Governments cannot rely on pension funds to tackle climate change

The climate activist group Extinction Rebellion had a clear warning for pension fund trustees while protesting at the Pensions and Lifetime Savings Association’s Local Authority Conference in 2019. 

“There’s no such thing as a pension on a dead planet.” 

Pension funds are a vital part of the UK economy, holding around £2.5 trillion in assets. How and where these are invested has significant implications. 

The Government is keenly aware of this – and has sought to harness it to drive change. 

For many years, it has relied on the concept of “catalytic governance” to put pressure on businesses to address issues such as climate change, modern slavery, and corporate responsibility. 

The intention is that key investors, including pension funds, will scrutinise projects and mandate greater levels of disclosure around initiatives and corporate behaviour.

This would effectively shift responsibility from the state and regulation towards private entities.

To this end, the Department for Work and Pensions introduced new rules in 2021, requiring pension funds to provide climate-related financial disclosures. These included assessing greenhouse gas emissions across investment portfolios and measuring their performance against targets. 

The problem with 'catalytic governance'

However, my colleagues Juliane Reinecke, from Saïd Business School, Susan Cooper, from HEC Montréal, and I suspected there was a crucial flaw with this approach. 

Typically pension funds do not invest directly into organisations, because there is a complex network of intermediaries between the investor and investee. While the concept was laudable, it would prove very hard to do in practice.  

This formed the basis for a piece of research – drawing on interviews from pension fund trustees, lawyers, asset managers, investment advisors, and government bodies – which sought to explore the extent to which catalytic governance operates in practice.  

The study confirmed our suspicions. It concluded that while catalytic governance can engage private actors, it is often ineffective due to the number of intermediaries who are involved in the process.

These intermediaries dilute any mandate from a single client to invest in particular types of organisation. 

A portfolio manager, for instance, might have 20 pension fund clients. In this context, a small pension fund has limited potential to influence how that manager chooses to invest the collective pot. 

Can investors influence company behaviour?

It is unlikely that the many pension funds have the clout required to make a difference through their individual actions, as they will make up only a small percentage of any investor base.  

Essentially, there is a gap between the assumptions governments make when they rely upon catalytic governance to drive change and the real-world dynamics of the markets. While we suspected this may be the case, we were surprised by just how evident this was. 

Another unexpected finding was what we called the second-order effect. This identified a relationship between the degree of stewardship and influence that is available over an asset and the amount of liquidity.

A private equity company buying a sizeable stake in a fixed asset would have a large amount of influence, but this would be highly illiquid if it proved unsuccessful in lobbying for change. 

In contrast to this, a pension fund purchasing shares would have less of a voice but could dispose of any asset relatively easily should something happen that it did not agree with. 

However, if a pension fund sought to sell a liquid asset because it did not agree with an organisation’s sustainability objectives, it would only be able to sell to an investor that did not care as much about the issue. Therefore, selling to that investor would not solve the underlying issue or drive positive change.

What disclosure rules mean for pension trustees

It’s also difficult to take a stance like this across a diversified portfolio, because it can be hard to avoid large numbers of companies. Investors therefore resort to making noise at an AGM or sending in letters raising concerns. This only has limited impact.  

There are implications here for trustees, who are tasked with making decisions on behalf of pension funds (whether they are professional trustees or act internally on behalf of company pension schemes). 

Historically, their main remit has been simply to get the best financial return. Now they must think about other issues, including sustainability, in line with members’ wishes.

Armed with the knowledge that there is an issue, they can think about steps they can take to ensure they are still able to impact funds.  

One option is for these funds to consolidate, so they can have greater overall clout. If they don’t want to do that, they need at least to co-ordinate with each other to exert more influence. By coming together, they can agree on a list of assets they will or won’t invest in, or request improvements in certain areas. 

What are the alternatives to greening portfolios?

Governments and regulators must also ponder the finding that pension funds in their existing structure are not an effective actor in making their portfolios greener.

There is a wider issue around what we call ‘responsiblisation’; the notion of making organisations take responsibility for enacting change. If an organisation is unable to exert sufficient pressure on the businesses it invests in, this raises questions over the viability of such a strategy. This in turn makes it more likely that regulation is seen as a solution.

Individuals can also do their bit by asking their pension fund – as long as it is big enough – what its climate change score is and ensuring this is an issue that continues to receive attention. IFAs, advisors, and other intermediaries can do the same.  

By highlighting the flaws within the established model and the erroneous assumptions on which it is based, we hope to create a better-informed debate which will allow investors, regulators, and other stakeholders to use the power of pension funds to exert meaningful pressure on organisations. 

The aim is that businesses become more accountable for their actions and climate change initiatives flourish, helping to protect the planet and the purpose of pension funds for generations to come.

Further reading:

Beyond the balance sheet: Accounting for sustainability

How to stop actively managed funds underperforming

Why pension funds must address the AI skills gap

How co-ops and mutuals should measure their social impact

Yuval Millo is Professor of Accounting and teaches Financial Reporting and Financial Statement Analysis on the MSc Finance, MSc Business and Finance, MSc Accounting and Finance, and MSc Finance and Economics.

Unlock the power of financial literacy with the part-time executive education programme Finance for Non-Finance Leaders at WBS London at The Shard.

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