Analysis: Disagreements abound over pension funds’ climate scenario models

Universities Superannuation Scheme (USS) has recently kicked off a project to develop “decision-useful” climate scenarios.

The move comes amid criticism that pension funds and consultants are using unfit models to assess the potential impact of climate change on portfolio returns, raising questions about prudence, fiduciary duty and asset owners’ ability to meet their net zero pledges.

The £90bn (€104bn) UK pension fund is working with academics at the University of Exeter to establish an “approach to climate scenario analysis that integrates a deep understanding of climate science with its interaction with macroeconomic and financial markets outcomes over different time horizons,” according to its latest TCFD report.

Today, the University of Exeter added to the growing pile of criticism being levelled at industry practice, publishing a report that urges UK pension funds, who are required to conduct climate scenario analysis under recently-introduced regulation, to rethink their approach.

Pension funds’ strategic allocations are ”backward-looking”

The paper suggests that pension funds’ strategic asset allocation decisions are underpinned by a backward-looking Capital Asset Pricing Model that predicts future returns based on past performance. This approach, which the authors describe as having “simply become ‘the way we take decisions around here’” for pension funds’ advisers, is not able to adequately incorporate forward-looking climate risks, it warns.

In addition, the report highlights the fact that most climate scenario methodologies do not fully incorporate physical risks such as weather events, or the economic implications of geopolitical trends such as climate-driven migration and war.

“Many funds are now seeking to align their assets to a halving of greenhouse gas emissions before the decade is out,” noted Mike Clark, one of the paper’s authors. “Official scenarios offer next to no guidance on how to achieve that.”

This is the latest in a flurry of analysis focused on climate scenarios in recent weeks – all of it reaching scathing conclusions.

Last month, the UK’s Institute and Faculty of Actuaries published research (also in partnership with Exeter University) arguing that “the results emerging from the [climate scenario] models are far too benign, even implausible in some cases”.

That paper showed that analysis commissioned by some UK asset owners had indicated that ‘hothouse’ temperature rises would not impact their portfolios dramatically, and in some cases would be better for returns than a climate transition.

Speaking on a podcast last month, Louise Davey, director for regulatory policy, analysis and advice at The Pensions Regulator in the UK, said: “If I was a trustee and I was being presented with a scenario as extreme as that, and being told it wasn’t going to have very much impact at all… that just instinctively doesn’t sound plausible, and I would want to make sure that I was given a real in-depth explanation of how that assessment has actually been made.”

Davey suggested that “trustees really need to be quizzing their advisers on the scenarios that are being put before them” in order to safeguard beneficiaries’ savings over coming decades.

She welcomed the recent attention on the topic, saying the new research “gives trustees more footing to really challenge their advisers, because that’s something we’re really keen that trustees are in a good position to do”.

Carbon Tracker’s critique of climate scenarios

Climate think-tank Carbon Tracker also published a critique of scenario models last month. In it, it warned that pension returns were at risk because advisers were not paying adequate attention to climate tipping points.

“Many pension funds use investment models that predict global warming of 2 to 4.3°C will have only a minimal impact on member portfolios, relying on economists’ flawed estimates of damages from climate change, which predicts that even with 5 to 7°C of global warming economic growth will continue,” Carbon Tracker’s researchers said, arguing that many funds defer responsibility for the results of scenario analysis to their consultants when, in reality, they “have a fiduciary duty to correct the erroneous predictions they have given their members”.

LGPS Central, the pension pool responsible for running the assets of a number of the local authority pension funds namechecked in the studies, did not respond to multiple requests for comment about the results of the scenario analysis they had commissioned on behalf of asset owners.

Climate scenario models need updating

Mercer, the consultant behind much of the analysis that’s been under scrutiny – and the only consultant to publicly disclose its methodology and assumptions – acknowledged that climate scenario models “are not perfect, and we know they’re not”, but insisted “they’re still helpful in informing decisions” if used alongside other types of analysis.

Speaking with IPE, Vanessa Hodge, who is responsible for sustainability integration at Mercer UK, said it was challenging to model the impact of climate on portfolios because “we just don’t know how it’s going to play out”. Embedding physical risks was a particular challenge, she added.

Last year, Mercer formed a partnership with climate data and software provider Ortec to enable it to update its models more regularly.

Mercer is opposed to any future regulatory interventions that would dictate climate pathways for scenario analysis.

“We do not want regulators to tell us to model one set of scenarios with prescribed assumptions and narratives, so everyone does the same set,” said Hodge. “We all know that they are wrong, in that we don’t know what the world is going to do. The more prescribed they are, the more wrong we’re all going to be collectively.”

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