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Designing decarbonization strategies for pension plans

As the world grapples with the urgent need to address climate change, pension plans will be close to the epicenter of the disruptions that will stem from decarbonization efforts. With their significant financial resources and long-term investment horizons, pension plans are unavoidably exposed to climate risks. They have an opportunity to tackle the implications proactively.

02/01/2024
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Authors

Jenny Mill
Climate Change Strategist

Net Zero commitments need to be backed up with plans

Pension plans will need to manage the impact that climate change will have on their portfolios, both from the low-carbon transition and from the physical risks of climate change. Equally, however, some pension plans are choosing to consider their portfolios’ impacts on the climate and have established targets to reduce the carbon exposures of their investments toward long-term net zero goals. Those dual goals are not in tension; thoughtful approaches to portfolio transition can help to identify risks and capitalize on opportunities from the low carbon transition that can unlock value over time.

Momentum behind Net Zero

Globally, more institutional investors than ever are making commitments to reach Net Zero. The Schroders Institutional Investor Survey 2023 found that 50% of institutional investors have made a commitment to reach Net Zero, of which the majority are targeting 2050 (39%). While there are disparities regionally, with the share highest in EMEA, it’s clear that more organizations globally are committing to Net Zero.

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However, commitments need to be backed up by plans setting out how they will achieve their ambition, and our study shows that so far only 29% have developed and implemented a strategy to meet their targets.

Agreeing your motivations and priorities

For pension plans, agreeing your motivation and priorities could be influenced by the investment preferences of your beneficiaries. More pension plans are taking steps to engage beneficiaries on their sustainability preferences, including their climate and Net Zero preferences. Regulations and disclosure requirements are also creating a growing need for pension plans in some countries to assess portfolio climate exposures and to articulate their strategies to manage them.

Decarbonization strategies can be tailored to reflect different goals.

Before setting out a strategy, it is therefore important to determine the key motivations which can drive decision-making, including manager selection, and help you to communicate your needs and expectations with investment managers or advisors.

Considering the decarbonization strategy

A decarbonization strategy needs to set out not just what you are trying to achieve but how you plan to achieve it. If an investor wants to decarbonize a portfolio quickly, arguably the easiest option would be to simply apply exclusions for high-emitting sectors or companies, divesting any current positions. However, the investment effect is only to narrow the investment universe and the impact on real world emissions reductions will be minimal.

By contrast, a more active approach has the potential to have transformative decarbonization impact in the real economy. By engaging the companies within a portfolio to set emissions reduction targets, publish transition plans and demonstrate progress to decarbonize over time, investors can play an active role in the transition, remaining invested in companies and benefiting from the value that can be unlocked as companies cut emissions, as well as supporting reductions in real world emissions.

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On the other side of the spectrum, pension plans should consider whether their portfolios are capitalizing on the opportunities associated with the low-carbon transition, including renewables and clean technologies. A transitioning portfolio will typically increase its allocation to such opportunities, as technologies scale to meet increasing demand over time. In doing so, valuation is a key consideration given the fluctuations in valuations of clean technology stocks and assets we have seen in recent years.

Implementing Net Zero transition strategies will require elements of each of these options, and pension plans should work with their advisors and managers to understand and plan for how their portfolios use these levers. Managers responsible for asset allocation or security selection should be able to deliver against decarbonization objectives. If choosing an active approach, the manager needs to provide you with the confidence that they can deliver your decarbonization objectives while generating risk-adjusted returns.

The development of more passive approaches to decarbonization, such as indices which track the EU Climate Transition Benchmark (CTB) and EU Paris Aligned Benchmark, offer a straightforward answer to decarbonization year-on-year to 2050, though at the expense of growing constraints on investment universes and often with limited impact on companies’ own emission reduction contributions.

Preparation for and Contribution to Net Zero

Many pension plans are becoming increasingly focused on climate change, for different reasons and in different circumstances. By engaging investment advisors and managers to meet decarbonization targets in a way that meets their aims, pension plans can proactively prepare for the impacts of a climate transition on portfolios, while also actively contributing to that transition.

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If you would like to learn more about designing a decarbonization strategy for your organization, take a look at our three-part guide which aims to help asset owners set and manage an effective net zero investment strategy.

Click the links below to access.

Part 1: Setting a Net Zero plan

Part 2: Implementing a Net Zero plan

Part 3: Tracking and measuring progress

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Authors

Jenny Mill
Climate Change Strategist

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