Pensions and ESG: where are we now and what can we expect in the future?

Trustees of occupational pension schemes in the UK are coming under increasing pressure to take into account environmental, social and governance (ESG) factors when making investment decisions.

The Pension Schemes Bill, which is expected to become law by the end of 2020, takes this a step further, with new requirements for larger schemes and master trusts to align their governance processes and disclosures with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. But it stops short of mandating a net zero target.

This blog post summarises the current requirements (as at November 2020) for UK pension schemes in relation to ESG and looks ahead to how we can expect these requirements to develop in the future.

SIPs and implementation statements

Trustees of occupational pension schemes are required to have a statement of investment principles (SIP), covering their policies in relation to matters such as the kinds of investments to be held by the scheme, the balance between different kinds of investments, risks and the expected return on investments.

In 2019, trustees were required to update their SIPs to include their policies in relation to financially material considerations over the appropriate time horizon of the investments, including how those considerations are taken into account in the selection, retention and realisation of investments. Financially material considerations specifically include ESG considerations which the trustees consider to be financially material.

Trustees were also required to update their SIP to include their policies in relation to the exercise of voting rights attaching to their investments and undertaking engagement activities in respect of the investments.

Since October 2020, trustees have also been required to prepare an implementation statement, setting out the extent to which the SIP has been followed over the previous year. The government intention is that requiring trustees to report on how they have followed their SIP will ensure schemes actually act on the principles they have set out.

For more information, see our publication: Investor Agenda: SIPs and implementation statements: what do trustees need to do next?

Climate change provisions in Pension Schemes Bill

The Pension Schemes Bill includes provisions intended to further strengthen the obligations of trustees specifically in relation to climate change risk. While it is not the government's intention to direct schemes or set their investment strategies, trustees may be required by regulations, to be made under powers in the Bill, to take steps to ensure there is effective governance of the scheme with respect to the effects of climate change.

The government has published a detailed consultation on the requirements to be included in the regulations made under the Pension Schemes Bill. It is proposing to require trustees of schemes with £5 billion or more in assets (as well as authorised master trusts and collective money purchase schemes) to have effective governance, strategy, risk management and accompanying metrics and targets for the assessment and management of climate risks and opportunities from October 2021. It is also proposing that they would be required to report on these in line with the TCFD recommendations by the end of 2022. Schemes with £1 billion or more in assets would be subject to the same requirements from October 2022.

Although the requirements would initially apply only to larger pension schemes, smaller pension schemes should expect similar requirements to extend to them in the coming years. The government has said it intends to “take stock” in 2024 and consult on the extension of the requirements to all other schemes.

For more information on the roll out of mandatory climate reporting in the UK to pension schemes and other organisations, see our blog post: UK paves way for mandatory TCFD climate disclosure for companies and other organisations by 2025.

Net zero targets

During the passage of the Pension Schemes Bill through Parliament, the opposition proposed an amendment that would mandate occupational pension schemes to develop a strategy for ensuring that their investments and stewardship activities are aligning with the goals of the Paris Agreement on climate change, and include an objective of achieving net zero greenhouse gas emissions by 2050 or sooner. Perhaps unsurprisingly, this amendment was defeated. The government is clearly committed to requiring schemes to disclose their approach to climate change (see above); but actively requiring schemes to reduce their carbon footprint is seen as a step too far.

In practice, of course, some of the larger pension schemes are adopting net zero targets. One example is Nest, the scheme set up by the government for auto-enrolment, which recently announced a new climate change policy to decarbonise its investment portfolio. The policy aims to align Nest with the Paris Agreement goals to keep global temperature rises within 1.5°C above pre-industrial levels by 2050. It sets out a goal of being net zero across its investments by 2050 or earlier, with the expectation that carbon emissions in its portfolio will halve by 2030.

For more information, see our blog post: The pursuit of net zero. Should pension schemes have a net zero target?

What about the “S” and “G” in ESG?

Although the focus of the Pension Schemes Bill is on climate change, it is worth remembering that this is just one element of ESG. Factors such as worker wellbeing and relations, diversity and inclusion, supply chain issues and corporate purpose and values are also capable of being financially material. The Covid-19 pandemic and the Black Lives Matter movement in particular have helped raise the profile of the “S” and “G” limbs of ESG.

We can perhaps expect to see an increasing focus on these other elements of ESG in the pensions space in future.