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Pension funds crank up transition pressure

Some of the most sophisticated UK investors are pushing for a faster energy transition than even the most ambitious promises of oil and gas majors

UK institutional pension funds are changing the way they invest in traditional oil and gas companies. The long-term investors are increasingly concerned about the impact of climate change on their future returns, and are exerting more pressure on companies to adapt to the future lower carbon economy.

The issue has become even more prominent following the recent oil price crash and associated falls in oil stocks and earnings. The long-term risks that ESG managers have warned about appear more plausible.

Over the last two decades, the trend among UK pension funds was to increasingly invest in passively-managed stock market indies such as the FTSE 100, of which oil and gas companies comprise around 6pc.

Passive management has contributed to company boards taking investors’ votes for granted, leading to several governmental attempts to bolster stewardship efforts and force consideration of climate change.

Pension scheme trustees, who are ultimately responsible for investment decisions, are now looking a lot more closely at how they invest their money, according to PTL managing director Richard Butcher, who is a professional trustee for several large pension schemes.

“Some pension funds are excluding oil and more commonly excluding other ‘sin’ stocks such as tobacco,” he says. “But others are still invested and just being more active stewards. So, they are using their voting rights to try to encourage those energy companies to veer towards renewable as opposed to fossil fuel energy sources.”

Too big to ignore

Oil and gas stocks remain a financially vital part of most indices, according to Diandra Soobiah, head of responsible investment at Nest, the £10bn UK government-backed defined contribution (DC) pension fund.

“We believe divesting fully is the wrong decision to make right now for members. Our approach is to try to minimise climate risks for members, and at the same time stay invested and engaged with companies, to encourage them to transition to the lower carbon economy,” she says.

“We explain to our members that while divestment may well be a strategy if we do not think the company will change in the future, our aim is to remain invested, exert an influence and continue to, so that companies can continue to be sustainable and profitable for our members.

“Companies are talking about being carbon neutral by 2050 [but] the world is probably going to move faster than that” Willsher, 20-20 Trustees

Increasing numbers of companies Nest invests in are being more transparent about their climate-related risks, according to Soobiah. “We are seeing better data, more internal pricing of carbon, and grand commitments to net-zero. We are seeing progress, and it is important to remain invested and push companies to go even further."

She thinks UK and European oil and gas companies are further ahead in the journey towards keeping global temperatures below two degrees above 1990 levels, while US companies are “lagging behind”.

“European companies are much more willing to speak to investors and have become much more transparent about how they are managing risk and the management process. More directors are being held to account and pay packages are incorporating climate metrics.”

Carbon analysis

Brunel Pension Partnership, which pools the £30bn assets of 10 local government defined benefit (DB) pension funds, similarly does not exclude stocks or sectors but subjects them to rigorous carbon intensity analysis.

“We have not set any restrictions on our asset managers across any sector, but we are looking for quite extensive and thorough climate change risk analysis. Our view on the oil and gas sector fits within this,” says its chief responsible investment officer Faith Ward.

“We considered whether some levels of restriction might bring about some of the outcomes we wanted around climate change, decarbonisation and carbon emission reductions. But we wanted to encourage our asset managers to look at the issues more deeply by using more data and analysis to hold companies to account.”

Brunel wants to reduce carbon intensity across all of its listed equity portfolios by 7pc/yr relative to their benchmarks. While it is not yet imposing restrictions, it will increasingly hold companies to account and develop a more “climate aware” analytical tools.

“In 2022 we will do a stocktake of the approach, and then identify if there are companies that despite systematic and persistent engagement, do not feel appropriate for us. Some oil and gas companies may well fall within those parameters,” says Ward.

The recent oil price falls have reinforced Brunel’s view that “oil and gas firms are not something that we would want to be overly exposed to because they seem to be subject to shocks,” she adds.

Short-term investment

Pension schemes typically have longer-term horizons than retail investors, particularly defined contribution (DC) funds that are most commonly held by younger members.

But private sector DB funds—which previously dominated workplace schemes and still do for older member cohorts—have a much shorter lifespan. These funds may be underfunded and therefore seeking assets that enable them to be ‘bought out’ by an insurance company, which would require the scheme to be fully-funded before guaranteeing the scheme’s pension payments.

Butcher says this need for funding makes growth stocks, including oil and gas one, look more attractive in the short term, especially given Shell is also the highest dividend-payer in the FTSE 100 and BP is close behind.

"When a DB pension scheme is underfunded, there will always be a desire for growth assets, because fundamentally we only have two sources of money—the employer and the investment portfolio. And we are always looking for areas to get growth. Some of them will possibly go to oil—it depends whether it is within their time horizon, or whether they think the risk is material enough to cause them not to."

But, in the much longer term, Butcher thinks the price of oil and gas will fall further and businesses will not be as profitable unless they adapt and embrace more renewable energy sources.

Renewable interest

Pension funds are showing more interest in renewable investments. Some funds, such as Brunel, invest in these through their allocation to private markets.

Funds typically expect oil and gas companies to diversify more into renewables over time but acknowledge there will be challenges, according to Duncan Willsher, trustee director at 20-20 Trustees.

“Traditional oil and gas companies are heavily invested in what they have done for a very long time. To just flick a switch and say 'we are just doing renewables' cannot happen.

“Companies are talking about being carbon neutral by 2050 [but] the world is probably going to move faster than that. Having a target that is 30 years out means there is risk of a lack of accountability today.”

“Coronavirus has taught us how unprepared we are for these types of crises” Soobiah, Nest

He adds that companies which can demonstrate they are genuinely thinking about the future will do well, and that it is about “walking the walk, not just talking the talk”.

“As long as companies are able to demonstrate that they are giving genuine thought to how they transition, not over 30 years but over the next five to 10 years, I think there is a really important role for these organisations to play,” Willsher says.

The Brunel pool wants companies to concentrate on their long-term strategy and how to best implement it. “It is not just renewables,” says Ward. “There are other decarbonisation investment commitments that some firms are looking to, which can assist the long-term trajectory to get to well below two degrees.

“We are looking for firms to diversify in a whole range of ways. Renewables are a part of the picture but it is for each company to set its own path and be conscious of the capabilities needed to do that effectively and positively.”

Nest wants companies to think about how they are moving away from oil towards more environmentally friendly energy such as natural gas to keep global warming under two degrees. "Some companies are sitting on lots of oil, which is quite a worry if they will not be able to reduce those reserves,” says Soobiah.

Covid-19 legacy

The global coronavirus lockdown could change society, business, and working patterns so much that it may accelerate the long-term decline in the demand for oil.

The unprecedented intervention of governments in response to Covid-19 may also be a sign of what is in store for the energy sector. With pollution levels having fallen during the lockdown, Nest’s Soobiah expects to see more focus on air pollution levels and a move towards renewable energy.

“Governments and countries will hopefully realise we need an orderly transition to low carbon. If anything, coronavirus has taught us how unprepared we are for these types of crises,” she says.

Brunel’s Ward adds: "Anecdotally, we have heard scepticism from some of the large energy corporates as to whether governments would ever take policy action. We have now seen evidence that, in a crisis like Covid 19, they will take action that completely changes the rules of society and business. Therefore, oil and gas companies must look at their transition pathways to see if they are adequate.”

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