ARTICLE
21 September 2023

Climate Reflections For UK Pension Schemes: The Risky Business Of Scenario Analysis

In part two, we dive deeper into the reports' often-complex strategy, scenario analysis and risk management sections.
United Kingdom Employment and HR

In part two, we dive deeper into the reports' often-complex strategy, scenario analysis and risk management sections.

Welcome back to our guide to the experiences of schemes that published TCFD reports in 2022.

Background recap

The reports were prepared following the Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations 2021, which were based on the recommendations of the Taskforce on Climate-related Financial Disclosures. We refer to them as TCFD reports in this article series. These reports represented the UK's largest schemes – those with assets of £5bn or more. The Pensions Regulator (TPR) published its review of these reports in March 2023, and this three-part series includes their key findings alongside our reflections, having advised many of the 71 schemes that published reports in this first wave.

In part one, Governance is king, we outlined some of the key findings from TPR's review, along with more detail on the governance aspects of the reports.

In this part (part two), we will dive deeper into the reports' often-complex strategy, scenario analysis and risk management sections.

In part three, we will discuss the metrics and targets section of the reports before concluding and setting out what we think schemes of all sizes should do next.

Strategy and scenario analysis

Trustee boards often use scenario analysis to help them understand the risks associated with different decisions, such as investment strategy. However, very few had considered the potential path of their scheme's funding under potential future scenarios for the world's climate until preparing their first TCFD reports. As a result, most trustee boards had a lot to get their heads around, and this was reflected in the varied feedback from TPR from their review. For example, TPR noted that many schemes missed information required by the legislation, including the impact of climate-related risks on the scheme's investment and funding strategy, rather than simply on asset and liability values.

"Whilst scenario analysis can highlight potential outcomes, it cannot illustrate the full range of possibilities."

James Wintle | Managing Director, Retirement

Although it was encouraging to see that most schemes opted for quantitative analysis (rather than qualitative), there is still more that schemes can do to take things further. Rather than just considering the impact on the assets and liabilities of the scheme under chosen scenarios, TPR pointed out that this could helpfully be extended to consider how the results might impact scheme's investment or funding strategy. With so many different climate scenarios available for trustees to choose from, TPR also noted that it would be more helpful for users of the reports if each trustee board chose a single set of scenarios for their scheme to cover all aspects of the analysis in their report (e.g. assets, liabilities, covenant) to ensure a coherent story could be told.

Our view: Many trustees reflected on insightful climate scenario analysis when drafting their first TCFD report. However, for schemes now in scope for reporting or for the second report of the largest schemes, more can be done to ensure trustees extract increased value from carrying out climate scenario analysis. With the release of further guidance on covenant implications for schemes more broadly to come from TPR later in 2023, we believe that trustees who compile the various risks and opportunities they have assessed into a Climate Action Plan will be best placed to make well-informed decisions. We do not believe that all schemes should adopt the same climate scenarios as that risks a 'herd' mentality, but it is important for all scenarios to truly reflect how bad some climate scenarios could be for the world – for example, the impact on the economy and asset values of different climate 'tipping points' being breached.

While scenario analysis is a useful tool for highlighting the likely impact of some potential outcomes, it cannot illustrate the full range of possibilities or capture all the intricacies of the complex meteorological, social, political and policy interactions that the climate crisis raises – trustees must therefore take quantitative results from such modelling with a grain of salt and may find the process more enlightening than the numbers.

Risk management

TPR commented that this section of many of the TCFD reports that they reviewed was shorter than others and appeared designed to meet the minimum requirements only. This may well be because the schemes will have already had risk management structures in place that climate-related risks were then embedded in. However, it is important that schemes detail the processes they have in place to identify, assess and manage risks in their TCFD reports, rather than simply listing the risks that have been identified.

Ensuring that the impact on the employer covenant is incorporated fully into this analysis and using the research to support strategic decisions are the next steps for many trustee boards.

Additionally, TPR noted that it would be useful to provide specific examples of actions that trustees took over the year to manage the risks they identified. For example, did they (or someone on their behalf) engage with companies known to be big polluters, or carry out a review of their investment managers where climate-related risks were part of the decision-making process?

As with the strategy section of the reports, ensuring that the employer covenant aspects are captured appropriately in this process is also key and underlines the importance of allowing plenty of time to prepare a TCFD report, given the range of inputs and considerations required. Further guidance to come on employer covenant considerations will be helpful for schemes in giving this area greater attention.

Our view: This is an area that we expect to bed in over the coming years, with wider changes to scheme governance from the long-awaited new General Code of Practice providing an ideal opportunity for schemes to conduct a wider review of their risk management processes.

Conclusion

The results of scenario analysis have generated healthy discussion and debate amongst many trustee boards, whom we have seen be fully engaged in the process of assessing the potential impact of climate on their scheme's assets and liabilities. Ensuring that the impact on the employer covenant is incorporated fully into this analysis and using the research to support strategic decisions are the next steps for many trustee boards. Join us again for the final instalment of this series, where in part three, we will cover metrics and targets before wrapping up and outlining the next steps for trustees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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