In the current internationally connected investment and insurance pools, the cost of damage caused by the physical impacts of climate change is felt around the world, including to an increasing extent by the members of pension funds.1
In September 2013, the UN Intergovernmental Panel on Climate Change (IPCC) reported that there is at least 95 per cent certainty that human activities have contributed to half the temperature increases since the 1950s, with the main causes attributed to the 40 per cent increase in greenhouse gases and changes in land use.2
The physical impacts of this changing climate include warmer temperatures and oceans, less snow and smaller ice caps and rising sea levels.3 The report mapped the probability of more extreme weather patterns around the globe, including heat waves, droughts, monsoonal rains and more severe storms.
We know all too well that extreme weather patterns cause significant financial and human loss, as we saw with the Victorian bushfires, the Queensland floods, the Russian heat wave, the American east coast snow storms and the recent flooding in the UK. Extreme weather conditions can damage agricultural lands, commercial, industrial and residential property as well as vital energy assets and their associated infrastructure. In the current internationally connected investment and insurance pools, the cost of such damage is felt around the world, including to an increasing extent by the members of pension funds.
The IPCC also concluded that “[c]ontinued emissions of greenhouse gases will cause further warming and changes in all components of the climate system” and that “[l]imiting climate change will require substantial and sustained reductions of greenhouse gas emissions”.4
More recently, the International Energy Agency has stated that “as the source of two-thirds of global greenhouse gas emissions, the energy sector will be pivotal in determining whether or not climate change goals are achieved”.5
Bleak House for investment in “polluting industries”?
Internationally co-ordinated climate regulation could have a significant impact on pension funds investing in “polluting industries”
One approach to achieve emissions reduction would be internationally co-ordinated climate regulation that discourages investment in polluting assets and encourages investment in green assets. Depending on the form and reach of climate regulation, it has the potential to result in “stranded assets” or “unburnable” reserves of fossil fuels, which may have a significant impact on the value of those reserves and the pension funds that invest in them through their share portfolios.
In January 2013, HSBC released a report that suggested that in a future low-carbon world, a substantial amount of the current fossil fuel reserves of European oil companies would remain unusable or ‘unburnable’, which could severely impact the value of those companies.6 It is not difficult to see how such co-ordinated climate regulation could have similar results for mining, oil and gas companies worldwide. Given that these companies make up a significant proportion of global securities exchanges, a low-carbon world could have a significant impact on the pension funds that invest in those companies and their associated infrastructure assets (such as ports, grids and pipelines).
Even if inter-governmental disagreements around the form of climate regulation delay the implementation of comprehensive global climate regulation, institutional investor activism involving a movement away from polluting assets and supporting greener assets may have an increasingly adverse impact on the value and liquidity of polluting assets and their associated infrastructure. Fossil fuel divestment campaigns such as those launched by 350.org have the potential to generate the same momentum as earlier campaigns, such as the tobacco and South African divestment campaigns.
The time for pension fund trustees to critically assess the potential impact of climate change on their asset holdings is overdue.
Given the weight of scientific evidence, the financial impact of severe weather patterns, the potential for widespread climate regulation and mounting investor activism, the time for pension fund trustees to critically assess the potential impact of climate change on their asset holdings is overdue.
A number of local and international reports have confirmed that it is open to pension fund trustees to take climate change into account in their investment decisions.7
Pension fund trustees have heightened investment governance obligations in the post GFC world and are subject to greater scrutiny by governments, regulators and the broader community. In the Australian context, the answer is clearly that trustees are permitted, and should, take climate related matters into account.
The sole purpose test under Australian superannuation law is a red herring and does not prevent climate related matters being considered in investment decisions. The recent stronger super reforms impose additional risk management and due diligence requirements on pension fund trustees in Australia, which clearly require those trustees to engage in the climate debate.
But how far should trustees go? Should they be actively repositioning their portfolios away from polluting industries (such as coal, oil and gas) and their associated infrastructure (ports, pipelines and grids) and towards greener assets (renewable energy, biofuels)?
Much depends on the expectations placed on trustees by the general public, which the courts take into account in determining whether trustees are discharging their legal obligations in managing their pension assets. The science and associated political debate are at a stage where the general public are likely to expect more of pension fund trustees than merely adopting a “watching brief”.
The regulators also have a role to play as their expectations find their way into mandatory prudential standards (which are an easier path than getting climate reform through the parliamentary process).
Under their legal obligations relating to investment governance, trustees would be required to source sufficient and reliable information about the risks that climate change, climate regulation and investor activism may pose for their investment portfolios.
Australian superannuation legislation is a multi-facetted and complex web that imposes a myriad of obligations on trustees, including those relating to investment governance. As a general obligation, trustees must act in the best interests of fund beneficiaries (who comprise the Australian workforce and their dependants). More specifically, they are required to exercise the same degree of care, skill and diligence as a professional superannuation trustee.
In addition, trustees are required to set investment objectives and formulate, implement and regularly review an investment strategy for the whole fund and for each investment option within the fund having regard to the risks involved in making, holding and realising the fund assets and the likely return on those assets.
In a climate change context, these legal obligations of themselves, would require trustees to source sufficient and reliable information about the risks that climate change, climate regulation and investor activism may pose for their investment portfolios.
Community and regulatory expectations would require trustees to engage experts who can educate the trustees and advise them on the likely financial impact of those climate related matters on their investment portfolios and the likely timeframe over which those impacts may be experienced.
This exercise is one of risk management, which is a global focus of pension fund regulators and is a theme that permeates the APRA prudential standards. Given the potential for adverse financial impacts on the value of polluting assets and their associated infrastructure, it would be remiss of trustees not to embark upon this risk management exercise.
Of critical concern in the climate debate is the reliability of information about the magnitude of the potential financial impacts of climate change and the timing of that impact. The sourcing of reliable information itself requires both a risk management assessment and a cost benefit analysis. However, trustees and their advisers are well versed in these practices.
Pride or prejudice?
The critical point is for trustees to give real and genuine consideration to climate related matters following the completion of a risk weighted information gathering process.
Literary analogies aside, trustees should not be swayed by their political views in relation to their stewardship of pension fund assets. They have a higher fiduciary and statutory allegiance to act in the best interests of their fund beneficiaries. This requires a considered approach based on reliable evidence provided by subject matter experts. There are likely to be differing views by advisers (and even more so within the climate change debate). The critical point is for trustees to give real and genuine consideration to climate related matters following the completion of a risk weighted information gathering process.
Trustees, and not the courts, are entrusted to make these difficult decisions and the important benchmark used by the courts to test their decisions is to critically examine the experience of the decision makers and their advisers, the investigative process they followed to gather the information before them and to be satisfied that they gave real and genuine consideration to the relevant issues and thereby made informed decisions.
To invest or not to invest?
The law and the climate debate are at a stage where trustees cannot just maintain a watching brief.
Whether trustees will decide to divest polluting assets and invest in green assets is a matter for them to decide. Much depends on the likely timing of any adverse financial impacts on their portfolios having regard to the reliability of the information provided by their advisers. However, the important point to note is that the law and the climate debate are at a stage where trustees are required to consider the impact of climate change on their portfolios. Maintaining a watching brief without more, may land you in hot water. In short, this is a call for action.
1A reference to pension fund in this article includes superannuation funds in Australia.
2The first working group report of its Fifth Assessment Report, ‘Climate Change 2013: The Physical Science Basis’ (WG1 Report), Summary for Policymakers, pages 4, 11 and 17.
3WG1 Report, Summary for Policymakers, page 4.
4WG1 Report, Summary for Policymakers, page 19.
5International Energy Agency, World Energy Outlook 2013, page 1, Executive Summary
6HSBC, Oil & Carbon Revisited: Value at Risk from “Unburnable Reserves” (January 2013).
7Superannuation Trustees and Climate Change Report, Baker & McKenzie ; Freshfields Bruckhaus Deringer, A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment ; and UNEP, Fiduciary Responsibility: Legal and practical aspects of integrating environmental, social and governance issues into institutional investment .