A trend that I am sure everyone has noticed is the increasing attention to environmental, social and governance factors as part of political, public and pensions discourse. Today we will focus on the “E” in ESG and consider how such a major global focus on the climate crisis is impacting the UK DB pensions space, and more specifically, employer covenant and integrated risk management (IRM).

Firstly, policymakers and regulators have acted. The Pensions Schemes Act 2021 (PSA 2021), which gained royal assent in February 2021, introduces mandatory requirements for large schemes to manage and report annually on climate-related risks and opportunities. Importantly from a covenant perspective, the requirements stemming from PSA 2021 explicitly require consideration of climate risks and opportunities in funding strategy, with funding strategy defined in the June 2021 statutory guidance as including “consideration of… the strength of the covenant offered by the sponsoring employer and how the strength of the covenant is expected to develop over the expected lifetime of the scheme.”

As such climate change is no longer just a topic for investment committees but should be engaged with as a scheme-wide topic, with trustees ensuring that climate change is a factor in decision-making from an employer covenant and funding perspective. TPR recently released its new climate change strategy which emphasised that climate change risks are not limited to certain size schemes or particular investment strategies. All schemes are encouraged to build out their climate change activities by dedicating more board time to the topic, engaging in specific training, and ensuring that climate change is part of trustees’ integrated risk management approach - being covenant, funding and investment.

But how do you undertake a climate risk assessment on your sponsor covenant? To understand how your sponsor will be impacted, both now and in the coming years, the place to start is engagement – working with sponsor management to identify and assess climate related risks and opportunities specific to your sponsor and sector.

I cover examples of some risks and how they might impact sponsors below.

Physical risks

Are your sponsor’s operational locations, products or supply chain at risk of extreme weather events? What could the impact of these events be on profitability through increased costs or decreased ability to deliver products or services? Is your sponsor considering how to enhance the resilience of its value chain?

Transition risks

Transition risks from moving to a lower carbon world – will changing technology or consumer preferences require an accelerated move away from fossil fuels not only in your sponsor’s production or service line but also within their supply chains? Is your sponsor innovating in line with its competitors? Does it have sufficient free cash to invest in such activities, and what does this mean for the pension scheme?

Emerging regulatory pressure

Increasing regulatory pressure is also important. With a growing interest in climate risk there is a rising demand for transparency, with policymakers introducing mandatory climate risk disclosures, financial regulators stress testing financial institutions against climate scenarios, and litigation against companies failing to address climate risk adequately. Is your sponsor in a sector or geography in the spotlight?

The prevalence and covenant impact on a sponsor of each of these three types of climate risks will depend on the nature and extent of the global energy transition that we see over the coming years. But most importantly, these climate risks will impact more than just your sponsor – through systemic risk transmission, your scheme’s funding and investment position will also be impacted.

So this brings us back to integrated risk management and how we are helping our clients at LCP to interrogate their exposure to climate risks and opportunities and, most importantly, seek to mitigate them.

We help our clients ask the right questions and provide insights into where climate risks - and opportunities - may be located in a sponsor’s business model, value chain and product life cycle. We can use these insights to help trustees understand the exposure of their sponsor’s cost and profit base to the different forms of climate risk, how this might differ under different climate pathways, and how this impacts on both the available cash that can be used to help the pension scheme reach its long term funding target and also the length of time that the sponsor covenant may be around to underpin funding and investment risks of the scheme.

By overlaying this form of covenant climate analysis with scenario modelling we can assess when and to what extent climate risk may impact on a pension scheme’s assets and liabilities. This allows trustees to implement a joined-up and comprehensive climate risk assessment framework, meet the latest regulatory requirements and protect members’ benefits from the systemic financial risks of climate change.