Moving with the times? Fiduciary duty and climate change

It’s tempting to reach for a soundbite when aiming to describe a trustee’s fiduciary duty in the age of climate change.

Something like: ‘I can invest responsibly if it enhances, or at least doesn’t harm, returns’.

But it’s not so easy: sustainability can’t simply be bolted on to a return objective. During Race to net zero, an LOIM event held for UK investment consultants, the concept of fiduciary duty was explored – from its origins to present-day relevance as pension funds assess the impact of climate change on portfolios.

In search of a definition

Ralph McClelland, Partner at Sackers, a specialist law firm for pension scheme trustees, explained how fiduciary duty is rooted in ideas of purpose, prudence and financial materiality, and how it has evolved in a series of legal cases and industry consultations over decades.

McClelland described the 1985 case of Cowan vs Scargill, in which a pension trustee sought to divest South African sovereign bonds due to the nation’s Apartheid policy. This early application of portfolio screening was judged to be outside of their “power of investment”. According to the case:

Power of investment must be exercised so as to yield the best return for the beneficiaries, judged in relation to the risk of the investments in question.

• Cowan vs Scargill (1985) Ch 270

Even if we were to agree with the interpretation of the court in this case, this does not fully resolve the issue – as it may well be that the concern identified (whether it be apartheid, or misalignment to the climate transition) would in fact affect risk and return calculations. In this case, even under a narrow definition of fiduciary duty, it would then be relevant and even essential for trustees to consider such questions.

More recently, in 2014, with the Principles for Responsible Investment established in the pensions industry and sustainability considerations progressing from the periphery to the core of investment debates, a Law Commission survey of the understanding of fiduciary duty yielded a range of views:

• [Trustees] must invest the scheme assets in the best interests of scheme members and beneficiaries.
• Trustees are not required to ‘maximise returns’. Trustees must weigh returns against risks, including long-term risks.
• [Trustees] should take into account factors which are financially material to the performance of an investment.

McClelland posed the question: can these perspectives be used to create a legal definition of fiduciary duty? If so, the industry hasn’t formulated one yet. But there is some consensus on an approach to fiduciary duty.

The fiduciary bundle

McClelland argued that trustees can fulfil something close to this elusive concept by exercising a bundle of fiduciary and trust law duties. These are:

1. Exercising trustee investment power for its proper purpose
2. Considering relevant factors – typically financially material risks and potential return
3. Acting in accordance with the prudent person principle

There is ample room for interpretation in this bundle, but it provides a framework for fiduciary decision making.

First, how should a trustee define the ‘proper purpose’ of their investment power? This varies among schemes. At the most fundamental level, trustees of a defined benefit fund must target a specified income stream for beneficiaries. Those overseeing defined-contribution (DC) default funds should grow a pension ‘pot’ from accumulated contributions, whereas trustees of DC member-select funds must provide a range of suitable investment options.

Second, relevant factors for investment evolve over time. Risks intensify and ease, market crises develop from different causes, and phenomena emerge that result in new return drivers – from globalisation to the rise of digital technology and the climate and nature crises.  

Third, how should a prudent person act? They are not judged by the outcomes of their decisions, but in the steps taken to reach them. This distinction is crucial: a prudent trustee is not expected to be prescient but should exercise care, skill and diligence in the context of the economic and financial conditions of the time. They are defined by their behaviour, in the context of contemporary issues.

Climate: a fiduciary concern?

Climate change is a defining challenge of our time. At LOIM, we believe that as policy and consumer appetite increasingly favour mitigation and adaptation efforts, it is impacting asset valuations.  

This is because many companies are implementing more sustainable business models to manage the physical, transitional and liability risks inherent in the decarbonisation of the global economy – and   to benefit from increasing demand for carbon-neutral goods and services. An imminent indication of the net-zero transition’s influence on asset valuations will be the repricing of European corporate bonds as the region’s biggest investor, the European Central Bank, tilts its €340 billion portfolio to climate-aligned firms.

Is climate change an essential concern for trustees? In our view, the decarbonisation of the global economy is a strong enough influence on risk and return to be seen by a trustee, acting prudently, as a proper and material investment concern. The fiduciary bundle certainly applies:

• Climate risk is a relevant factor among other financially material risks and sources of return
• A prudent person would assess how the net-zero transition is impacting business models and asset valuations
• Minimising exposure to the risks of the transition, and optimising access to its opportunities, is an exercise in using trustee investment power for its proper purpose

Trustees do not hold an investment power to solve Earth’s problems, to protect a scheme’s reputation or meet a particular desire expressed by its members. But as economy-wide decarbonisation impacts asset valuations, it would be prudent to take action.

An unavoidable risk? The ‘universal owner’ concept

The ‘universal owner’ hypothesis provides another perspective on the investment materiality of climate change. It posits that there are clear links between the performance of large, diversified portfolios and the overall economy:

A free-market economy delivers clear advantages, from competitiveness and innovation to adaptability. But one severe flaw has been the ability of companies to transfer costs – from environmental pollution to poor health and safety standards – to nature, other companies or social institutions.

A universal owner can’t avoid these costs, the theory goes. A large asset owner, such as a pension fund, typically has a diversified portfolio relying on stable and productive economic, environmental and social systems to underpin the assets it invests in. Costs externalised by one company are likely to negatively impact other holdings, entering the portfolio as taxes, insurance premiums, inflated input prices, litigation on environmental concerns and the physical cost of disasters – including extreme weather caused by failing to hit net zero.

Investors subscribing to the universal owner concept recognise the financial impacts of externalities. And those focused on the net-zero transition see the value not only in making companies accountable for their emissions, but also in championing decabonisation across the entire economy.

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