With over £1.3trillion of investments held in the occupational pension arrangements of over 24 million of its citizens, it’s easy to see why pension schemes are an essential part of the UK government’s drive to net-zero. In terms of wider sustainability issues, however, trust law is slower to respond, leaving pension scheme trustees with difficult decisions in some instances. This article provides an overview of the current state of play.
Action follows intent
As recently as summer 2019, there was no mandatory requirement for UK pension scheme trustees to have a policy about taking environmental, social and governance issues into account in their investment decision-making. That changed from 1 October 2019, when for the first time the Statement of Investment Principles (SIP) for most pension schemes with 100+ members had to state:
- trustee policy on taking financially material considerations (including, but not limited to, environmental, social and governance issues) into account in investment decisions;
- the extent (if at all) to which non-financial (eg ethical) considerations are taken into account; and
- trustee policy on stewardship matters.
Then, from 1 October 2020 onwards, trustees of schemes with 100+ members have been required to include an implementation statement within the scheme’s annual report. For most schemes, this statement must set out information about how the trustees have put their SIP into practice (and/or an explanation of areas in which they have diverged from it); for all schemes it must describe their stewardship and engagement activities during the year. Trustees must publish the statement online and tell members about its availability.
The aim of the implementation statement is to enable interested parties (members, campaign groups and others) to ‘scrutinise and compare across the market. Trustees will be able to share best practice, and members and others will be more able to question poor policies or implementation’. It’s clear that a major focus of this scrutiny will be on sustainability issues.
Requiring trustees to report on how they have followed their investment principles will ensure that the text [of the SIP] reflects what pension schemes aim to do, and that schemes act on the principles they set out.
UK government, responding to consultation on changes to SIPs and the introduction of implementation statement requirements, September 2018
Does trust law hold trustees back?
In some ways, trust law curtails trustees’ freedom of movement on sustainability issues, because of the fiduciary duty to act (and make investment decisions) in members’ interests, which has traditionally been understood as meaning their best financial interests.
A recent Law Commission review reshaped understanding of the issues by differentiating between financial and non-financial considerations. Trustees must take financial considerations into account when making investment decisions, and the Pensions Regulator has made clear that climate change is a ‘core financial risk’, so there can no longer be any debate that trustees should have climate change high on their agenda.
The Law Commission made clear, however, that trustees have greater constraints in relation to ‘non-financial considerations’ – so clarity from asset managers and investment consultants about the financial risk implications attached to environmental, social or governance concerns is vital.
Climate change reporting
On climate change issues, 2021 will see a step-change for trustees, with new requirements being implemented from 1 October 2021 for the largest (£5bn+) schemes and for master trust schemes. The requirements include:
- mandatory knowledge and understanding requirements in relation to climate-related risks and opportunities;
- new governance, strategy and risk management activities; and
- monitoring and assessment duties. These include a requirement to undertake scenario analysis of the potential impact on the scheme’s assets and liabilities of at least two climate-related scenarios; and to measure the performance of the scheme’s investments against at least three metrics (total greenhouse gas emissions, emissions intensity and one other metric).
Trustees are reliant on data received from their asset managers, and the FCA is due to consult on TCFD-aligned rules for asset managers in H1 2021, aiming to improve regulatory alignment and to increase the flow of data that is vital to trustees to embed effective climate risk governance. The FCA has already introduced a new Listing Rule to require disclosures from premium listed commercial companies: read more on the Listing Rule.
The output of these new regulations will be an annual TCFD report for each in-scope scheme, which must be made freely available online. Another tranche of schemes, with assets of £1bn+, will be required to comply from 1 October 2022 onwards, and a review in 2023 will consider whether the long tail of smaller pension schemes should also be brought within scope.
Of course, sustainability is a much broader concept, of which climate change is just one element. This is reflected in regulations, originating from an EU Directive and already implemented in UK law, which require the Pensions Regulator to publish a new Code of Practice for pension schemes setting out its expectations for schemes to:
- maintain an ‘effective system of governance’ including consideration of environmental, social and governance factors related to investment assets in investment decisions; and
- carry out and document an own-risk assessment of the system of governance, including ‘where environmental, social and governance factors are considered in investment decisions, how the trustees or managers assess new or emerging risks, including—
(i) risks relating to climate change, the use of resources and the environment;
(ii) social risks; and
(iii) risks relating to the depreciation of assets as a result of regulatory change’.
This new Code (due for consultation this year) is likely to apply to more pension schemes, more quickly, than the TCFD regulations – and the expectations to be set by the Regulator are likely to be broader in scope. The express references to social risks and to assessing regulatory/transition risks in relation to environmental, social and governance issues, suggest that trustees will be encouraged to look carefully for signs that otherwise ‘non-financial’ considerations could be ‘financial considerations’ after all – particularly over the time horizons that are applicable to open pension schemes.
Will trust law catch up?
Regulation and regulatory expectations are outpacing the evolution of trust law, but litigation risk in relation to sustainability issues has also become a hot topic in the pensions world, with cases in both the UK and Australia making headlines. The publication of implementation statements and TCFD reports is designed to allow comparison by members and campaign groups and to establish new standards of best practice. This is only the start of that journey; clarification of trustee powers and duties by the courts, potentially reshaping the understanding of trust law duties, may be another step along the way.
Britain’s pension schemes lead on climate risk. These measures will ensure pension schemes are in an ideal position to drive change to a sustainable, low carbon economy which will benefit everyone.
UK government, August 2020, launching consultation on TCFD-style reporting for UK pension schemes