Climate change an 'essential part' of covenant assessment - ECPA

Understanding climate change impacts has been highlighted as an “essential part of covenant assessment” by the Employer Covenant Practitioners Association (ECPA), with trustees urged to collaborate with sponsors on climate change reporting requirements.

The report from the ECPA, Reflecting climate change impact and risks in employer covenant assessments, argued that climate-change issues are having and will continue to have an impact on the employer covenants supporting defined benefit (DB) schemes, particularly sponsor financial capacity and sponsor longevity.

It suggested that climate issues should, in the first instance, be considered in sectoral terms, to include consideration of sectoral regulation and technological evolution, as well as the likely impact on competitiveness and market positioning, arising from climate change and required adaptions.

This should, according to the ECPA, be followed by reflection of sponsor-specific issues, either through identified cash flows in forecasts or as sensitivities and scenarios, to allow practitioners to consider the impact of these risks, or opportunities, on sponsor financial capacity and adaptability.

It also suggested that the impact of identified risks and opportunities be reflected in ongoing investment strategies, funding arrangements and associated integrated risk management (IRM) plans.

Whilst the report acknowledged that climate change is only one element of both the E and S in environmental, social and governance (ESG), it argued that it is "a very
specific matter, capable of evaluation and assessment", which should not be conflated with other areas of ESG whose evaluation and impact may be very different.

Indeed, ECPA chair, Karina Brookes, said that association members are seeing the impacts of climate change feed into the performance of sponsors "right now".

“Transitional risks, for example, are affecting both the free cash flows and – potentially – the longevity of sponsors where demand for their existing products may atrophy over time; or where substantial investment in R&D is needed," she explained.

“But, as the paper emphasises, many sponsors are successfully addressing the impacts of climate change – and a number will secure market-leading positions through innovation in response to regulatory and demand shifts.

“The paper sets out clearly and systematically how our member firms can consider climate change in their work – and advise trustees and sponsors on how it might be reflected in scheme funding and IRM plans.

“It contends that robust sectoral analysis – including understanding regulatory requirements – is a helpful starting point from which climate change impacts on sponsor free cash flows and longevity can be considered.

“Certain of the longer-term time horizons relevant to climate change – such as 'net zero by 2050' – are distinctly relevant for the run-off of pension liabilities over decades to come.

“It is vital, therefore, that appropriate and proportionate consideration is given to climate change in employer covenant work. This paper sets out how, as a profession, we can reflect this crucial issue in our advice."

RSM covenant assessment services partner and co-author of the report, Donald Fleming, highlighted the report as “a collective effort by covenant practitioners to help pension trustees and employers navigate the impact of transitioning to net zero”.

He continued: “Understanding climate change is integral to the UK and global economy as it has a long-term impact on how every company does business, both financially and practically.

“Those running the UK’s larger pension schemes are responsible for investing huge sums across the world. It is therefore essential they remain abreast of law, regulations and best practice, and the disclosure issues arising from this. They are also dependent on their employer’s covenant, ie its ability to fund its contributions and support their scheme.

“It is therefore crucial that both trustees and employers have a clear understanding of how the company manages its net-zero strategy and how the financial impact of climate change will affect their pension scheme."

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