What is Trillion Dollar Transformation?
TDT is a project undertaken by Mercer and CIEL to explore the financial and legal circumstances facing public pension fund fiduciaries in the context of climate change and the financial risks it poses. It encompasses one report each from Mercer and CIEL, and will be followed by in-person events to educate pension fund trustees about the risks identified in the reports.
Mercer’s report presents a financial analysis of pension fund performance under four climate change scenarios. CIEL’s analysis builds on these financial forecasts and explains why pension fund trustees’ legal obligations require them to consider, and possibly act on, climate change and climate-related risks.
What is the main conclusion of CIEL’s report?
Climate change poses potentially material financial risks to pension fund investments. In accordance with their several fiduciary obligations, pension fund trustees should consider their funds’ exposures to climate risks when making investment decisions. Failure to do so could result in losses for the fund and legal liability for the trustees.
Can you elaborate on that?
Pension fund trustees owe a general duty of prudence to their beneficiaries – they must act as a reasonably prudent investor would in the same circumstances. Because certain assets are more vulnerable to climate change and climate-related risks – especially equities in fossil fuel, energy, and other carbon-intensive industries – trustees should evaluate their exposure to such assets as an independent financial evaluation, understanding climate-related risk to be an independent risk variable.
What are your key recommendations?
Our key recommendations fall into three categories. First, we suggest pension funds make changes to their organizing documents to create structures for the continuous evaluation of climate-related risks in the fund’s portfolio. Second, upon evaluation of that risk, we suggest a rebalancing approach to mitigate those risks. Specifically, we recommend reducing exposure to fossil fuel and other carbon-intensive assets and increasing exposure to clean energy and sustainable technology investments which are likely to benefit from policy and market responses to climate change. Finally, we recommend engaging as a shareholder with the companies in which a pension fund invests, so as to obtain better information about the company’s climate vulnerabilities and to help reduce its exposure.
Is this about Environmental, Social, and Governance (ESG) factors? Won’t pension funds lose money?
Our reports are concerned strictly with financial outcomes. Mercer’s report lays out the financial landscape facing pension funds, concluding that in each climate change scenario there is some negative financial impact to returns. Our legal argument stems from that and other financial analyses that demonstrate the riskiness of carbon-intensive assets and the financial threats posed by climate change.
What about diversification? Doesn’t it require that we continue to invest in fossil fuels?
Diversification is good, and in fact mandated by fiduciary duties. However, there is no obligation to remain invested in a dying industry. Diversification is about reducing risk by spreading it across investments. Because of the risks posed by climate change, shifting funds away from climate-vulnerable assets can ultimately reduce the overall risk of a portfolio, despite slightly limiting the number of possible investments.
Consider: would a pension fund be required to invest in real estate in 2008? (probably not)
Are pension fund trustees really going to get sued?
The fiduciary duties trustees owe their beneficiaries are not in place solely to trigger litigation; they are there to help guide the behavior of pension fund trustees. We believe that most trustees truly do have their beneficiaries’ best interests in mind, and the purpose of our analysis is to help trustees act in accordance with their obligations and in their beneficiaries’ best interests in the context of a changing climate.
The purpose of this paper is not to outline if, how, or when litigation may happen, or to make predictions on the likelihood of litigation under different scenarios. However, it is nonetheless true that were trustees to violate their fiduciary duties they might get sued.
Isn’t oil a big money maker? Isn’t climate change regulation happening in the future?
One of the important characteristics of pension funds is their long-term investing horizon. They are supposed to invest in value-producing assets that will grow over the long term. They are not supposed to invest speculatively or try to “time the market”.
It is hard to predict what will happen to fossil fuel assets in the short-term. Economic forces, geopolitics, and weather patterns all affect oil, gas, and coal prices. However, over the medium-to-long term, fossil fuels are a sector in decline. The Paris Agreement signifies global political will to tackle this challenge – “the age of fossil fuels is over” – and it is intellectually dishonest to pretend that fossil fuel companies can operate indefinitely without radically changing their business model.
There is a second, practical component to this analysis. It is possible that fossil fuel asset prices will decline slowly – note the steadily decreasing return on investment witnessed by the oil industry over the past twelve years or so – but it is also quite likely that these price decreases will be rapid. The coal industry collapse was a good example of this; the industry imploded extremely rapidly, and not long after those analysts bullish on coal predicted a “new coal renaissance”.
This is important because, out of all financial actors, pension funds may be the most conservative and risk-averse. There is an additional premium on safety. Put another way, compared to a similar fund (e.g. a mutual fund), pension funds should prefer a slightly lower return on investment if it guarantees more security. Even if it is the case that these climate-vulnerable investments are currently profitable, there is a real concern about a sudden downturn and significant impairment of fund value. This, separate from short-term financial analysis, is another reason to avoid climate-vulnerable and carbon-intensive investments.
What about Donald Trump?
Obviously, the election of Donald Trump will present challenges, but the fundamentals haven’t changed. Global momentum to address climate change remains strong.
First, the Paris Agreement. It’s true that Trump has claimed he will try to withdraw from the agreement. However, in the two weeks immediately following his election, four more countries ratified the Paris Agreement. At the international climate negotiations (COP22) in Marrakech, countries made it abundantly clear that the actions of the United States will not dictate their actions on climate. Business and US states have issued similar statements.
Second, the cost curve on renewables keeps bending down. It’s true that the Trump Administration could reverse some regulations that make fossil energy more expensive or repeal credits that make renewables cheaper, but that train has left the station. Renewables are the future of energy.
Third, oil is a global commodity. Global market shifts, geopolitical strategy, and other forces dictate the price of oil (which is the main determinant of oil industry profits). While it may benefit some drillers to have relatively cheap sources of oil available if the Trump Administration opens up new drilling areas in the United States, it won’t change the fundamental trend of excessive supply putting downward pressure on oil prices.
A Trump presidency may slightly delay the inevitable. But the fundamentals are in place, political will is strong, and market trends are only making renewables cheaper and fossil energy more expensive. The political situation in the United States is a factor worth considering, but it is only one factor. It does not change the legal obligations of pension fund trustees who must still weigh, with prudence, care, skill, and caution, the level of climate risk they can tolerate in their portfolios.