The law can catalyse a shift away from high-risk carbon investments to low-carbon ones

Natalie Smith, ClientEarth

"Walney Offshore Windfarm - geograph.org.uk - 2391702" by David Dixon. Licensed under CC BY-SA 2.0 via Commons - https://commons.wikimedia.org/wiki/File:Walney_Offshore_Windfarm_-_geograph.org.uk_-_2391702.jpg#/media/File:Walney_Offshore_Windfarm_-_geograph.org.uk_-_2391702.jpg

The days of considering climate change as a discretionary investment concern are over. The law requires us to go further.

Part of the Climate Dialogues blog series

The days of considering climate change as a discretionary investment concern are over. The law requires us to go further.

Picture an entity that could help the transition to a low-carbon future, and a pension fund is probably not what comes to mind.

The reality is, institutional investors such as pension funds have assets under management in the trillions USD, so continued investments in carbon-intensive industries and activities will likely have a considerable impact on whether we stay within the 2°C globally agreed threshold.   

The major stumbling block to these investors making a potentially major contribution to climate change mitigation at present appears to be confusion around the status of climate change in the investment decision-making process. There are those who classify climate change exclusively as an environmental, social or governance (ESG) concern requiring, at best, discretionary or cursory investment consideration. In contrast, there are those who understand climate change to pose material financial risks, rendering these risks mandatory considerations when making investment decisions. 

The reality is, institutional investors such as pension funds have assets under management in the trillions USD, so continued investments in carbon-intensive industries and activities will likely have a considerable impact on whether we stay within the 2°C globally agreed threshold

We believe the latter view to be the accurate one, both from an investment and legal perspective. There is already a considerable body of evidence drawing a direct link between climate change and material financial risks to investment portfolios. And legally, since pension fund trustees and asset managers are required to consider material financial risks to funds, the same principle would necessarily apply to the financial risks associated with climate change.

So, whereas many industry players see the law as mute in this area, our view is that the days of identifying climate change as purely an ESG concern are over. The law requires us to go further.

How can climate change pose financial risks?  

With emerging regulation to curb global temperature increases and growing competition from low-carbon energy sources, there is a real risk of "stranded sets" and "unburnable carbon".

"Stranded assets" refers to assets that lose their value or turn into liabilities before the end of their economic life cycle. This could well be the case for much of the world's fossil fuel reserves, a large percentage of which is said to be unburnable (over 80% of coal, 50% of gas and 30% of oil) if we are to stay within 2°C.

This poses a clear and present danger to the economic stability of the carbon-heavy industries but it could also have a negative economic effect on the various institutions that invest in these industries such as pension funds, sovereign wealth funds and insurance companies.

The expected physical impacts of climate change (such as extreme weather events, shifting rainfall patterns and ocean acidification) are also said to pose financial risks to investors' portfolios.

These climate risks are causing major financial players like the Bank of England and the G20 to inquire into the fallout faced by the financial system. This year, a Climate Finance Day held in Paris saw more than 1,000 high-profile representatives of the financial sector's major players (including AXA, Swiss Re, Bank of America Merrill Lynch, Bank of England, and the Fourth National Swedish Pension Fund (AP4)) exchange ideas and solutions on how to "shift the trillions" to secure an orderly transition to a low-carbon and resilient economy.

The expected physical impacts of climate change (such as extreme weather events, shifting rainfall patterns and ocean acidification) are also said to pose financial risks to investors' portfolios.

A significant piece of the puzzle comes in the form of the new Mercer report, which report unreservedly concludes that climate-related risk factors should be standard considerations for investors because climate change "will inevitably have an impact on investment returns".

Mercer states, depending on the climate scenario which plays out, the average annual returns from the coal sub-sector could fall by anywhere between 18% and 74% over the next 35 years, with the effects being more pronounced over the next decade (eroding between 26% and 138% of average annual returns).

The Economist Intelligence Unit more recently reported that the expected losses to the global stock of manageable assets, in discounted present value terms, are valued at US$4.2 trillion - roughly on par with the total value of the world's listed oil and gas companies. Despite this, carbon is still largely an un-priced externality in the vast majority of investment portfolios. The Generation Foundation warns this has a "profound potential to disrupt the financial markets in a non-linear progression"

Consequently, pension fund trustees and asset managers who manage these trillion dollar portfolios could drive the financial system toward a new form of sustainable, long-term and low-carbon economy. 

The law as a catalyst

The future wellbeing of millions of people in the UK and around the world depends on the people who look after their pension savings: pension trustees and their asset managers. They are required to assess and manage financial factors that are relevant to their investment duty of balancing returns against risk. This was explicitly pointed out by the Law Commission in their recent report on the fiduciary duties of investment intermediaries. This statement of law in turn derives from a number of legal sources, including the Occupational Pension Schemes (Investment) Regulations 2005 and the common law.

By ignoring the financial risks associated with climate change, pension fund trustees are placing members' savings in jeopardy and failing to conduct themselves in a way that balances long-term returns against risk. This, we believe, is contrary to the law.

ClientEarth, through its Climate and Pensions Legal Initiative (CPLI), is investigating what pension funds are doing to manage climate risks that might affect the value of pension pots, and assessing whether they are meeting their legal duties. We may bring legal challenges against those funds not doing enough to fulfil their legal obligations. A successful legal challenge has the potential to shift more capital away from high-risk carbon investments to low-carbon ones. While this might seem radical in certain circles, it would actually mean an acceleration of the type of change the financial sector has already realised must happen, highlighting the link between pension funds and a low-carbon future.

By ignoring the financial risks associated with climate change, pension fund trustees are placing members' savings in jeopardy and failing to conduct themselves in a way that balances long-term returns against risk. This, we believe, is contrary to the law.

Good for investments, good for people, good for the planet

The law here promotes economic stability in that it serves to protect people's investments and future savings from financial detriment. In this context, if pension funds and other institutional investors were to take adequate account of climate change investment strategies, this could mean large sums of capital being redirected from high-carbon to green investments. 

Therefore, financial well-being and a low-carbon future appear to go hand-in-hand.  This shift would also go some way to addressing the devastating human impacts of climate change – including on health, water, food, housing, livelihood and life.