U.K. lifeboat fund opens up on climate strategy

Setting and communicating the climate and wider ESG strategy for one of the U.K.'s highest-profile pension funds has taken time and careful thought — but the Pension Protection Fund is ready to go on the record.

As the lifeboat fund for the defined benefit plans of insolvent U.K. companies, the London-based PPF has "not said as much externally (on the climate strategy) up until now … because we don't want it to sound like it's just words: We're really trying to look at the data, be led by the data and to make sure that what we're analyzing is actually specific to us," said Claire Curtin, head of ESG, the first person in that role for the £33 billion ($41.1 billion) pension fund.

In an interview shortly after the publication of the fund’s third Task Force on Climate-Related Financial Disclosures report in August, Curtin said the PPF’s first report had been fairly qualitative in terms of information. Last year, the team pulled together more data and metrics, and then this year it further increased the number of charts and data.

One of the challenges for the PPF is that it looks very different in terms of asset allocation compared with its global peers, with less than 10% in equities — while North American plans are at 50.4%, European pension funds have an average 47.4% allocation to equities, and Asia-Pacific funds invest an average 47.3% in equities, according to the Thinking Ahead Institute and Pensions & Investments' 2023 data of the 300 largest retirement plans.

"Most of the information out there is thinking about equities," Curtin said.

But also, the PPF doesn't want to preach. "We want to make sure we don't come across as if we think we know what we're doing about everything, and that we know the right way" to do things, she added.

In its 2023 climate change report, the PPF included operational emissions for the first time. The PPF stated that it has achieved net zero for Scope 1 for its direct operations — covering direct greenhouse gas emissions from owned or controlled sources — and aims to reach net zero in its operational supply chain by 2035 or sooner.

That's requiring continued focus on internal operations. Regarding operational emissions, the PPF is "looking at what options there are for reducing travel emissions and working with our suppliers to reduce our supply-chain emissions because these are the two areas that have the main impact on our Scope 3 operational carbon emissions."

Scope 3 emissions are a consequence of a company's activities but come from sources not owned or controlled by it. For example, the use of sold products and services.

As luck would have it, the PPF's own offices are in good shape when it comes to its net-zero standing: It has a heating, ventilation and air conditioning system in place, no gas, and the electricity supply was moved onto a renewables contract in mid-2019.

The next internal measurement will be "how to calculate our employee work-from-home emissions," Curtin said. More accurate approaches to this will require employees sharing information such as energy use, heating and cooling.

The efforts are part of a desire by Curtin — and the wider PPF team — "to lead as an organization and make a difference in the industry," she said. That desire has also led to the creation of internal networks, especially to support the fund's diversity and inclusion strategy: There's a menopause café, family alliance and other communities. The fund is also targeting 30% ethnic minority representation across the organization by December. The proportion of employees from an ethnic minority background was 26.1% in December 2022.

The PPF also is extending those expectations of good stewardship to the external managers, counterparties and portfolio companies it works with. The fund is pushing for more disclosure from private markets portfolio companies, and Curtin said that the exercise the PPF has gone through itself to report on its own operations and organizational strategy has helped executives understand the challenges these companies face.

The PPF does not split out its actual asset allocation, but it has a 41.5% strategic allocation to return-seeking assets, which includes private equity and other alternatives.

That desire to lead from the front, help to make a difference in the industry and to develop the strategy and its communication carefully and thoughtfully means Curtin's first few years in the role have required a lot of detailed work.

The PPF started work around the alignment metric requirement — the need for disclosure of the extent to which investments are aligned with the Paris Agreement's goal of limiting temperature rises to 1.5 degrees Celsius — before it became mandatory in October 2022.

"It took a lot of (work) in-house with an external consultant to help us," she said. "It was very manual — we sat down with our internal portfolio managers and went through, line by line, 'is this asset renewable or exposed to that?'"

With the work done on asset identification, Curtin and her team now need to overlay the more accurate data as it comes in, "refining the inputs as they become more available. So, although it was very painful, it was really useful."

The PPF has worked on its equity benchmark over recent years, which included removing a few companies overly exposed to activities that were at risk of becoming stranded — largely thermal coal-related — and the carbon footprint reduced by 50%. "That was more of a risk-management exercise," she said.

Outside those risk-related divestments, the PPF has seen the number of companies that were considered not to be aligned at all with the Paris Agreement decreasing, while those moving into the aligning or aligned bucket is increasing.

"It's not that we've actually changed the underlying portfolio construction so much — it's that the companies are starting to set targets and they're starting to operationalize in a lot of these commitments," she said.

Now, Curtin and her team are working on the next stage of the PPF's ESG journey: what happens to the companies that fail to improve.

Oil and gas companies can remain in the benchmark if they're integrating climate into their strategy, "but (with the portfolio alignment metric work) we can show that the commitment at a company strategy level is starting to come through, and we have to give them the benefit of the doubt over the next couple of years. There probably will come a point in two or three years' time where we have to question whether that commitment has actually played out. And if it hasn't, then we will need to look at escalation."

As such, she's drafting a formal escalation policy now. "At the moment, the plan is not to sell out of those names, but to specifically push for better disclosure and then the company setting targets. This escalation policy will say, if by an appropriate amount of time they haven't done this, then we will follow a process of escalation, all the way up to being really public such as submitting a resolution. I think you have to be able to show there are teeth, but you've got to use the teeth wisely," Curtin said.

Investors need to strike a careful balance between divestment and engagement, and Curtin and the wider investment team's decisions are not taken lightly.

The overall narrative in the industry has shifted from "paper decarbonization" — reducing the portfolio's carbon footprint through divestment — to "staying invested where you can — accepting that, actually, the emissions today are still rising, and therefore you can't show that progress straight away, but just selling out isn't going to be the way to bring that down," she said. "That's something that, as a team of people, understanding a lot more that it's OK if we've got some brown assets in the portfolio, as long as we know what we're expecting in terms of transition strategies. There are some legacy positions that we'd prefer not to sell at a discount necessarily — we will hold them as responsibly as we can. But we know there will be reallocation of our capital as things wind down," Curtin said.

She's "nervous about potential unintended consequences from setting incentives" around explicit carbon reduction, or targeting minimum investment requirements — particularly with climate solutions since "it's still such a small market and from an institutional perspective, it's already becoming overcrowded. If everyone explicitly targets allocating 10% of their portfolio to this very small opportunity set in the next two years, what's that going to do to the expected IRRs of these assets?" she said.

And ultimately, "the objective at the PPF is to make sure we can meet compensation payments."

While Curtin has packed a lot into her first few years as head of ESG — including integrating the ESG team with the investment team so much so that it joins the morning investment meeting — she still sees some hefty challenges ahead.

Her biggest challenge is that we "live in a very unstructured data world" when it comes to ESG. "It's still a lot of qualitative data. Social science data can be just as relevant as trying to put a number on everything. It's about skilling up people to get comfortable with this," she said.

She's also keeping a close eye on ESG-related corrections that could be coming down the road — one of which relates to the commitments some investors have made to achieving net zero and other climate-related goals.

"We've seen even now with the retractions from (the Glasgow Financial Alliance for Net Zero group, which committed to accelerating the net-zero transition) and some of the net-zero alliances, as we get towards 2025 — some of the commitments that have been made, investors may have to decide either to double down or get out. I worry because so many of these targets are defined around 2025, 2030, that paper manipulation is going to be required even more to meet the target," Curtin said.