Does your sponsor have the cash to implement its net-zero strategy?
24 May 2023
In this blog, John explores the challenges that sponsors of DB pension schemes may face when adopting a net-zero strategy, and considers how trustees can incorporate ESG considerations into their assessment of covenant strength.
What is net-zero?
In simple terms, achieving net-zero means that an organisation’s total greenhouse gas (“GHG”) emissions would be equal to or less than the GHG emissions it acts to remove from the environment.
Working towards net-zero does not only mean an organisation taking steps to drastically reduce its emissions – it means that any remaining GHG emissions should be balanced with an equivalent amount of carbon removal. This can, for example, be achieved by reforestation or through other technologies designed to directly extract CO2 from the atmosphere.
Net-zero strategies are now commonplace amongst many organisations, and particularly for large multinational companies.
Within these strategies are clear commitments to reduce emissions over set timeframes, often agreeing targets with agencies like the Science Based Targets initiative which is designed to provide companies with a clearly defined path to reduce GHG emissions in line with the goals set down by the Paris Agreement in 2015.
Less promises, more action?
Commitments for change are indeed a good start, but a sponsor’s stakeholders (in particular investors and consumers) are now expecting action. The theme of implementation was key at the recent COP27 event held in Sharm El Sheikh in November 2022.
This is increasing pressure on companies to act, often requiring costly investment. However, it can be challenging to implement these actions at a time when many businesses are struggling due to the macroeconomic environment.
How should this be assessed?
Cash is required to implement net-zero transitions (albeit getting cheaper as technologies develop). This can be a significant investment in some cases and companies only have finite liquid resources. Decisions will need to be taken on how such funding needs will be prioritised alongside other competing demands for cash such as debt servicing, 'regular' capital expenditure and dividends. Where there is a DB pensions arrangement in place the sponsor may also have to pay contributions to the scheme.
When analysing business plans and forecasts, making the link between what was promised to a sponsor’s stakeholders (eg achieving a sponsor’s committed climate goals) and how this will be achieved (eg the cost of implementation and success in execution) is fundamental in assessing whether a sponsor is making credible promises.
For trustees considering affordability, important considerations are to understand if a) their sponsor’s cash flow forecasts are understated (ie if they are not being realistic about the cost of transition) and b) whether they are at risk of not implementing the promises they have made to stakeholders.
The latter has potentially serious reputational consequences and in turn potentially harms future covenant strength. But with concept of 'affordability' to soon be enshrined in law, trustees will have more to think about when establishing the level of cash potentially available to fund the pension scheme and demonstrating that deficits are paid as soon as they can be reasonably afforded by the sponsor.
Beyond simply thinking about the transition to net zero, we recommend three clear action points when incorporating ESG considerations into your covenant assessment:
- Develop a robust understanding of your sponsor’s net-zero strategy
- Analyse how this strategy interacts with the financial information assessed (particularly cash flow forecasts)
- Integrate ESG factors with your broader covenant assessment and journey planning strategies.
Check out our new tool, LCP Beacon, designed to help pension scheme stakeholders understand and engage with how climate risks and opportunities may be impacting upon their sponsor, providing clear actions that are tailored to their circumstances.
Please get in touch if you would like discuss how the climate experts within our covenant team can help further.