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Standardised transition plans will help schemes focus on action rather than disclosure

I have just finished my review of the implementation statement of a small defined benefit (DB) scheme. It helped me realise that this is the ideal time to add to the discussion on transition plans.

A growing number of market participants agree that transition plans are the natural next step to achieve the original purpose of DB implementation statements (small schemes) and TCFD reports (large schemes). They have the potential, if designed well, to provide clear strategic action plans that are practical to address how a pension scheme is seeking to manage it risks in a world that is being increasingly damaged by climate change. They offer accountability and have the potential to not only replace TCFD disclosures and/ or implementation statements but to incorporate the scheme’s strategy to address biodiversity and social risks as well as ESG opportunities.

Background

Pension schemes have been the target of regulation around stewardship and climate change, ever since the Kay Review of 2013 highlighted the fact that the billions of assets held by institutional investors were not, on the whole, using their voting rights. More recently, following the Paris Agreement in 2015, regulators have required largest schemes to report on their climate action in line with TCFD.

In addition, schemes with over 100 members have had to disclose their ESG stewardship and engagement policies in their statement of investment principles for a number of years. More recently, they have been required to produce an implementation statement which, for DB schemes, requires them to detail their stewardship and engagement policy and how they have followed that during the year.

Plenty of other authors discuss the history of this regulation in more detail. I will concentrate here on the outcome of the regulations and how regulation could evolve in the future.

Experience to date

I first started my ESG journey in earnest a number of years ago, during which time I decided to study for the CFA Institute’s certificate in ESG investing. The study for the exam really opened my eyes to both the history of stewardship and governance and the extent of issues, including climate change, biodiversity and social imbalances.

Since I have become a professional trustee, I have had discussions with many experts, particularly on the subject of climate change. Some of these experts were initially critical of the action, or lack of it, that pension funds were taking until I spent time explaining the background.

For example, the fact that scenario analysis for climate risk was required at a time before appropriate models existed – TCFD does not strictly require modelling but most schemes performed some form of modelling. Further, the asset liability modelling used by advisers was not designed to measure climate risk, a risk which could lead to a failure of capital markets. This was further demonstrated as some of the results that appeared in the first wave of TCFD reporting appeared to show that climate risk could have a positive effect on outcomes for pension schemes. Again, there is plenty written on this elsewhere.

What has become clear is that most experts now agree that pension schemes cannot change the world on their own, even though they can play a significant part. And the more pension schemes help tackle climate, biodiversity and other ESG challenges, the better.

It is also clear that, without regulation, pension schemes and fund managers would not have come as far as they have. Regulations have definitely raised the bar on climate change, biodiversity, social matters and governance – with TCFD forcing large pension schemes to provide climate polices and DB implementation statements forcing schemes to report their stewardship and voting activity.

Problems with the current approach

I am only going to discuss issues with TCFD reporting and implementation reports in this article.

The laudable aim of this regulation is to focus minds on the issues, in particular the real financial risks of climate change, and then to make sure, through voting and engagement, that pressure was being put on companies to adopt climate strategies.

However, this is not what has transpired – and the schemes that are producing TCFD reports are spending a significant amount of time and resource on reporting rather than investigating and investing in climate solutions and planning how to manage climate risks over the medium- to long- term.

Smaller schemes which are producing implementation reports are spending a significant part of their investment budget on implementation reports which, in most cases say they are following their investment managers’ voting policies and list the five largest votes from the funds that they are invested in.

These reports can cost up to £2,000. For small schemes this could easily be 10 to 20% of their annual investment consulting budget, leaving very little room for any other work on ESG or climate change.

I have been working on some initiatives for smaller pension schemes – amending an implementation statement for one scheme to include actions that have been implemented at minimal cost. Even so, the reporting on these initiatives make up only a small part of the total statement, being swamped by all the standard wording. So, even if this statement is read, the real world actions that this scheme has taken may be missed.

And, while I was impressed by the voting report and checklist provided by the consultant on this particular scheme, the actions could have been reported in a much clearer way through the use of a transition plan.

The solution

If we really want to manage climate risk, and seek investment opportunities then the ideal approach to take would be to:

  1. Assess the risks
  2. Identify the opportunities
  3. Put in a strategy appropriate for the scheme
  4. Disclose and monitor

The pension scheme disclosures have brought schemes in at the bottom rather than the top. A transition plan allows the process to start from the top and work down.

For example, a £10m scheme could learn about the potential risks to the environment and capital markets of bad climate outcomes. They could examine their investments, the levers that they can pull, and agree on what actions they can take.

These actions could include look at the sustainable version every time they choose a new fund. They could also use their relationship with their fund manager – as my small scheme did earlier this year – to ensure they are supporting good stewardship policies.

Large funds are already moving towards producing transition plans. But, at the moment, this would be in addition to TCFD reporting. Transition plans are a much better governance tool to identify risks and opportunities, and drive actions to address them. They then provide a benchmark against which schemes can monitor progress.

I believe that all schemes could come up with an appropriate transition plan. As all schemes have had to look at ESG and climate change, they would not be starting with a blank sheet of paper. Yes, small schemes are restricted by their investment in pooled funds, so the tools they have will be limited. However, a transition plan will concentrate on those levers they can use, and will allow the industry to concentrate on the areas that will add value.

I also believe, contrary to the feeling of a lot of small schemes producing implementation reports, that they can make a difference. And they can do this at a cost no more than the cost of the current implementation statements.

For larger schemes, I believe a good transition plan will be much more valuable, and provide an actionable strategy, rather than pedestrian TCFD reports.

Proposal

So, to come to my proposal. We should now work as an industry, with the Department for Work and Pensions as well as The Pensions Regulator, to see how we can come up with a specification of transition plans that allow all schemes to produce one. This will support all schemes as they take better action on ESG and climate change. And when we have crafted a suitable specification, this will mean there is no need for schemes to waste resources producing TCFD reports and/or implementation statements. Surely, a more efficient use of the resources we steward for our beneficiaries! This also would solve the other issue on the horizon – how to cope with TNFD and the task force on social factors. A transition plan could cover all of these areas.

This article by: Bobby Riddaway, managing director of HS Trustees