Political realities are forcing a recalibration, says Tegs Harding, professional trustee and Head of Sustainability at the Independent Governance Group.
In December, UK regulators launched a consultation on whether current standards of trusteeship are high enough to guarantee optimal outcomes for pensioners, in light of future challenges.
These are many. The UK pension system is expected to create powerful Australian- or Canadian-style investment behemoths, while managing the transition from defined benefit (DB) to defined contribution (DC), demonstrating and delivering value for money, and bolstering the national economy – and strategically significant industries, in particular – via increased allocations to illiquid but productive assets.
Trustees have got plenty on their plate. While the pressures on them have been building for some time, many point to their obligations to manage climate risks as a step change that stretched trustee expertise and workload beyond traditional boundaries.
UK pension schemes were required to start managing and reporting on climate-related risks in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) from October 2021, under the Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations.
Overlaying existing fiduciary duties to members focused on financial risks and returns with oversight of an evolving and all-pervading societal risk was a paradigm shift. As well as understanding the causes and effects of climate risks on diversified portfolios, trustees needed to set policies and frameworks to limit these in line with policy commitments to net zero made by signatories to the Paris Agreement.
“There’s a wide recognition that frameworks like TCFD, while very well intentioned, have caused some unintended consequences around the target-setting process,” says Tegs Harding, professional trustee and Head of Sustainability at the Independent Governance Group.
“Overall, there’s been too much focus on emissions intensity at a portfolio level, rather than going a layer down and concentrating on decarbonisation at a company level. It just doesn’t translate to portfolios very well because there’s lots of ways you can hit that target, without seeing anything in the real economy.”
This disconnect is far from a UK-only phenomenon. Recent analyses have flagged weak and incomplete targets as a flaw in the climate strategies of both US and Canadian pension schemes, where investment in climate solutions remains low. In January, campaign group Reclaim Finance recommended financial institutions use a broader set of climate targets as part of a “coherent and ambitions” climate strategy, covering emissions, alignment, engagement, and climate solutions investments.
With these shortcomings in mind, Harding – a trustee and chair of the investment committee for the L&G WorkSave Mastertrust and a board member for the London Pensions Fund Authority – views how pension schemes respond to the challenge of climate change as one of the critical tests for trustees.
As long-term investors, should they limit themselves to financial materiality, ensuring that member returns are not compromised by the failure of individual portfolio companies to address physical and transition risks? Or should they go further, recognising that neither their portfolios nor pensioners can thrive over the long term without a whole-economy elimination of greenhouse gasses?
The extent and nature of fiduciary responsibility to clients and beneficiaries is a question that goes to the heart of pension funds’ climate strategies. It has been interpreted differently within and across jurisdictions, with the US notable for a narrow working definition.
In the UK, the guidance for trustees was recently clarified by the Financial Markets and Law Commission (FMLC), an independent body with responsibility for reducing legal uncertainty in the financial markets.
A paper published by the FMLC in February 2024 said consideration of the financial impacts of climate change in investment decisions was consistent with trustees’ fiduciary duty, also describing sustainability as “integral” to investment decisions.
This was seen by some as a green light but others felt it did not go far enough, in terms directing trustees to consider systemic risks. Investor rights advocacy group ShareAction has sought an opportunity for bolder guidance to trustees via an amendment to the Pension Schemes Bill currently being scrutinised in the Houses of Parliament.
In December, the UK government responded to the broadening campaign for change by agreeing to provide statutory guidance on how trustees of private sector pension schemes should balance their traditional fiduciary duties with the responsibility to address long-term systemic risks that could have a negative financial impact on beneficiaries, such as climate change.
Harding admits to a change of mind over the course of 2025, now favouring further clarification, but aware of the need for flexibility of interpretation.
“There are a number of legal positions out there. But in a world where the government wants schemes to invest in productive assets in the UK, it makes no sense for there to be a question mark over what a trustee’s fiduciary duty is,” she says.
“If we are going to get guidance [on fiduciary duty], the challenge will be how it is tailored to different types of scheme. What you need to think about as trustee of a small closed DB scheme is very different to what you need to think about if you’re a trustee on a £100 billion (US$136 billion) open DC scheme where those investment decisions have direct impact on member outcomes.”
Consensus breakdown
Even with clearer guidance, the climate challenge facing pension trustees has been further complicated by a breakdown in the political consensus on the policy response to climate change. With major jurisdictions travelling at different speeds toward net zero – and some opting out of the race entirely – investors are left exposed by the decarbonisation commitments they have made, and which their beneficiaries broadly support.
“If you take the point in time where lots of schemes, including my own, were setting net zero targets, the world looked very different. The world’s largest economy was signed up to the Paris Agreement. That’s no longer the case,” says Harding.
The rationale for investing in the net zero transition has strengthened, but it has done so largely in response to the economics of supply and demand, with only mixed levels of support provided by countries’ strategies for delivering their Paris Agreement commitments.
“Renewables are much cheaper and much more widely deployed than they were in 2020. There are those pockets of success, but they’re very much technology- rather than legislation-driven,” she adds.
Weaker policy drivers have reduced the options available to pension funds and other asset owners to invest in companies and assets whose emissions trajectories are consistent with net zero pathways. Overall emissions levels are continuing to rise even though fewer can be found in the portfolios of sustainability-minded institutions.
“For funds that have embedded decarbonisation in line with what the Paris Agreement would have implied, unintended risks are arising as the world fails to decarbonise along that pathway,” says Harding.
“Portfolios are going much quicker than the real world, leading to secondary concentrations of risk that nobody expected when these goals were set. Lots of boards are looking at how you recalibrate those targets for the world that we find ourselves in.”
One response has been to loosen targets, to enable greater flexibility to invest in carbon-intensive firms with challenging routes to net zero, accompanied by detailed and ongoing scrutiny of their transition trajectories.
Another is an increased focus on resilience, with pension schemes increasingly factoring adaptation into their investment due diligence, as well as engaging with portfolio companies to better understand how they intend to handle the physical risks of climate change on their operations, staff and supply chains.
“A big part of that is accepting the consequences of not transitioning as quickly as we need to,” says Harding.
“There are going to be physical risks arising that impact the economy, across water systems, supply chains, and infrastructure, for example. The current methodologies ignore that adaptation question.”
Systems thinking
A further response to the imbalances and exposures faced by pension funds with net zero commitments is to adopt a systems thinking approach to the systemic risks that threaten future portfolio returns.
This can cover a range of actions beyond traditional engagement and voting used by shareholders to influence the policies and processes of individual portfolio companies. These include working with standards setters and regulators to encourage greater transparency or to improve accepted behaviours and processes, as well as using influence both along the financial markets value chain and at the policy level.
Harding acknowledges that pension funds are making more progress in some areas than others.
“Pension schemes are already taking this responsibility quite seriously. They recognise that they play an important part in the overall infrastructure of markets, particularly in signalling to asset managers and investment advisors that these things are really important for member outcomes,” she says.
Pensions providers have become increasingly vocal about what they consider best practice among asset managers especially around climate stewardship. Last November, New York City’s Comptroller recommended three of its pension schemes drop asset managers, including BlackRock, over concerns about their ability to support climate strategies.
Noting that her own schemes are actively engaging with policymakers and regulators, including by responding to consultations, Harding admits the nettle has not yet been fully grasped.
“I think what isn’t happening is the ‘big picture’ policy engagement on systemic risk. You need to be a bit realistic about how impactful that could be when you consider just how much of institutional portfolios are reliant on the US, which of course, is no longer a signatory to Paris,” she adds.
Much comes down to limited resources. In many cases, pension funds have taken a collaborative approach to tackling the systemic risks they cannot diversify away from. They have also made use of channels with which they are already most familiar.
Harding sees the consolidation being encouraged by the UK government as helping to address the resource and skills challenges that have traditionally left pension schemes relying on the support of others.
“Today the vast majority of policy-level engagement is done at asset manager level, not trustee level,” she observes.
“And the [pension schemes] that are doing it directly are the ones with internal stewardship teams that have the expertise to do that engagement on schemes’ behalf. That’s definitely a gap and I’m hopeful that is going to be one that is filled in a world where you’ve got consolidation of DC schemes.”
Bigger and better?
The UK government’s pension sector agenda is explicitly targeting fewer, larger schemes in the belief that these will have the scale and skill do deliver better outcomes – in part by making them less dependent on the advice of others.
Long gone is the era in which pension schemes tamely followed the advice of their investment consultants. But many did depend heavily on third-party advice to accelerate their understanding of climate risks. This led to an over-reliance on over-simplistic climate scenario models developed by mainstream economists and adopted by many across the finance sector, including central banks and investment consultants.
“There is now wide acceptance that the climate scenarios [used by many pension schemes], especially ones that were based on the NGFS (Network for Greening the Financial System) scenarios, completely undersell climate risk. They ignore tipping points, for example, and understate some of the systemic risks,” notes Harding.
When presented with models that suggested one or two percentage point dips in GDP resulting from climate change in excess of the caps proposed by scientists, many pension fund trustees saw little need to radically reshape their portfolios.
A recent report co-published by the University of Exeter and climate think tank Carbon Tracker suggests economic models used across the public and private sectors are still underestimating the impacts of climate risks.
The report says prevailing economic models fail to account for the risks likely to characterise a 2ºC warmer world, such as cascading failures, threshold effects and compounding shocks across sectors. Rather than reducing rates of growth, these reinforcing phenomena have the capacity to reshape entire economies and undermine the conditions for growth, the report says.
As well as proposing a research agenda to improve climate damage modelling, it highlights the limits of diversification, recommending that institutional investors pay greater attention to regional risk concentrations and extreme-event exposures, as well as stress-testing portfolios against tail-risk scenarios, not just median temperature pathways.
“Alternatives are being developed that take a more narrative-led approach, but it takes time to make these scenarios scheme-specific and decision-useful. Part of the problem is that they take a top-down view of investments when they really need to be bottom up,” Harding adds.
“Especially in a world where 1.5ºC is in the rearview mirror, we’re going to see extreme weather testing infrastructure, supply chains, and our economies more broadly. But not in a uniform way that fits into those top-down models. Your exposure is going to differ depending on where you are in the world, what you do, and whether or not your assets can be moved.”
The UK government is expected to deliver its guidance on climate, systemic risk and fiduciary duty shortly. Meanwhile the Pension Schemes Bill is nearing the end of its parliamentary journey and a regulatory consultation on value for money from UK pension providers is due to close in March.
As Harding acknowledges, climate might not be the only issue facing trustees as they seek to meet their commitments to members, but it could be the defining one.
