Scenario analysis is acknowledged to be the most challenging element of the new governance and reporting requirements for UK pension scheme trustees. The uncertainties and complexities involved mean that it is not a predictor of outcomes, but a tool for better understanding the risks and opportunities presented to the scheme by climate change in order to inform trustees’ strategy and investment decisions.
The regulations and statutory guidance recognise that some trustees will find scenario analysis particularly difficult, and that scheme approaches will evolve and become more sophisticated over time. Here we look at the requirements, practicalities and potential flexibilities for trustees as they develop their approach.
What are the scenario analysis requirements?
Trustees must (as far as they are able) undertake scenario analysis to help them understand the risks and opportunities posed to their specific scheme by climate change, and to inform their strategic, investment (and, for DB, funding) decisions accordingly. Trustees must consider at least two potential scenarios, both of which must involve an increase in global average temperature; in one of the scenarios the increase must be 1.5 to 2 degrees Celsius above pre-industrial levels. The following matters must be considered as part of the analysis:
- the potential impact on the scheme’s assets and liabilities of a global average increase in temperature and of steps which might be taken (by governments or otherwise) due to this; and
- the resilience of the scheme’s investment (and, for DB, funding) strategy in these scenarios.
Scenario analysis must be undertaken in the first scheme year in respect of which the requirements apply, and then three-yearly. Trustees must conduct reviews in the interim years to determine whether to undertake new scenario analysis (for example, data availability may have improved or the investment or funding strategy may have changed); if they decide not to do so, they must disclose their reasons. The government has suggested that once asset managers become subject to mandatory TCFD disclosure requirements, trustees who have carried out scenario analysis without this would be expected to conclude that the increase in available data warrants refreshed analysis.
‘As far as the trustees are able’ means taking all such steps as are reasonable and proportionate
in the particular circumstances, taking into account financial and time costs. This wording is intended to recognise that there may be gaps in the data that trustees are able to obtain about their assets, or other limitations on how far they are able to quantify risks in particular aspects or in relation to certain types of asset. Even if trustees cannot obtain a complete picture, they must perform the analysis using modelling or estimation to fill in missing data, or using a partial or qualitative approach where necessary – and they must describe the reasons for any limitations in their report.
Understanding the new duties
While choosing two temperature rise scenarios might, on the surface, sound relatively straightforward, the statutory guidance is clear that trustees must also consider the circumstances in which they assume that rise would occur – for example, would there be a measured transition with state commitments to net zero being met in an orderly way, or would there be delayed action and tougher measures at a later date? These assumptions will have an impact on the output from the analysis. Trustees should also consider how the scheme’s asset allocation is assumed to change over the relevant time horizon. Trustees should select scenarios that they consider plausible, and ensure that these are sufficiently differentiated to provide useful information.
Where the first scheme year in which the requirements apply is a part-year, the requirements still apply (but the drafting of the report can take place after the end of the scheme year, with publication within seven months).
The levels at which the analysis should be applied (and reported on) are the same as for the wider strategy requirements, namely:
- in a multi-section DB scheme, each DB section (but sections with similar asset, liability and funding characteristics may be grouped together);
- for DC schemes: each ‘popular arrangement’ offered by the scheme. This means any arrangement in which £100m or more of the scheme’s assets are invested, or which accounts for 10% or more of the assets used to provide DC benefits (excluding assets that are solely attributable to additional voluntary contributions).
The Pensions Regulator’s guidance suggests that trustees should consider the following factors as part of their scenario analysis:
- the nature of the transition to the temperature (for example, an orderly or disorderly transition);
- the potential impacts of that transition in the scheme’s identified short, medium and long time periods, including the potential impact on specific asset classes;
- for DB schemes, the potential impact on scheme liabilities and on the employer covenant; and
- the implications of adjusting the scheme’s strategy in light of this analysis.
The statutory guidance suggests that trustees with limited experience might find it easier to start with qualitative (i.e. narrative) analysis, but all trustees should progress towards using quantitative analysis (possibly using a combined approach to explain their conclusions). It is expected that trustees are likely to require assistance with this from a third-party provider, but they must be able to understand the underlying assumptions in the scenarios and the results produced by the analysis. The guidance also reminds trustees that the purpose of scenario analysis is to better understand the risks and opportunities posed by climate change for their particular scheme – trustees should consider whether a simpler form of analysis conducted in-house (for example, on a qualitative basis) might provide them with greater insight than outsourcing the exercise to a third party.
For DB schemes, qualitative analysis might be particularly helpful in relation to considering the impact of the scenarios on the employer covenant. For example, trustees will need to identify what the greatest risks to the employer are in their chosen scenarios, and what the employer could do (and what it is doing) to avoid or address those risks. This will involve working with the employer and may involve confidential information (which should also be borne in mind at the reporting stage).
A possible starting point may be for trustees to ask their asset managers for details of any scenario analysis they have carried out and actions taken as a result, but trustees should be wary of collating information from different asset managers about individual asset classes, as the assumptions underlying the analysis may differ.
The Pensions Climate Risk Industry Group has published guidance on ‘Aligning your Pension Scheme with the TCFD Recommendations’ (this is due to be updated). This provides useful resources on scenario analysis including free tools and resources; questions to ask when appointing a provider, and two case studies.