How pension funds and supervisors can act on environmental risks in a world of imperfect models and data.

Pension funds have long-term obligations and are therefore sensitive to uncertainties from the effects of climate change and nature degradation. Pension funds increasingly consider these environmental risks but face challenges in data availability, modelling and estimating the financial impacts on their portfolios. The models are mostly backward-looking and fail to accurately represent potential economic damages of climate change and do not recognise non-linear dynamics, such as environmental tipping points. These models underestimate potential damage and overestimate the time we have to solve the issues.

In order to make decisions in a time of increased uncertainty there is a need to strike a balance between improving the models and taking action based on precautionary principles. This policy brief summarises key insights from conversations with Dutch pension funds and supervisors and regulators.

This publication by Gerdie Knijp, Aleksandar Simic and Brenda Kramer provides key insights for pension funds:

• Focused portfolio management. Shift from broad and overdiversified passive portfolios to more focused and consciously selected portfolios, to improve knowledge of the companies in those portfolios. This also enables closer engagement with portfolio companies and better alignment with sustainability objectives.

• Enhanced risk management. Focus on managing inherent uncertainty rather than only risk management. Improve risk models with relevant forward-looking metrics and challenge scenarios and models created by other parties. Become familiar with the underlying narratives and assumptions and perform sensitivity analysis. In decision-making, employ expert judgment and qualitative scenarios to complement quantitative models.

• Act on negative impacts. Act on negative environmental impacts directly by engaging companies that can transition and reducing exposure to known harmful companies that cannot or are unwilling to transition. Implement a transition plan to align with net-zero and nature-positive goals and set ambitious targets, for example, on the reduction of carbon emissions and exposure to deforestation.

• Impact integration. Adopt a “risk, return, and impact” model to systematically prioritize environmental impacts alongside financial performance. 

Key insights for supervisors and regulators:

• Expand current supervisory expectations. Strengthen the consideration of double materiality and add the disclosure and assessment of environmental impact to current supervisory expectations (in IORP II and the supervisory expectations defined by local supervisors). Strengthen the requirements related to scenario analysis in the own risk assessment. 

• Improve scenarios and stress testing exercises. Explore alternative models in scenarios and allow for more severe stress in supervisory and economy-wide stress testing exercises. 

• Mandate transition plans. Mandate the creation of transition plans to align financial institutions with net-zero and nature-positive goals.

• Limit exposure to harmful activities. Introduce charges or limits on exposure to environmentally harmful activities to reduce systemic risks.

Policymakers should act too. Although not the focus of this policy brief, pension funds and the supervisors are dependent on governments defining stable long-term polices, transition pathways and regulatory guidance. Policymakers are primarily responsible for setting and committing to long-term pollution pricing. These policies bring regulatory certainty to the real economy and thereby the financial. Pension funds and supervisors can simultaneously advocate for consistent policies on sustainability. Regulatory clarity and predictability are a prerequisite for financial institutions to make informed investment decisions.

You can find the full publication below.