Put simply, ‘net zero’ refers to achieving a balance between the amount of greenhouse gas (GHG) emissions produced and the amount of GHG removed from the atmosphere. When human activities adds no more GHG emissions than we take away, we reach net zero. Achieving net zero is important, as to eventually stop global warming, net additions of GHG into the atmosphere have to reach zero.

A decade ago, the concept of net zero was still confined to the scientific community. The term only started to become more widely used following the adoption of the Paris Agreement in December 2015. The Paris Agreement established goals of keeping global average temperature rises to well below 2°C above pre-industrial levels and aiming for 1.5°C. In order to meet these goals, signatories undertook to make rapid reductions in GHG emissions with the aim of achieving net zero in the second half of the century.

Since then, the concept has taken off.By April 2022 over two thirds of countries (66%) had made net zero pledges.

For an asset owner, setting a net zero target means identifying a point in time by which the net GHG emissions of all companies invested in will be zero.

In order to be meaningful, a long-term net zero target will usually have interim targets for emissions reductions from a baseline level. Importantly, adopting a net zero target would not necessarily mean that trustees could only invest in businesses which have achieved GHG neutrality themselves. The key is that the net emissions of the portfolio are balanced so, in the future, GHG intensive businesses may still be held as long as those emissions can be offset elsewhere by carbon capture or other emerging technologies.

New climate reporting obligations were introduced in 2021 under the Pension Schemes Act 2021 and the accompanying Occupational Pension Schemes (Climate Change Governance and Reporting) Regulations 2021 (the Climate Change Governance Regulations). Trustees of in-scope schemes are required to meet certain governance and disclosure obligations in respect of climate-related risks and opportunities which underpin the TCFD recommendations.

However, to date, the Government has steered away from imposing mandatory net zero targets on pension schemes and the Climate Change Governance Regulations do not require trustees to set them (or any other mandatory targets to reduce portfolio emissions).

That said, a number of bigger schemes have chosen to adopt a net zero target for their investments over the past year (an approach which has been commended by TPR in its Climate Change Strategy) and this is increasingly an area which trustees are keen to explore.

The new requirements are being phased in, with larger schemes whose net assets are GBP 5bn or more, and master trusts, already required to comply. Schemes with GBP 1bn or more of assets have been required to comply since 1 October 2022.

Trustees of schemes in scope are required to put in place appropriate governance arrangements to manage climate-related risks during the first scheme year in which the Climate Change Governance Regulations first apply to them. They must then produce and publish an annual report on how they have done so (the Report) within seven months of their scheme year end date.

The Climate Change Governance Regulations focus on improving climate change risk, governance and reporting, in line with TCFD recommendations. They include requirements on selecting and reporting on climate-related metrics and setting targets in respect of at least one of these metrics.

In practice, meaningful disclosures on climate will not be possible without trustees undertaking certain governance activities, and for the first time the Climate Change Governance Regulations not only tell affected trustees what they must disclose on ESG matters, but also prescribe specific actions that must be taken first. A mandatory net zero requirement had been proposed during the legislation’s passage into law, but ultimately did not make it into final legislation. However, amendments to the legislation already look set to introduce some reporting of scheme alignment, albeit without mandatory targets.

Under the regulations, trustees must:

• Establish and maintain, on an ongoing basis, oversight of the climate-related risks and opportunities which are relevant to the scheme.
• Establish and maintain processes for the purpose of satisfying themselves that persons undertaking governance activities on their behalf (and/or who advise or assist the trustees in respect of governance), are taking adequate steps to identify, assess and manage any climate-related risks and opportunities which are relevant to the scheme.
• Identify and assess, on an ongoing basis, the impact of climate-related risks and opportunities which they consider will have an effect over the short, medium and long term on the scheme’s investment strategy.
• As far as they are able, undertake scenario analysis assessing the impact on the scheme’s assets and liabilities and the resilience of the scheme’s investment strategy, for at least two climate scenarios.
• Establish and maintain, on an ongoing basis, processes for identifying, assessing and effectively managing climate-related risks which are relevant to the scheme and integrate them into the trustees’ overall risk management of the scheme.
• Select certain climate-related metrics to monitor and report on an annual basis. The current requirement is that such metrics should include at least one absolute emissions metric and one emissions intensity metric, as well as one additional climate change metric. However, amendments to the Climate Change Governance Regulations proposed by the DWP would require trustees to additionally obtain and report on a fourth ‘portfolio alignment metric’ describing the extent to which their investments are aligned with the goal of limiting the increase in the global average temperature to 1.5°C above pre-industrial levels (see below).

• Set a non-binding target for the scheme in relation to at least one of their chosen metrics, and, so far as they are able, measure and report performance against it on an annual basis. It should be noted, however, that the requirement to set a target does not necessarily mean that trustees must set a target to reduce their emissions. Other targets, such as improving data quality, are equally permissible under the regulations. The statutory guidance also makes clear that long-term targets (e.g., net zero by 2050) will not be sufficient to meet the regulatory target-setting requirements without shorter-term interim targets.

Fiduciary duty of pension trustees

In our view, there is no doubt that trustees can take account of ESG issues as financial factors in their investment decision making. Indeed, we would advise that trustees are under a positive obligation to take account of such factors where material and as part of their trusts law and fiduciary duties.

Broadly speaking these legal duties require trustees to:

• Exercise their investment powers for their ‘proper purposes’, namely the provision of members’ pensions.
• Take account of factors which are relevant to that purpose, which will usually mean those which are financially material (this may be consideration of risks as well as returns).
• Do so in accordance with the ‘prudent person’ test – broadly this is the principle that trustee investment powers must be exercised with the ‘care, skill and diligence’ a prudent person would exercise, when dealing with investments for someone else for whom they feel ‘morally bound to provide’. 

Financially and non-financially material factors

Taken together, these fiduciary duties will usually act as good reason for trustees to act on ESG factors and to take account of climate-related risks and opportunities in their investment strategy, where to do so is financially material.

The law is generally more restrictive on the circumstances in which it is permissible for trustees to take account of ‘non-financial’ factors in making any investment decisions where these are not in the best financial interests of the scheme’s beneficiaries. Non-financial factors may include expressions of moral disapproval, political or ethical motivations or furthering of external purposes not directly attached to the pension scheme and the financial best interests of its beneficiaries.

The distinction between financial factors which trustees are legally able to take into account and ‘non-financial’ factors, which they generally cannot (at least not without surmounting particularly high legal hurdles), is not always a bright line. Many issues, including those relating to climate change, will have both financial and non-financial aspects. Further, some issues that start out as non-financial may become financial. The key is that trustees must base their investment decisions on what is financially relevant to the pension scheme in relation to the applicable time horizon being considered, which in the context of pension schemes may be many years.

Trustees’ consideration of any net zero commitment must be taken in this context. That means such a commitment should be made where trustees consider that the commitment (and the actions that follow from making it) will support financially the provision of members’ pensions from their pension scheme.

Understanding climate change as a financial risk

 In the absence of policies to reduce emissions of GHGs (such as net zero commitments), global warming is expected to reach 4.1°C – 4.8°C above pre-industrial levels by the end of the century (the ‘baseline scenario’). Current policies presently in place around the world are projected to reduce baseline emissions and result in about 2.7°C warming. Temperature rises at any of these scales, however, would have large and detrimental impacts on global economies, society and investment portfolios.

Keeping temperature rises to well below 2°C above pre-industrial levels in line with the Paris Agreement (and the pursuit of efforts to limit these even further to 1.5°C) requires a rapid reduction in GHG emissions in the coming years, and to net zero around the middle of the century. This will require a significant change in the fundamental structure of the global economy.

As investors, all pension schemes are exposed to financial risk from these issues. Higher global temperatures and more extreme weather events pose physical risks to assets, but perhaps of even greater significance to investors is the market impact of the required transition to a net zero economy.

Keeping temperature rises to those aspired to in Paris will require a fundamental shift in how all businesses and society operate. For an investor, some businesses invested in may be well positioned for this transition and some will not.

Considering a net zero commitment as a financial factor

A net zero commitment may be capable of being considered within the parameters of financial factors.

Ultimately, it will be up to the trustees and their investment advisers to consider whether a net zero commitment (and the actions that follow from making it) will support financially the provision of members’ pensions. However, the following points may assist in making such an assessment.

• There is a reasonable expectation that governments and policy makers will seek to deliver on their commitments to achieve net zero and that doing so will require a significant change in the fundamental structure of the economy at national and international levels. Trustees may reasonably take into account the financial risks to their pension scheme of holding an investment strategy that is not aligned with this anticipated global transition.
• Trustees are not bound to ‘call’ the global economic transition precisely before making their own investment decisions. Adopting the principles outlined above as part of the ‘prudent person’ test, trustees may reasonably consider the merits of an aligned investment strategy in contrast to a non-aligned one. On this, consideration may be given to the risk of an Inevitable Policy Response, as described by the PRI.
• Trustees may also reasonably consider the climate-related opportunities of a global economic transition to a low carbon economy and the extent to which investment advice would support the investment opportunities consistent with a net zero commitment.

Trustees may also be tempted to ask whether they can take wider factors into account, such as the impact their actions may have on their members’ quality of life or the wider economy. However, this is a particularly difficult legal area. Trustees would always need to consider this carefully with their own legal advisers.

A net zero commitment may be adopted by trustees where it is considered to be consistent with the primary purpose of the pension scheme of paying members’ pensions.

Trustees can act prudently in making their investment decisions and may reasonably base their assessment of what a prudent investment strategy for their pension scheme would be on an expectation that governments and policy makers will seek to deliver on their commitments to achieve net zero. Although trustees should take investment and legal advice on this, this may support a net zero commitment as part of a prudent investment approach.

The making of a net zero commitment should not fetter the future investment discretion of trustees and should be considered as an overall objective. Trustees should retain an ability to determine, in respect of any given investment decision, what is in the best financial interests of their pension scheme.

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