrinsically tied to risk management and manager research processes.

Crossing the Atlantic

Simon Howard, chief executive at sustainable investment trade body UKSIF, says the latest developments in California are part of a rising tide of attention being paid to divestment issues and the future presence of fossil fuel stocks in scheme portfolios.

Back in July the Environment Agency Pension Fund detailed the five-point criteria it uses to assess managers for its responsible investments, as it awards £180m to a global sustainable equity mandate.

The EAPF has also selected the MSCI World Low Carbon Target Index as the benchmark for its £280m global passive equities portfolio, which now constitutes more than 10 per cent of the fund’s total assets.

Trustees and independent governance committees of UK schemes should be considering their fiduciary response to the mounting risks, says Howard.

Last year’s report from the Law Commission clarified trustees’ fiduciary duties in respect of responsible investment.

In the eyes of the commission, there is scope for schemes to consider non-financial factors when making investments.

Many high-carbon industries are listed in London and our pension funds are holding them – AE members are over-exposed

Catherine Howarth, ShareAction

The report said IGCs in the contract-based defined contribution space should act with reasonable care and skill to protect members’ interests in the environmental, social and governance arena.

An update from the Department for Work and Pensions expected later this autumn will firm up trustees’ fiduciary duty with regard to ESG factors in new scheme rules.

Trustees are bound by their duty to members to consider all material financial risks and Howard categorically rejects a view of climate change as anything other than a “material financial risk”.

“It’s not an ethical or moral driver, although that is part of thinking of many people: it’s a financial driver,” says Howard.

Ian Simm, chief executive of Impax Asset Management, echoes Howard’s view.

“This is not about social responsibility, it is not about achieving non-financial objectives or helping society, this is about taking a rational, clear-headed view of risk and adjusting your portfolio accordingly,” he says.

CalPERS’ investment committee identifies engagement as the first step on the path towards tackling climate change risk across the fund’s portfolio.

In a statement issued prior to the bill back in April, the investment committee said: “We are tackling climate change issues through policy advocacy, engagement with portfolio companies, and investing in climate change solutions.”

Growing awareness

A report from consultancy Mercer published earlier this year, ‘Investing in a Time of Climate Change’, projects the potential impact on returns across portfolios, asset classes and industry sectors between 2015 and 2050, based on four climate change scenarios. 

The report estimates average annual returns from the coal sub-sector could fall by anywhere between 18 per cent and 74 per cent over the next 35 years, with the effects ratcheting up over the coming decade.

In Simm’s view, UK pension funds are becoming increasingly aware of the financial risks of holding fossil fuel assets.

“Institutional investors in the UK are… realising that it’s not the weather and shifting climate belts that’s going to impact the values of their assets for the next five years so much as government policy to reduce emissions of greenhouse gases through health and taxation,” he says.

Simm says declining subsidies for fossil fuel production and consumption, combined with the Europe 2030 target for greenhouse gas emissions and the COP21 negotiations on climate change in Paris in December, should galvanise the sense of urgency for investors.

“The most constructive way of looking at this climate change issue for investors is to apply the normal investment management techniques, looking at risk scenarios and doing some modelling – if risk has gone up then take some money off the table,” says Simm.

“You can take some money off the table through the increased risk in holding these stocks without selling out completely.”

The risks for DC

Where funds maintain a position within a company, trustees and IGCs have the power as asset owners to engage and challenge management on ESG issues.

However, Catherine Howarth, chief executive at responsible investment charity ShareAction, sees growing risks for auto-enrolment members who are largely invested in low-cost passive equity vehicles with high exposure to the resource-heavy FTSE 100 Index.

“Many high-carbon industries are listed in London and our pension funds are holding them – AE members are over-exposed,” says Howarth, adding that she has raised these concerns with the Pensions Regulator.

UKSIF’s Howard says there are already numerous carbon-capped solutions out there for funds with large passive holdings.

“I’d simply urge owners who, for very sensible reasons of size or cost are choosing to use the passive approach, to look at the wide range of passive equity vehicles available – which are already reflecting the threat to value coming from the carbon bubble,” he says.