Climate fiduciaries: part III – mind the model gap
Climate models help pension funds estimate the financial costs of climate change, they are often imperfect. Do pension funds have a fiduciary obligation to critically engage with the models they adopt?
“All models are wrong”, British statistician George Box famously quipped, “but some are useful”. For pension funds trying to predict the effect of climate change on their portfolios, Box’s maxim rings true.
Predicting the future is inherently erroneous but predict they must. For a while now, pension funds have had a go at testing their portfolios against the best and worst case climate scenarios. They do so to identify financial cracks – in equity valuations for instance – and what, if anything, they can do about it.
Over the years, models evolved. So too, did the awareness of their shortfalls. A minority of pension funds refused to take the models at face value. Others seemingly did. There is now a legal precedent being set surrounding the latter.
Could funds be held in breach of fiduciary rules if they do not routinely assess how plausible their models are? Part III of this series explores a relatively silent corner of the climate fiduciary puzzle - climate models.
Early days
To appreciate where things stand, it is helpful to look back. In the shadow of the Paris Agreement, a climate risk modelling industry emerged. Fairly quickly, the commercial prospects of climate models became apparent to data providers.
For instance – MSCI, one of the world’s largest in that category, acquired Swiss fintech firm Carbon Delta in 2019 to serve investor demand for climate risk analysis.
Regulators responded too. In 2017, the Network for Greening the Financial System came about. In 2020, this coalition of central banks and banking supervisors began designing climate scenarios.
These were the early days. “Early work has done a stellar job in pioneering the space and socializing the importance of climate informed scenario analysis”, says Willemijn Verdegaal, a former MSCI executive director who is now co-CEO at Trex, a scenario analytics provider.
Pioneering as they were, Verdegaal notes these models had shortfalls. For one, they did not adequately account for tipping points. They often had very little to say on the short-term. When they did, their assumptions were unrealistic.
The NGFS itself went so far as to recommend caution in the use of its own work.
Riccardo Rebonato, senior advisor at the EDHEC Climate Institute notes another key drawback. He points out that in the early days, physical risks became more of an afterthought. As a result, the financial consequences of climate change were underestimated.
Your model, your duty
Underestimating these consequences and overestimating the models can be costly for pension funds. Prudent risk management – of which these models are a part – falls under their fiduciary duty towards members.
“Fiduciary duty requires the identification, assessment and management of material risks, including climate-related financial risks”, explains Karine Péloffy a lawyer and project lead for sustainable finance at Ecojustice, a non-profit.
Péloffy is representing four young members of the Canada’s CPP Investments in a case against their fund’s mismanagement of climate risk. Their complaints extend to CPPIB’s use of the MSCI Climate Value-at-Risk model.
“Deficiencies in the MSCI CVaR model have been recognized by several mainstream financial institutions and investors, such as Norges Bank Investment Management, Danish pension fund AkademikerPension, AXA Insurance, and leading economists for not credibly reflecting the physical risks of catastrophic climate change”, she told Net Zero Investor.
“The case alleges CPPIB uncritically relied on the MSCI CVaR results to report its scenario analysis despite these known deficiencies and without disclosing them, therefore failing to exercise the diligence, prudence and sound judgment required”, Péloffy explains.
Questioning the model
The case raises a hitherto unexplored question: are pension funds, under the aegis of fiduciary duty, expected to critically engage with scenarios and models they use? If they are, they could begin by questioning their models. Rebonato recommends three queries.
“They [pension funds] should ask what the critical assumptions underpinning the advice they receive are, how much the answers they receive would change for different reasonable assumptions and they should ask for an estimate of the uncertainty associated with the estimates they receive”, he says.
Climate narrative
That is not to say that questions are not being asked. Shortfalls in commercially available climate scenarios prompted the Universities Superannuation Scheme – the UK’s largest private pension scheme – to partner with the University of Exeter in 2023.
Together, they developed four new climate scenarios which the £76.8bn scheme said were a "richer, broader, and more realistic range of possible scenarios on which we can base our investment decisions”.
Transition Risk Exeter Limited – Trex – the company Verdegaal jointly leads, was born out of that partnership.
“Our data and insights enable improved investment decision making under deep uncertainty taking into account non-linearities, cascading impacts and tipping points. Trex offers the 'non-linear' alternative to NGFS scenarios”, she explains.
In a bid to depart from old ways, pension funds also seem to be taking on a more qualitative perspective on what has historically been a quantitative exercise. Climate narratives, they call it.
“A 'storyline' is often more intuitive than just quantified results. To act, decision-makers need to believe the scenario is credible. A well-constructed narrative helps with this”, says Verdegaal.
"Narratives eat modelling for breakfast", reads a USS-Exeter joint report on scenarios.
Since their inception, climate models have evolved in technical sophistication and investment relevance. Without a credible story about long-run climate change, it is hard to imagine investment decisions taking account of it.
Pension funds are now being pushed, in court, to critically engage with their climate crystal balls. A prudent fiduciary, the plaintiffs claim, should notice the fault in their models.
