Articles - Climate change implications for the LGPS

While climate change may have been considered in LGPS funds’ investment strategies for some time, climate risk is something that LGPS funds will have to consider in their covenant assessment and funding strategies too. As the government introduces measures embedding climate change into pensions’ law, we take a look at what’s coming next for the LGPS and what we can do to prepare.

 By Nicola Tait FFA, Associate and Actuary and Melanie Durrant FIA CERA, Principal and Actuary at Barnett Waddingham

 What's coming?
 The Task Force on Climate-related Financial Disclosures (TCFD) is a framework that aims to help companies and investors measure, manage, and report their climate-related risk exposures and opportunities in a consistent manner. The Government sought public comment on their proposed changes to regulations to incorporate TCFD requirements into pensions law earlier this year, and from October 2021, TCFD reporting will be written into pensions’ regulation (although Local Government Pensions Scheme (LGPS) Regulations will follow).

 TCFD is primarily about governance. It also covers risk management and strategy, along with scenario analysis and metrics. With a range of potential climate scenarios and highly complex impacts reaching far into the future, implementing the new framework isn’t going to be straightforward, but the LGPS is well placed to meet the TCFD challenge. Although we are aware that some funds have started the journey to develop plans to quantify and address the risks of climate change as well as capitalise on the opportunities of the transition to net zero, there is a long way to go.

 The process of carrying out climate change reporting should lead to better-informed decision making on climate risks, while improved transparency throughout the investment chain (as companies and asset managers are also required to meet TCFD recommendations) should improve accountability and provide useful information to Pension Committees when making decision as investors. Ultimately, it will enable funds to demonstrate their journey to net zero.

 The Ministry of Housing, Communities and Local Government (MHCLG) is expecting to consult on proposed changes to the LGPS Regulations to bring in TCFD requirements soon. Their aim is for any new requirements for the LGPS to come into effect from 2022/23. It is expected that the proposed changes will take a similar direction to those made by the Department for Work and Pensions (DWP) in the private sector, but the consultation will enable stakeholders to help shape the framework for the LGPS.

 The Pensions Regulator has already published draft guidance on governance and reporting of climate-related risks and opportunities which they suggest decision makers at LGPS funds may wish to follow to improve the governance and resilience of their funds in relation to climate change, although it’s not yet law. This is helpful as funds begin to navigate their way through the new requirements.

 Investment strategy
 So far, investment strategy has been the main focus of climate change risk. How investments will fare in different climate scenarios is a complicated and widely discussed and debated issue in the investment industry. There are issues at both an individual investment level (how a company is impacted by physical climate risk and climate transition risk), and the wider economy (what will be the impact on countries of changing patterns of land use and climate migration, for example). With Environmental, Social, and Governance (ESG) now embedded into many funds’ investment strategies, this provides a starting point for funds to take this a step further and ensure they have fully considered the impact of climate risks and opportunities on their investments. Read more commentary on ESG from our in-house experts here.

 As Fund actuaries, we will support you in understanding how climate change risk could affect funding. On the liability side, our three key assumptions – the discount rate, long-term inflation, and longevity – could all be affected by climate change. We consider each in turn below.

 Discount rate
 For funding purposes, the discount rate used to value a fund’s liabilities reflects the expected return on the investments that the fund holds (reduced by a margin for prudence). Funds generally invest in equities, bonds and property, along with other alternative assets. The price of these depends on the market outlook of how each company underlying the investments will perform in the future. To the extent that the market has anticipated the effect of climate risk on each company, it is already reflected within the discount rate.

 However, climate risk is complex and whilst it is easy to imagine the various ways that climate change could impact an energy company, for example, it becomes less clear with other companies (such as those in the service or healthcare sectors). If the market cannot anticipate or agree on the impact, then it’s unlikely this will be priced in to today’s market value or return expectation – in particular where investors’ timeframes vary.

 Long-term inflation
 Inflation is another of our key assumptions, with the majority of LGPS benefits increasing in line with the Consumer Prices Index (CPI) each year. No one knows for sure how inflation will move over the long term. However, we typically look to the bond market to gauge the market’s expectations of this in order to set our assumption at each valuation.

 As is the case for the discount rate, however, if the inflationary impact of climate risk is not being priced into the bonds in the market then this will have a knock-on effect on our inflation assumption – the impact of which is, again, unknown.

 It is easy to see that climate change will have an effect on how long we will all live, but it’s more difficult to gauge exactly how. The list of implications of how it will affect the world is long (and growing), and includes risks like zoonotic pandemics such as Covid-19. But how much of that will impact on the life expectancy for members of UK pension schemes? How quickly will an effect be seen? And will it vary by location?

 For example, it’s possible that in the UK, longevity might actually improve due to climate change. If winters are milder in future then that could mean fewer deaths. On the other hand, if our summers get too hot then that might not count for much.

 Scenario analysis
 The one thing that is clear is that the impact of climate change is not. As part of the climate change governance and reporting requirements under TCFD, funds will need to assess the resilience of their assets, liabilities and investment and funding strategies to climate-related risks in at least two or three climate-related scenarios. For example, how are these affected by:

 a measured, orderly transition to a low carbon economy;
 a sudden, disorderly transition to a low carbon economy; and
 a “hot house world”?

 We will be reviewing the MHCLG consultation to see what requirements are proposed for the LGPS and responding accordingly, so that we can best support you. In the meantime, however, we are already developing modelling tools as part of the 2022 valuation process, to allow us to consider these and other scenarios so we can help funds gauge the potential impact on their assets and liabilities. It makes sense to consider any scenarios as part of the triennial valuation process, and so we hope to see the MHCLG consultation soon.

 For some of our funds we are already working with the investment advisers to test climate risk as part of the investment strategy review in the lead up to the 2022 actuarial valuation. This may be based on the scenarios listed above, or alternatively we are able to run a stochastic model to simulate many different possible future outcomes.

 Inevitably, certain funds and employers are likely to be more at risk from these changes than others. For example, airlines and manufacturing companies may have to evolve considerably to satisfy new net zero requirements. Other companies or employers, such as schools and leisure centres may be affected by supply chains if those are disrupted.

 Some areas are at greater risk of flooding and extreme weather events than others, affecting funds as a whole. Or local authority budgets may be affected by non-pensions issues surrounding climate change. This will all have an impact on covenant: how able and willing employers are to pay contributions to the fund. This should be considered and can be factored into the triennial valuation by means of the prudence allowance in the discount rate, or in some other way.

 Governance and disclosure
 We understand that reporting will be required at fund level, but we won’t know for sure until we have sight of the updates to the LGPS Regulations. With the expectation that reporting requirements will come into effect from 2022/23 for all funds (rather than a phased approach like the private sector), we eagerly await these and the MHCLG consultation to help plan for what is shaping up to be a very tight turnaround.

 We understand there will be an aim for consistency in reporting across all funds and, based on the TCFD requirements, these are likely to cover:

 describing risks, opportunities and impacts over the short, medium and long term
 reviewing the exposure of the fund to risks of a prescribed description
 assessing the assets of the fund in a prescribed manner
 risk identification, management and integration processes
 measuring performance against targets
 preparing documents containing information of a prescribed description
 reviewing targets to determine whether they should be maintained or replaced

 Next steps
 TCFD will require funds to identify and assess the impact of climate-related risks and opportunities on assets, liabilities, investment strategy and funding over the short, medium and long term. Funds need to consider whether the companies they are investing in are on the right path and how their investments are impacted by climate change.

 In the absence of the updated Regulations, there may be reluctance for funds to go too far at this stage. However, regulations or not, these risks exist and are something all funds should have on their radar and many will already be considering as part of the review of their investment and funding strategies.

 We expect MHCLG to consult on draft regulations soon, and we anticipate a similar approach to that taken by DWP, with the exception that it will apply to all LGPS Funds from the start irrespective of size. Due to the tight timeframes, we hope that there will be some initial flexibilities as funds get to grips with the new framework.

 We will therefore be well placed to support you in meeting the requirements. Additionally, BW are members of the cross-industry Pensions Climate Risk Industry Group (PCRIG) that has published guidance for pension schemes on how they can adopt the TCFD recommendations on climate governance and disclosure.

 We will, of course, keep you updated as and when further detail is provided for the LGPS. In the meantime, we are preparing to provide scenario modelling for funds before or as part of the 2022 valuation, should it be required. 

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