Climate risk reporting on liability-hedging mandates | Insight Investment

• Pension schemes are beginning to report on climate metrics in their portfolios, and Insight has been in extended discussions with clients about how best to fulfil their obligations.
• Lack of standardisation is leading to a mix of approaches, with clients expressing concerns both about the extent of reporting required and the potential consequences.
• We encourage our clients to communicate about the use of the data and the limitations of the methodologies used, as well as explaining the context of gilt exposures within their strategy.

The first cohort of UK pension funds is starting to report on the emissions financed by their investments, in line with relatively new requirements for the Department for Work and Pensions (DWP). The reporting framework is based on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

As the market starts to find its feet on this topic, we thought it may be helpful for us to share a summary of discussions we have had with some clients and investment advisers. It is evident that further effort on this topic is required and that may best be done by stakeholders working together.

While alignment of climate and environmental, social and governance (ESG) objectives is becoming more commonplace in public equity and corporate bond mandates, this is not yet the case with LDI strategies. As the market grapples with how best to view LDI in that regard, the initial focus is really on reporting. Many clients are embracing the benefits of building a deeper understanding of climate metrics, yet cautious about the challenges presented by data quality issues.

The focus of the DWP recommendations is not the production of reporting information, but the opportunities that reporting may bring for pension schemes to use that data and consider how to act to mitigate climate change. It will be interesting to see if this results in any changes in hedging strategy or in approaches to engagement, and to see how climate-related goals marry themselves to the overarching and broader obligation of LDI strategies to manage risk.

Climate reporting on liability-driven investment (LDI) mandates

Given that reporting in this way is a first for most pension schemes, the lack of a standard or established approach to reporting is a key focus of our discussions with clients and their advisers. The guidance is being interpreted as having some flexibility about what is covered in the reporting and the exact methodologies applied for calculating certain metrics.

This apparent flexibility means that, to date, we have seen a mix of approaches being considered, from reporting on the full exposure of the hedge, to reporting only on the funded gilt component, through to not reporting on the liability hedge at all.

While there is generally a clear intent to report, careful consideration has been given to the scope for reputational or even legal risks of both over-reporting (disclosing large or incorrect metrics) and under-reporting (under-stating or excluding emissions associated with liability hedges). As well as the potential challenge from regulators, clients’ concerns arose from the possible reaction of pension fund members, or the press, to the figures reported – particularly relative to those of other pension funds. For example, the possibility of a simplified league table being published that either ignores the size of a scheme or data and methodology limitations, or wrongly aggregates metrics across asset classes, could result in a pension scheme being incorrectly and unfavourably compared with others. Larger schemes and/or schemes whose sponsors are most often already in the public eye may feel these risks more acutely.

An additional point of discussion has been about the potential unintended consequences of reporting – specifically the investment decisions taken thereafter. It has been highlighted several times that it would be disappointing to see adverse economic outcomes being adopted in pursuit of a stated emissions improvement goal. Theoretical examples have been given of a pension fund replacing gilts funded on repo with more expensive interest rate swaps simply to improve its reported emissions metrics, or even reducing its liability hedges.

As a consequence, it feels like it is important for the disclosure of associated emissions to be accompanied by a clear description of the purpose of the mandate, context about the reported emissions figures and for trustees to be clearsighted about what they are trying to achieve.

Metrics to use

Initially, reporting is required on three metrics: absolute emissions, an intensity-based measure (carbon footprint per £m invested is recommended in official guidance, but weighted average carbon intensity, or WACI, is also mentioned) and one other (such as implied temperature rise or data quality). Some decisions need to be taken about which assets these measures are calculated for and the specific methodology for the metrics on each asset type.

As noted above, when applying the metrics to an LDI mandate, an important decision is whether to base reporting off the net asset value (i.e., the funded part of the portfolio) or to apply it to the full exposure (i.e., including the unfunded, or levered, part of the hedge).

DWP guidance allows for variation in metrics used, which makes it difficult to apply a standard across multiple schemes, or even within a scheme across different asset classes. Again, clients have highlighted that the lack of standardisation makes life more challenging for them.

Within LDI, we have had discussions with investment advisers and clients about which normalisation factor to use for WACI (e.g., GDP, PPP-adjusted GDP, or per capita). Different metrics and normalisation factors can result in materially different results.

Insight view

• We support efforts to highlight the climate-related risks faced by pension schemes, but observe that in relation to the application of TCFD metrics to pension schemes more work is needed to improve the quality of relevant data and to develop a better understanding of their relevance to schemes’ investment strategies. We note that TCFD alignment requires not only data disclosures, but also the publication of information around how trustees will seek to act on and manage climate-related risks.
• LDI mandates form such large parts of pension funds’ assets that it does not feel optimal to exclude them from reporting if that can be avoided. DWP guidance sets out a regulatory requirement for pension schemes to report “as far as they are able” and, for UK LDI mandates, it appears relatively straightforward to calculate and report on climate metrics related to gilts (based on UK emissions).
• However, we do think it is also important to communicate a clear message about the use of the data, the limitations of the methodology, and to explain the context of large gilt exposures within the pension scheme’s strategy.
• We encourage the industry to explore the possibility of greater standardisation, while also mitigating the chances of unintended consequences. We are engaging with investment advisers and industry bodies with the aim of influencing appropriate change.