New EU Directive Requires Pension Funds to Assess Climate-related Risks

EU FlagOn December 8th, 2016 the EU adopted a new regulation regarding Pension Funds, the IORP II Directive — the successor of the Institutions for Occupational Retirement Provision Directive adopted in 2003. The directive’s main objectives are to enhance pension funds’ governance, risk management and supervision, and to facilitate cross-border activities.

A key feature of the directive is the consideration of environmental, social and governance (ESG) factors as part of pension providers’ investment. In particular, pension providers are now required to carry out their own risk assessment, including climate change-related risks, as well as risks caused by the use of resources and regulatory changes.

Moreover, the Directive explicitly allows pension funds to take into account ESG factors in investment decision-making, within the ‘prudent person’ rule. This comes as an important clarification as fiduciary duty is often cited by investors as a reason they cannot pay more attention to ESG issues in investment processes.

The implementation of the Directive

IORP II applies to all the 14,358 registered EU pension funds, among which 160 have cross-border activities.

Member States (EU countries) have until January 13, 2019 to transpose IORP II into their national law, which was published early January in the Official Journal of the European Union. According to current projections, the implementation deadline should therefore fall before Brexit, an important fact considering that the UK accounts for 50 percent of the EU occupational pension fund sector, followed by the Netherlands (33 percent).

A new risk assessment covering climate-related physical risks

The risk assessment is to be carried out every three years or after any significant change in the risk profile of the pension funds “in a manner that is proportionate to their size and internal organization, as well as to the size, nature, scale and complexity of their activities”.

The assessment must cover “new or emerging” risks, “including risks related to climate change, use of resources and the environment, social risks and risks related to the depreciation of assets due to regulatory change”.

The Directive’s preamble invites EU member states to use the Principles for Responsible Investment (PRI) as a reference for ESG and climate change-related reporting requirements and states that “the relevance and materiality of environmental, social and governance factors to a scheme’s investments and how they are taken into account should be part of the information provided by the scheme under this directive”.

While physical impacts of climate change are not mentioned in these terms, the inclusion of risks related to climate change, use of resources and social risks clearly point to the inclusion of physical impacts, in addition to regulatory and energy transition risks. National transpositions might provide more explicit guidance.

Beyond compliance considerations, pension funds are particularly exposed to climate risks given their long-term investment profile. The longer an asset manager’s time horizon, the more climate-related risks increase. As pension funds also tend to be particularly risk-averse, taking into account climate-related risks is crucial for effective risk mitigation. In 2015, the Economist Intelligence Unit valued the average expected loss as a result of climate change across scenarios as $4.2tn in financial assets.

Considering that EU pension funds now manage more than €2.5 trillion ($2.65 trillion) in combined assets, the assessment of physical climate risks will require considerable effort to access raw climate data at asset level, select appropriate indicators, and interpret the output.

Climate-related regulatory efforts gaining momentum

The adoption of this new climate risks mandatory disclosure at EU-level follows the adoption of an pioneering climate risk reporting law for asset managers and asset owners in France, discussed in a previous post, and occurs almost concomitantly with the release of the Task Force on Climate-related Financial Disclosures (TCFD) Phase II Report discussed  in a policy brief and a webinar.

European central banks and financial regulators are increasingly aware of the threat to financial stability of sudden market adjustments caused by climate-related risks. The concern is that the scale of impacts would pose a systemic risk to the financial system as a whole. A growing number of public institutions are paying attention to this issue including De Nederlandsche Bank; the Bank of England; Finansinspektionen; the SEC and the ESRB.


Four Twenty Seven helps investorsFortune 500 companies and government institutions understand how to quantify and monetize climate change impacts on operations as well as social factors that affect their value chain. Our clients rely on Four Twenty Seven’s tools and models to factor into financial and operational planning processes. Learn more about how we are helping our clients assess and adapt to climate risks.

 


You can find the full text here and the impact assessment made by the European Commission here

A handbook by Lane, Clark & Peacock on the IORP II

 

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