Institutional investors of all stripes—from those responsible for paying pensions or endowment grants to those providing wealth management products—collectively manage trillions of dollars globally. They each have varying objectives and portfolio allocations and function within different regulatory requirements and contexts. However, they are typically true long-term investors, allocating across the global economy to deliver returns to members, beneficiaries and stakeholders over multiple years or decades.

Recently, evidence has grown to demonstrate that there are substantial climate-related financial implications for investors. As such, financial regulators are increasingly formalizing the expectation that investors consider the materiality of climate-related risks and manage them as part of their fiduciary duties—particularly for pension funds.

Two key elements necessitate this fiduciary duty alignment: financial materiality and growing legal and regulatory consensus.

Financial Materiality

Technology and policy changes will be necessary—and are, to some extent, already underway—to transform the economy away from fossil fuels and mitigate additional temperature increases. This transition will necessarily open up certain companies and industries to increased risk. The financial implications most naturally point to the energy sector, but transformative change will invariably have significant implications for all energy-dependent and high-emitting sectors of the economy.

Physical risk captures the damages that come with temperature increases that we have failed to avoid. The frequency of storms, wildfires and floods will shift, as will the availability of natural resources such as water. The willingness of and ability for society to adapt to these changes is uncertain. Physical damages are expected to negatively impact sectors such as consumer staples and telecoms. Investors with real asset exposures, such as property (held directly or indirectly), will need to increasingly review insurance cover and uninsured loss implications together with additional capital expenditure requirements.

The expected financial materiality of these risks is evidenced in Mercer’s 2015 Investing in a Time of Climate Change report and the recently released sequel. It is supported in reports by The Bank of England, the G-20 Financial Stability Board and The Economist Intelligence Unit, as well as an increasing number of other investment-industry participant reports on recommended actions.

The findings in the sequel report particularly support the view that it is in investors’ best interests—and therefore consistent with fiduciary duty—to actively support the low-carbon transition to avoid scenarios with the worst physical damages, which will have almost entirely negative impacts across sectors and asset classes. Even just through 2030, the portfolios modeled in the sequel (invested across multiple asset classes) could experience additional return impacts of between +0.29 percent per annum and -0.08 percent per annum, depending on the scenario and the exposures within equities and infrastructure in particular.

Financial regulators have indicated that many investors will need to consider climate-related risks in order to comply with their existing fiduciary duties.

Return impacts, however, are unlikely to be neat and annualized. They are more likely to manifest as a sudden surprise. Stress testing an increased probability of a 2 degrees Celsius scenario or a 4 degrees Celsius scenario with greater market awareness results in between +3 percent and -3 percent return impacts in less than a year for these same well-diversified portfolios.

The Growing Legal and Regulatory Consensus

As awareness of the financial materiality of climate-related factors has increased, financial regulators in a number of jurisdictions have indicated that many investors will need to consider and manage climate-related risks in order to comply with their existing fiduciary duties. In the UK, for example, a 2018 paper by law firm Pinsent Masons neatly summarizes the fiduciary duty debate in recent years and how the absence of legislation and case law has led to the focus on financial materiality and fiduciary duty. The paper concludes that “in cases where climate change has the potential to impact on long-term investment performance, pension scheme trustees have a fiduciary duty to consider climate change risk when making their investment decisions.”

The legal argument has been strengthened by recent pension-fund guidance and legislation. Europe, in particular, recognizes the potential for financial materiality and requires climate change to be considered in investment decisions, consistent with the time frames of beneficiaries; for example, the 2016 EU directive on institutions for occupational retirement provision and the UK’s Department for Work and Pensions. Regulatory activity has also extended across the Atlantic, with the provincial government in Ontario, Canada, requiring pensions to disclose in their statements of investment policies and procedures whether environmental, social and governance factors are considered and, if so, how. And, in California, the insurance regulator requires insurers to disclose their fossil fuel-related holdings.

In a number of other countries, particularly in Europe, laws are also being changed to explicitly require investors to consider and disclose management of climate change-related risks, for example, the French Energy Transition Law, Article 173. The China Securities and Regulatory Commission issued guidelines requiring listed heavy polluters to give more-specific information on emissions, with all listed firms to disclose environmental impact information by the end of 2020.

Laws and litigation related to climate change also continue to develop. Litigation is primarily being targeted at companies for failure to mitigate, adapt or disclose, but there are examples of litigation against governments and, most recently, pension funds. ClientEarth, a legal advocacy organization, has also been developing legal challenges against pension funds and investors that fail to consider climate change-related risks.

As signals from regulators become stronger and/or more investors take action, those who fail to consider, manage and disclose their potential portfolio-specific risks may be susceptible to legal challenges in the future.