Capital markets and climate change: can pension funds save the world?

The way pension funds invest will determine the future, which means that to thrive they’ll need to wake up to climate change.

June was a big month for sustainability announcements – the launch of China’s first carbon market, a commitment to tackle climate change from the G8 and yet another warning from the International Energy Agency that we remain on course for average temperature rises of 3.6°C if greenhouse gas emissions remain on their current trajectory.

Meanwhile, the United Nations Environmental Programme warned that climate change, water shortages and biodiversity loss will havean increasing impact on global business in years to come. Perhaps most importantly, President Obama altered the course of climate policy in the US with a speech that promised to curb emissions from power plants at home and stop funding coal-fired power plants abroad.

It might not seem immediately obvious what this has to do with the financial system, and pensions in particular, but the above factors are examples respectively of a price on carbon, possible policy changes, and the physical impacts of climate change – issues that will affect the financial performance of businesses and therefore the investors that put their money into those businesses.

Overwhelmingly, those investors are pension funds, allocating money so people can have decent pensions when they retire. But are these pension funds up to the job or are they actively undermining the security of future retirees?

“Very few pension funds are set up to deliver what pensioners will need in 40 years’ time,” says Alice Chapple, director of consultancy Impact Value and former director of sustainable financial markets at Forum for the Future.

Funds think that they are minimising their risk by investing in what they know, such as fossil fuel companies, but there is plenty of evidence that they are not valuing these companies correctly. For example, the IEA says that to meet our climate targets, two thirds of the companies’ fossil fuel reserves will have to remain in the ground.

But pension fund trustees do not see it as their job to come up with solutions to these problems, says James Cameron, chairman of cleantech investor Climate Change Capital. Partly this is because of inertia – “the most powerful force in the pensions world” – and partly because “almost all they can think about is the massive liabilities gap they are confronted with,” he says.

In addition, the structure of the industry encourages funds to reduce volatility and maximise returns in the short term – returns are appraised every three years. This, along with natural caution, encourages herd behaviour, says Louise Rouse, director of engagement at Share Action.

“I don’t think asset owners have a good understanding of the risks in their portfolio,” adds Chapple. According to the Asset Owners Disclosure Project, 50% to 60% of the average pension portfolio is invested in high-carbon assets, against just 2% in low-carbon assets.

“Despite several years of learning about climate risks, the industry has done very little to alter asset allocations,” Cameron says.

While some in the industry just don’t think this matters, others think that they will be able to sell out of unsustainable stocks when the time comes, says Chapple. “People see no sense in moving out until the writing is on the wall.” This attitude was famously summed up by former Citigroup boss Chuck Prince back in 2007, who said that “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”

Yet if the financial crisis showed us anything, it was that when everyone realises at the same time that they need to sell, things can get ugly. Taking this attitude is akin to rearranging the deck chairs on the Titanic rather than trying to avoid the iceberg. And when the inevitable happens, it is not the funds that get hurt, it is pensioners.

Despite all that is at stake for fund beneficiaries, they have very little control over, or indeed knowledge about, how their money is allocated. Pension funds have largely escaped scrutiny because people do not understand how the system works. “What else would you spend your money on without having any idea of what you are getting?” asks Kelly Clark, director of the Tellus Mater Foundation.

This lack of transparency matters, says Tony Manwaring, chief executive of Tomorrow’s Company. “Pension funds are our money. They are the means by which we plan for our future at a personal level and on a societal level the way that we invest now to deliver sustainable outcomes for the future.

“They are the point at which we connect to the financial system – which is complicated and alien and appears not to meet our needs. Yet they are an odd black hole of economic democracy.”

Because they were originally a paternalistic gesture by companies rather than something ordered by the state, pension funds have never felt an obligation to tell beneficiaries what they were doing with their money, says Saker Nusseibeh, CEO of Hermes Fund Managers, which is owned by BT’s pension scheme.

“It is almost a case of handing over your money and the pension fund saying: ‘We know what we’re doing and you don’t have to worry about it’,” says Rouse. “And yet very few people realise that it was their pension funds that voted in favour of RBS taking over ABM Amro [the deal that led to the bank having to be rescued by the government] and their funds that are encouraging the oil industry to invest in very polluting heavy oil.”

Future pensioners are going to have to bear more of the investment risk themselves, which makes transparency even more important. The decline of defined benefit schemes and their replacement by defined contribution plans means people pay into a pension fund without knowing what they will get out at the end, points out Rouse. This makes it vital that funds are not encouraging risky behaviour – so beneficiaries need to know where their money is going. “Pension funds need to be more open,” Clarke says. “It’s just good financial practice.”

Climate change and dwindling availability of natural resources such as water will shape future profit and loss and drive new markets, says Achim Steiner, executive director of the United Nations Environment Programme. “Companies that face up to these realities are likely to be the ones that thrive and remain competitive in a rapidly changing world,” he adds. The same applies to the pension funds that back them.