Key Findings and Recommendations
Trillion Dollar Transformation, a collaborative initiative by Mercer Investment Consulting (Mercer) and the Center for International Environmental Law (CIEL), is designed to educate pension fund fiduciaries on the challenges and opportunities presented by climate change.
In addition to its profound human and environmental impacts, climate change presents an array of material financial risks that reasonable investors must take into account when making investment decisions. These include transition risk, physical risk, and litigation risk among others. The Mercer Investments and CIEL reports are intended to equip pension fund fiduciaries with the information and tools necessary to respond to these risks.
Mercer’s analysis finds that, regardless of the response scenario, climate change will impact pension fund returns, with the greatest impacts on carbon intensive sectors including coal, oil and gas, and utilities. CIEL’s legal analysis builds on these findings and concludes that the nature and extent of the financial risks posed by climate change implicate several fiduciary duties owed by pension fund trustees to fund beneficiaries. Failure to acknowledge and address these risks may result in a breach of one or more of these duties and exposure to subsequent liabilities and financial losses.
Climate Change Poses Material Risk for Pension Funds
Climate change is a potentially material investment risk that presents fiduciaries with a distinct risk management challenge due to the time horizon over which its worst physical effects are expected. Climate change is also not a single risk but rather a diverse “risk of risks” that threatens damage to portfolios from increasingly frequent/severe weather events and, more pressingly for investors, from the transition to a low-carbon economy encouraged by the Paris Agreement which positions a 2oC rise in global average temperature as its baseline goal.
According to Mercer’s analysis the average US pension fund would be most negatively impacted by a 2oC “Transformation” scenario. However, climate change will give rise to investment winners and losers regardless of which scenario unfolds. Impacts across scenarios on different asset classes and sectors varies widely and can be significant in either direction; thus, investors should consider the impact of climate risks on asset classes as well as at the industry-(sub)sector level where companies in Energy, Utilities and Materials sectors are considered to be most vulnerable.
Tools Exist to Assess and Act on That Risk
Climate change challenges investors to think long term since the worst related physical impacts are not expected for decades and because the timing, speed and magnitude of an economic transition to a low-carbon economy over the coming years is uncertain. This “tragedy of horizons” and the complexity of climate change have until recently confounded many efforts to quantify and address related risks in typical risk management frameworks. Mercer’s paper recommends concrete governance processes, risk assessment methods and risk management decisions that public pension boards can use to address climate change as an investment risk.
Determining the organization’s beliefs regarding the prospective investment implications of climate change can be a helpful starting point, and establishes a foundation for further unified action, such as investment policy statement updates and portfolio changes.
Climate-change risk can be assessed and monitored in portfolios using a variety of tools and processes, including the top-down asset allocation modeling method described in this report.
Information gleaned from risk assessments can inform a range a potential risk management decisions, including whether to hedge, reallocate and/or engage to address risks that fall outside tolerance levels.
Trustees of US public pensions should review these risks to determine if they are tolerable and, if not, what actions to take to minimize them.
Climate Risk Implicates Fiduciary Duties Owed to Fund Beneficiaries
Pension fund fiduciaries are obliged to act solely in the interests of plan beneficiaries, and must exercise reasonable care, skill, and caution when making investment decisions. They must also balance the interests of current beneficiaries with future retirees and benefit recipients, and must ensure stability while pursuing growth.
Because climate change could pose a threat to these interests, fiduciary duties may be triggered by climate risks. Climate change should, therefore, be considered an independent risk variable along with other modeling inputs used when making investment decisions.
Addressing the materiality of climate-related risk implicates and triggers several duties pension fund fiduciaries owe to their beneficiaries. These include:
- duty to inquire,
- duty to monitor,
- duty to diversify,
- duty of impartiality,
- duty of loyalty, and
- duty to act in accordance with plan documents
Failure to Assess and Act on Climate Risks May Violate Fiduciary Duties, Resulting in Financial Losses to the Fund and Potential Liabilities for Fund Trustees
Breaches of fiduciary duty may result in liability for pension fund trustees as well as financial losses. Trustees should employ deliberate, climate-aware strategies to avoid liability and prevent losses.
As with any other financial risk, fiduciaries should weigh climate-related risk when making decisions about where to invest, what to divest from, how to allocate resources, and how to plan for the future.
Because climate-related risks will likely affect future beneficiaries more than current beneficiaries, a lack of consideration of longer term climate-related risks in the plan’s portfolio could be seen as an unreasonable bias favoring short-term gain at the expense of long-term sustainability, and favoring older over younger beneficiaries.
Failure to act with reasonable care, skill, caution, loyalty, impartiality, and fact-based inquiry in the face of climate-related risks could expose fiduciaries and their attorneys and advisors to legal liability.
To avoid liability and prevent fund losses, pension fund trustees should consider the following strategies:
- modify plan documents to reflect climate risks as a potentially material risk factor, and ensure fiduciaries and managers act in accordance with the plan;
- avoid or minimize investments in assets most vulnerable to climate risk, such as fossil fuels;
- engage actively with owned climate-vulnerable companies to demand information and assess resilience to climate risks; and
- invest strategically in clean energy assets both as an opportunity for returns and as a hedge against climate risk.
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