Pressure Is Building to Consider Climate Change When Investing

Retirement plan fiduciaries, for now, should at least consider the role climate change will have on plan investments and vice versa.

Recent news reports say an environmental scientist in Australia is suing his pension fund for not adequately disclosing or assessing the effect of climate change on its investments. The participant is only 24 years old and won’t be retiring any time soon. But, the news reports say, he is acting now because he is “concerned about what the world may look like then.”

There is no doubt, whether you believe it is happening or not, climate change is the subject of a strong activist movement.

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A just-published report about a yearlong, cross-disciplinary research effort at McKinsey & Company says climate change is already having substantial physical impacts in regions across the world. And it finds substantial impacts continuing until 2050—the latest date for which the study makes projections—unless measures are taken to reduce global warming.

The study measures the impacts in five systems. For example, for livability and workability, the report says, “Hazards like heat stress could affect the ability of human beings to work outdoors or, in extreme cases, could put human lives at risk. Increased temperatures could also shift disease vectors and thus affect human health.” It makes similar observations about food systems, physical assets, infrastructure services and natural capital.

What does this have to do with retirement plans? As the McKinsey report says, “Financial institutions could consider the risk in their portfolios.” There is a portfolio risk in investing in companies that are allegedly hurting the climate, and there are opportunities in investing in companies that are working to mitigate the effects of climate change.

George Michael Gerstein, fiduciary governance group co-chair at Stradley Ronon Stevens & Young LLP in Washington, D.C., says there are more studies coming out by asset managers and insurers that are identifying material risks to performance based on climate change. “It’s not a reaction to some moral uproar; they are really analyses based on risk and return,” he says. And he anticipates there will be increasing acknowledgement that climate change can influence investment performance.

Google “risk to investment performance from climate change” and a number of reports will pop up. One study led by Mercer and supported by International Finance Corporation (IFC), in partnership with Germany’s Federal Ministry for Economic Cooperation and Development and the UK Department for International Development (DFID), says effects on returns from climate change are inevitable. The report—“Investing in a Time of Climate Change”—assesses investment exposure to climate risk, estimates the impact on investment returns through 2050 and offers insights on how investors can improve the resilience of their portfolios. The study concludes, “However, if we manage to cap the temperature increase to two degrees Celsius, financial returns for long-term diversified investors will not be jeopardized because of investment opportunities created by the world’s transition to a low-carbon economy.”

A report from Ernst & Young says, “The risks posed by ‘stranded assets’—assets that unexpectedly lose value as a result of climate change—are rapidly climbing the investment industry’s agenda.”

Suing over climate change

The Australian environmental scientist’s lawsuit is not the only one related to climate change. Dr. Maximilian Horster, managing director and head of climate solutions at Institutional Shareholder Services (ISS) ESG in Germany says climate litigation has been around for many years and individuals have been suing companies for harming the climate. Horster gives the example of a Peruvian farmer suing Germany’s largest power producer for causing glaciers to melt, which threatens to flood his town and his home. According to Time magazine, the farmer says that because research by the Carbon Disclosure Project and the Climate Accountability Institute says the power producer is responsible for 0.5% of global greenhouse-gas emissions, it should pay for 0.5% of the cost of flood defenses for his town.

But, according to Horster, there is a new trend of entities considering offenses against asset owners. “It’s kind of preparation for large cases happening,” he says.

For example, Horster says, the Swiss Federal Office for the Environment decided just last week that if pension plans are found in breach of climate commitments by investing in high carbon assets, it should sue them.

In December, the Dutch Supreme Court in the Netherlands upheld a ruling requiring the government to slash greenhouse gas emissions by at least 25% of 1990 levels by the end of 2020. Horster says the court also just ruled that if companies or the government act against this reduction target, they are in breach of law and will be assessed a penalty.

Providing a different take, this month, in a case in the United States, a divided 9th U.S. Circuit Court of Appeals decided federal courts could do nothing to stop the U.S. government from causing climate change. The court said the youth plaintiffs’ case in Juliana v. United States must be made to the Congress, the president or to the electorate at large.

Horster also mentions that ClientEarth, based in the U.S., Australia and Europe, is a group of lawyers that sue companies and investors for harming the environment. And the two-degree investment initiative says if an asset manager claims a fund is addressing climate change and it is found not to be, the asset manager is misleading investors and it will get into trouble.

“The bottom line is there are many initiatives around by which investors face the risk of being sued about climate change,” he says.

A fiduciary duty to address climate change?

So reports say investing in companies that harm the environment affects returns, and courts and activist groups say it helps companies harm the environment. Whether considering investment returns or the effect on the environment, do retirement plan sponsors have a fiduciary duty to consider climate change when choosing investments?

Gerstein notes that in the environmental, social and governance (ESG) investing trend, institutional investors would make decisions based on collateral objectives—e.g. divesting from companies doing business in Sudan or from gun makers. The Department of Labor weighed in, issuing Field Assistance Bulletin (FAB) No. 2018-01. Under 2008 guidance, ESG investing factors could serve as a tiebreaker when considering economically similar investments. Gerstein says, “FAB 2018-01 expressly reaffirmed the notion that a fiduciary under [the Employee Retirement Income Security Act (ERISA)] could take a factor such as climate change into account where he thinks it has a super impact on performance and he doesn’t have to use the tie breaker test. I think that’s where the trend is going.”

As for whether there is a fiduciary obligation for plan sponsors to take specific action to mitigate the risk of climate change, Gerstein says he doesn’t see any obligation to take any affirmative action. But, he adds, “I think there is a fiduciary obligation to at least consider the risk. Fiduciaries don’t have to take action, but at least be aware.”

“It is reasonable to think that these risks are baked into share prices already. There’s an idea that particularly with U.S. securities in a highly efficient market, if there’s a hidden risk, the share prices would already reflect that,” Gerstein says. He adds that early court indications suggest that retirement plan fiduciaries can generally assume that.

However, Gerstein says, some very public officials say the risk is not reflected in share prices. “Should a participant challenge a plan sponsor for failing to take action to mitigate climate change risk, I don’t see that as a successful strategy now—not until there becomes a greater mountain of evidence that climate change is incorporated in share prices. In five years it could be there, in 10 years, yes,” he says. “Because we are in early days of really understanding the link between climate change and investment performance, I believe courts will wait for the data to be more refined.”

Gerstein contends this ties into a broader issue regarding federal securities law. He says one of the obstacles to greater ESG adoption is a lack of good disclosure by issuers in terms of how climate change affects their bottom line and how they are mitigating climate change risk. “How much disclosure do federal securities laws require in public filings and statements,” Gerstein queries. “This has an effect on retirement plan fiduciaries evaluating holdings.”

He adds that whether climate change information should be put in prospectuses provided to participants is one of those issues still working its way through securities laws. There is a desire for disclosure on climate change and ESG more broadly, he says.

And, Gerstein says, there is disparate treatment of disclosures about climate change globally.

Horster says plan sponsors are wanting to understand how climate change influences investments and vice versa. They want to understand what the risk of climate change is to investments or how to invest to help mitigate climate change. He says there are firms that offer services to tell investors if they have risks from climate change and what they are.

Horster notes that in the case filed by the environmental scientist in Australia, he is not suing for his retirement plan to invest differently, he is suing because plan fiduciaries don’t even understand or measure the risk from climate change. This is why the first step is to understand.

Gerstein says, as part of plan investment committee meetings, it would be helpful to be aware of the studies and public statements or actions by very large asset managers globally. “When there are very large, respected investment managers making significant pronouncement on these issues, committees should be aware of and discuss them,” he says.

Just last week, BlackRock announced it will be accelerating efforts to deepen the integration of sustainability into technology, risk management and product choice. In a client letter, the firm said, “Over the past few years, more and more of our clients have focused on the impact of sustainability on their portfolios. This shift has been driven by an increased understanding of how sustainability-related factors can affect economic growth, asset values, and financial markets as a whole.” It said the most significant of these factors today relates to climate change.

This week, MSCI, a provider of decision support tools and services for the global investment community, released its own view on ESG investing, urging all investors globally to more readily integrate ESG throughout their investment processes. The firm also published, “The MSCI Principles of Sustainable Investing,” a framework to illustrate actionable steps investors can take to improve ESG integration.

While the first step is to understand, Horster says the next step is to act on the information—divest or shift asset classes. He points to Climate Action 100+, an investor initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change. Retirement plan sponsors can say, “I want to invest in you, but I want to make sure you will be viable in the future by avoiding the risk of climate change,” Horster says.

“Pension plans are very special outfits in the financial industry because they invest money for a future for people. More than any other investors, they should invest in a way that people’s future wealth is worth retiring into,” Horster says. “Not only should they make sure the plan’s investments generate returns necessary for participants to have a secure retirement, but they have a societal role to play in considering what the investments mean for the world participants will retire in.”