Time for Canadian pensions to grapple with climate risk

Last Friday was Climate Finance Day in Paris. The world’s largest financial players gathered to discuss how to assess and manage the investment risks associated with the transition to a low-carbon energy system.

Among the world’s largest and most influential pension funds and asset managers, the consensus was clear: financially material climate risk must be measured and managed by pension funds seeking to act in the best of their beneficiaries.

Worryingly, there was not a single Canadian pension fund in attendance.

Why is this a worry? Because by continuing to pump cash into capital-intensive, high-carbon assets like the oil sands and coal, risk-blind pension investors, including the Canada Pension Plan, are setting themselves up for a market crash on the magnitude of the sub-prime mortgage crisis.

Investment in new fossil fuel reserves that are uneconomic under sustained, relatively low oil prices —including oil sands, coal, and offshore oil, as well as other high-carbon assets — could become worthless.

In the face of an energy transition away from fossil fuels, combined with more active regulation of carbon by all levels of government, pension investors must move out of the most exposed fossil fuel projects.

A number of Climate Finance Day panelists stressed that in order to invest in the best interests of their members, and operate in line with their legally-binding risk management duties, pension fund managers must account for the serious financial risks associated with climate change. This includes policy moves to price carbon, and increasing competition from renewable energy.

A message to pension trustees from the leaders: carbon risk management is a legal duty

The resounding message for Canadian pension trustees following Climate Finance Day is that management of material carbon and climate risk falls within their legal risk management duties under federal and provincial law.

Depending on the province in question, this may be based on common law fiduciary duties, or statutory provisions on responsible risk management. However you slice it, pension trustees who ignore portfolio carbon risk can expect increasing accountability to their members under the law.

According to Philippe Desfosses, CEO at ERAPF—one of France’s largest public pension funds with US$26 billion in assets under management— the need for trustees to act is clear.

Desfosses told the financial newspaper Pensions & Investments that in their own investment strategy, ERAPF representatives “stress that carbon is a risk… and if you are running [that risk] in your pension fund, it is clear to us that from a fiduciary duty perspective, you should assess that risk and mitigate it.

"How can you justify not assessing that risk, [despite the fact that] it will impact the value of the assets that you are invested in and will compromise your ability to deliver on the promise to pay pensions to your contributors?”

Mr. Desfosses’ question, and other comments on statutory and fiduciary duties by a number of pension leaders, are important for pension managers whose funds are exposed to potentially stranded sub-prime carbon assets, including coal and Canadian oil sands.

Those pension trustees who do not take steps to address their portfolio carbon risk may face legal action by members concerned over negligent investment risk management.

Further down the investment chain, asset managers are already responding to the financial risks and realities of a low carbon transition.

“Pension funds are saying they are very concerned about this,” Colin Melvin, CEO of Hermes, one of the world’s biggest pension fund advisers, emphasized in an interview with Bloomberg. “They’re under pressure about climate from their beneficiaries. They recognize the world is warming and this will damage their own livelihoods and governments aren’t able to deal with it.”

What is clear is that Hermes’ 40 client funds in 10 countries (representing US$230 billion in assets) have already begun to weigh in on the climate risk management debate. This should give pause for thought among Canadian pension trustees and their asset managers who are doing nothing.

Structural carbon risks and Canadian pension investors: how will regulators respond?

While pension trustees face the spectre of legal action over risk management failures, financial market regulators are beginning to grapple with the implications of the structural risks posed by inaction. As the global financial NGO Carbon Tracker points out, and as the Bank of England appreciates, even if the impacts of an energy system transition to low carbon are long-term, setting up new financial regulatory standards requires immediate action in order to avoid the risk of stranded assets and dysfunctional capital allocation.

Investment industry agreement regarding the requirement for pension leaders, and their fund managers, to assess portfolio climate risk was given added impetus by the French government’s announcement of an Energy Transition Law.

The pending law mandates disclosure of the climate impacts and carbon risk exposure of French companies and asset owners. Under the new rules, institutional investors, including pensions, will have to disclose the carbon footprint of their investment portfolios and explain how these align with an internationally agreed-upon 2°C warming scenario (itself dependent on the massive shifts that would limit global emissions and cap the global temperature increase at that level).

In addition to these industry requirements, in December 2016 the French government will publish a carbon and climate risk stress-test report on the country’s financial sector as a whole.

Al Gore, who gave a speech in Paris at the beginning of Climate Week in Paris on May 19, summed up regulators’ and pension investors’ concerns over structural carbon risk with what he described as “a conscious reference to sub-prime mortgages,” referring to the growing threat posed by “sub-prime carbon assets.”

“There is a certain unreality to the assumption that the proven reserves on the books of these companies — $7 trillion in public multinationals, another $14 trillion owned by sovereigns - are all going to be burned," said Gore. "They are not."

While financial regulators fumble, Canadian pension leaders must act

Against this backdrop it is time for Canadian financial regulators, including the Bank of Canada and our pension regulators, to take the steps necessary to ensure capital markets are not ignoring the extent of the climate risk to portfolio value. In particular, regulators should be concerned that Canadian pensioner savings are invested in high-carbon portfolios based solely on fossil fuel companies’ misplaced confidence about the future being a business-as-usual, "burn it all” scenario.

In the context of statements made at Climate Finance Day, Canadian pension leaders can no longer do nothing and communicate nothing to members who are concerned about how their savings are invested and managed in the context of new climate policy scenarios.

Ignoring the material financial risks associated with climate change and carbon pricing is no longer a professionally or legally defensible option for Canadian pension plan administrators wishing to carry out their professional duty to protect their members’ savings.