Pension funds are adjusting their investment portfolios to incorporate climate risk. But how do you align with the Paris agreement? Karen Shackleton offers a guide.
An increasing number of discussions among LGPS funds now seem to be centred around climate change and how to shift the investment strategy so that the portfolio becomes Paris-aligned.
This means that the underlying investments should become climate-resilient and consistent with the Paris agreement’s goal of limiting global warming, achieving target net zero by 2050 (net zero is reached when the amount of greenhouse gas produced is offset by the amount being removed from the atmosphere).
Yet funds can struggle to gain a clear sense of how practically to achieve this in their investment portfolios. Many funds just dive straight in and decide to divest from fossil fuels. A growing number are trying to think more holistically about how to shift their entire investment strategy to achieve their climate goals. For these funds, a five-step climate action plan can provide a clearer sense of the direction of travel.
12th Local Authority Treasurers Investment Forum & FDs’ Summit
NOW A VIRTUAL EVENT + ZOOM151 Networking
Jan 21, 22 & 23, 2021
Step 1. Clarifying investment beliefs
Pension funds are run by committee, and it is likely that individual members of that committee will have different views. It is important to spend time discussing these views before progressing with an investment strategy, so that everyone supports the agreed way forward.
One way to do this is to consider the Sustainable Development Goals (the UN’s SDGs’) and decide on three to five that the fund wishes to prioritise, giving careful consideration to the financial impact of those goals. Having made this decision, it is then much easier to draft wording that properly reflects the committee’s investment beliefs.
Step 2. Mapping the current portfolio
This is an important step. An LGPS fund needs to be aware how well the current portfolio is aligned to the agreed investment beliefs, and where it falls short.
Depending on the agreed priorities, this might entail a carbon-mapping exercise, or it could involve a mapping of the whole portfolio to the agreed SDGs identified in Step 1 (this wider mapping exercise is particularly useful if social or governance goals were prioritised as well as environmental goals during the investment beliefs discussion).
Step 3. Investment strategy review
The next step is to ask the fund’s investment consultant to reconsider the strategic review that is typically undertaken every three years following the triennial valuation.
Now, however, in addition to the risk and return dimensions that normally feed into the consultant’s modelling work, a third dimension around “purpose” (in this example, climate action) should feed into that modelling.
The recommendations that come out of this exercise might include, for example, shifting the passive portfolio to low carbon alternatives, or allocating to renewable energy; moving the fixed income to a sustainable bond mandate; or ensuring that the property managers are all incorporating BREAAM ratings into their investment process (BREEAM is an environmental assessment method that allows property investors to determine and drive sustainable improvements in assets that are owned).
Step 4. Manager selection
Where the consultant has recommended changes that move the fund to a more aligned position with respect to the committee’s investment beliefs, the next step may well be a manager change. For the LGPS, the starting point is now their pool, and many of the pools are carefully considering their sustainable and impact offering.
Having an ongoing, open and transparent dialogue between pool and member funds will mean that appropriate investment strategies can be delivered as quickly and efficiently as possible.
Step 5. Monitor and review
LGPS pension fund committees have become used to assessing their investments on risk and return criteria.
Many will use terms of reference which guide their judgement, for example the market environments when a manager will perform well or poorly, the key man risks, the importance of any changes to the investment process, and so on.
Introducing a climate action plan means that there is an additional dimension to these terms of reference. Committees are advised to discuss in advance the measurement criteria for climate action success and to consider the implications if a given manager fails to deliver to these criteria.
Impact measurement
Finally, a word on impact measurement. Line up five different equity managers and ask them how they measure the climate impact in their portfolios and it is likely that you will get five different responses. There will be some commonality in approach and the measurements that they use, but as always, the devil is in the detail.
It is important that an LGPS committee understands these nuances when comparing “manager A” against “manager B”. This is also why some LGPS funds are choosing to appoint an external mapping provider to assess the climate impact in their portfolios. Such a process brings a consistent methodology which allows for comparison of the different mandates in the fund.
There is, perhaps, an important role to play here for the pools, going forward: to line up an external provider to run this analysis across all their sub-funds. Not only would this be a cost-saving exercise for each member fund, but it would allow all the members to start from a level playing field, when developing their chosen climate action plans.
Karen Shackleton, senior adviser, MJ Hudson Allenbridge, and founder of Pensions for Purpose.
FREE monthly and weekly newsletters
Subscribe to Room151 Newsletters
Monthly Online Treasury Briefing
Sign up here with a .gov.uk email address
Room151 Webinars
Visit the Room151 channel
