“ESG litigation risk” is a topic which is increasingly on the agenda of risk committees at many corporations and institutions. Even governments aren’t immune, with news of the revived Court action by Client Earth against the UK government’s Net Zero Strategy which is being challenged as being in breach of the Climate Change Act 2008. Pension scheme trustee boards should be joined to this list of parties with an eye to ESG litigation risk. Pension scheme trustee boards are no doubt used to assessing risks and considering probabilities; it is in their very nature. However, faced with their risk register, or ‘Own Risk Register’ under the General Code, what should ESG litigation risk actually mean to pension trustees? In this article Kate Granville Smith, Director and ESG lead for Pensions and Suzanne Padmore, Partner, Pensions Disputes consider this further.
What is ESG litigation risk in the context of pension schemes? A trustee faced with this as a box on their risk register should seek to answer this very question before they go on to consider what they should do to mitigate it. This is a rapidly developing area but in this context, we consider that ESG litigation risk involves not only claims before a Court, but also claims before the Pensions Ombudsman (PO), claims under a Scheme’s Internal Dispute Resolution Procedure, investigations or penalties imposed by the Pensions Regulator (TPR) and also claims which may not proceed but may need legal or risk advice.
As with any potential claim, there are certain hurdles including standing to bring a claim, evidential burdens and rules of procedure and we do not intend to go into such detail here. Rather, we are looking at themes which may give rise to claims. As TPR says in relation to its climate change strategy, this is a rapidly developing landscape and expectations on trustees will change over time, even within the legislative framework. Further, different schemes may experience different risks, for example defined contribution versus defined benefit and occupational versus personal pension schemes.
Claims where Trustees have failed to comply with the legislation, for example in relation to their Statement of Investment Principles (SIP), implementation statement and - for those in scope - their TCFD report and / or best practice guidance
It is imperative that trustees are conversant with the legislative requirements of their role in order to comply with them. These include requirements in relation to their SIP (detailing the policies controlling how a scheme invests, including consideration of financially material ESG and climate factors), and their Implementation Statement (showing how the principles in the SIP have been followed). For schemes with assets over £1bn, they are required to adopt and report against the Taskforce on Climate-related Financial Disclosures (TCFD) recommendations.
TPR has said that where trustees do not comply and where it is appropriate to do so, it will take enforcement action which it may publicise. As it points out, these requirements represent compliance with the “basics on climate change”.
It should be noted that as well as strict requirements in legislation, trustees should ensure they comply with regulatory guidance, such as that of TPR. In relation to TCFD reporting in particular, the DWP has published statutory guidance; although trustees are not required to have regard to it, it is intended as ‘best practice’ and trustees are encouraged to follow it. TPR’s General Code outline's TPR’s expectations in relation to ESG and climate change.
In terms of mitigating risks, trustees should ensure that their documentation and processes are compliant. They cannot outsource these responsibilities; where advisers produce documentation on the trustees’ behalf, the trustees retain responsibility for them.
Claims where Trustees have failed to provide information requested by members in relation to climate change
Assuming trustees are compliant with obligations, are the trustees confident that they are providing the information that they are required to disclose?
Campaign groups have recognised the power of investments, including pension scheme and pension saving to make positive changes and are therefore encouraging members to ‘green their money’. Whilst members may be more interested in their pension investments in the future and make more requests for information years down the line, some requests should be anticipated sooner. So what are the requirements on trustees? Some of the requirements are set out in the legislation mentioned above. TPR has increased its focus on ESG non-compliance by launching a campaign in early 2023 to check whether trustees are publishing the appropriate information in their SIPs and Implementation Statements. Further, in September 2023, TPR issued its first climate change reporting fine against the ExxonMobil Pension Plan for failing to publish its TCFD report. The trustees pointed out that although the report had been produced by the deadline, it was not published due to an administrative error. The Regulator said that the case shows that it ‘will and must act by using the mandatory fining regime set out in law.”
We have already seen a case come before the Pensions Ombudsman (“PO”) in 2019; that of Mr D v The Shell Contributory Pension Fund (PO-27469). In this case, Mr D complained that the Fund would not provide all the information he had requested, in particular, information relating to how the Fund is taking the potential risks of climate change into consideration. Mr D met with the Trustees for the Pension Fund after which he requested a copy of the recent investment strategy, including the sections that specifically dealt with;
- climate change;
- the risk management framework;
- the relevant sections of the employer covenant report;
- sections of documents that describe the techniques and processes used by the Fund to identify, monitor and respond to climate risk;
- a copy of the most recent actuarial valuation; and
- extracts from minutes in the last 2 years recording decisions the Trustee made in relation to climate change.
The Trustees did not provide the investment strategy, risk management framework or internal management processes on the basis that these were confidential. Mr D said that the information not being disclosed amounted to maladministration. The PO considered that the Disclosure Regulations 2013 set out the specific information that must be provided to members on request and that in this case, the Trustees had complied with these regulations. Moreover, the PO noted that the Trustees had gone above and beyond their duties by arranging a meeting with Mr D and had provided more information that they were legally required to provide. When the Trustees made the decision not to provide further information, they took into consideration the legal requirements relating to sharing information, confidentiality, commercially sensitive information, the direct relevance of additional documents to the provision of Mr D’s benefits, resourcing requirements and other priorities, proportionality as to whether the information should be provided to Mr D and potential conflicts of interest. Mr D’s complaint was not upheld.
Although that looks like a balanced decision by the PO, it must be remembered that as this case was heard in 2019, there would have been no requirement to produce a TCFD report. Furthermore, since 2019, trustees of pension funds with 100 or more members have been required to set out policies on stewardship and on ESG governance considerations including climate change that they consider financially material in their SIPs. This information must then be published on a publicly available website. However, this decision still provides comfort that in whatever wider disclosure environment trustees find themselves at the time, the PO should still consider what information a scheme is required to provided and also what may be reasonable considerations in not providing further information.
In terms of mitigation, trustees will need to be aware of what information and which documents they need to disclose to members. Trustees will need to ensure that they are meeting their statutory disclosure obligations and respond appropriately to members who raise queries.
Claims where Trustees have failed to consider the risks and opportunities from climate change in their investments
ESG issues are of course, wider than climate change. However climate change and the transition to a net zero economy is an aspect which naturally presents obvious risks (as well as opportunities) in relation to investments. Pension schemes need to be resilient to protect members from these risks. We have already seen the case of Universities Superannuation Scheme (“USS”) v McGaughey come before the Court of Appeal.
This claim was brought by two members of the USS (representing a wider group of 100s of members who had all contributed to fund the legal fees) against the directors of the corporate trustee of the USS for allegedly failing to deliver on their climate change commitments. The basis of the claim was that the corporate directors’ had failed to divest from fossil fuel investments, following key commitments from the USS to achieve net zero on or before 2050. The members argued that this failure caused and would continue to cause significant financial detriment and was and continued to be against the interests of members of the scheme. It was argued that the directors’ inaction in failing to divest constituted a breach of the proper purpose duties which were placed on directors by section 171 and 172 Companies Act 2006. It was further argued that the directors had failed to comply with their duties under the Investment Regulations 2005 in relation to their power of investment.
In May 2022, the High Court had dismissed the claimants’ claim on the basis that that they had “failed to show even a prima facie case” that justified any of their claims and in particular, had not provided any evidence that the USS trustee directors had not failed to comply with the 2005 Investment Regulations.
The claimants appealed but on 21 July 2023 the Court of Appeal dismissed this appeal. The Court of Appeal highlighted that the claimants were unable to prove that the directors’ alleged breaches of duties had caused them to suffer loss. It was summarised that “as there was no prima facie case of loss in relation to this claim, it falls at the first hurdle”.
The Court of Appeal further held that even if the first hurdle had been met, there was a lack of evidence that the directors had “furthered their own interests” or that the “directors’ actions put their own beliefs with regards to fossil fuels above the interests of the beneficiaries and the Company”. The claimants’ evidence for their claim consisted of an ethics survey which had been completed by less than 1% of USS members which led the Court of Appeal to find the only reasonable conclusion to draw was that the directors had been acting in accordance with what they considered to be the best interests of USS.
The Court of Appeal also agreed with the High Court in finding that the trustee directors had complied with their duties under the Investment Regulations 2005. As the trustee directors had ensured the proper diversification of assets and exercised discretion following the receipt of appropriate professional advice, a breach of the regulations was not identified.
Accordingly, the claim failed. The Court of Appeal concluded that the claimants’ assertions in relation to fossil fuels were simply “an attempt to challenge the management and investment decisions of the USS trustee without any ground upon which to do so.”
This case highlights that trustees do have significant discretion in how they discharge their duties under the legislation. However, it also shows that trustees should ensure that climate risks are carefully considered and accounted for when consulting with investment advisers or making investment decisions. They should ensure a robust decision-making process and audit trail. Given the significant assets under management of pension scheme trustees, and the increasing awareness of the power of investments in tackling climate change, more challenges by members can be anticipated.
Trustees may take comfort from some of the more practical aspects of this case. For example, members having to fund their own legal fees compared to the resources of one of the largest pension schemes in the country, creates a David / Goliath scenario which may lead to thinking that member claims are unlikely. There is also the approach that the Court took in Client Earth v Shell: here it was held that the claimants’ claim was unsuccessful as the claimants only owned 27 shares and were motivated by concerns which did not reflect the “multifarious factors which the Directors are bound to take into account when assessing what is in the best interests” of a company. However, we expect that climate change litigation is an area where developments in both litigation funding and group litigation will support, rather than hamper, similar claims being brought in the future.
Claims where Trustees have taken into account ‘ethical considerations’ which have caused loss to the value of investments
In contrast to claims where it is asserted that ESG and client change were not adequately considered, it is conceivable that there may be a basis for claims where trustees have taken into account ethical considerations or “non-financial factors” which have then prejudiced financial returns.
Schemes which are required to produce a SIP must detail the extent (if at all) to which non-financial matters are taken into account (i.e. the views of members and beneficiaries including their ethical views and their views on social and environmental impact). The Law Commission’s report entitled “Fiduciary Duties of Investment Intermediaries” of 2014 set out a two stage test when determining whether non-financial factors may be taken into account:
- trustees should have good reason to think that scheme members would share the concern; and
- the decision should not involve a risk of significant financial detriment to the fund.
As the 2014 report says, the Courts will focus on the process by which trustees reach their investment decisions, rather than the outcome of those investments. The Courts will examine whether or not the trustees applied their minds to the right issues and whether they went about the decisions in the right way.
There have been a number of cases concerning whether ‘ethical considerations’ may be taken into account such as Harries v Church Commissioners (a case in the charity sector) where the Church Commissioners refused to invest in alcohol, tobacco and armaments firms. In that case, the Court held that when considering whether the trustees may accommodate the views of those who consider that on moral grounds a particular investment would conflict with the objective of the charity, that trustees would need to be satisfied that such a course would not involve a risk of significant financial detriment.
We mention this case as an ESG litigation risk since trustees will need to ensure that where they do take non-financial factors into account, they have been appropriately advised on the process of consideration and decision-making, and ensure that they have a robust audit trail in place in case there is a challenge in the future. The trustees would need to be able to show, for example, how have they determined if members would share the concern, and how this stacks up against the considerations towards other beneficiaries. Trustees could show their consideration by pointing to member surveys or perhaps by seeking the views of a representative body. Trustees must also consider how they will ensure that this is kept under regular review. We have seen that in some territories (such as the US), there is an “ESG backlash”, where investors are sceptical of, or even oppose, “philosophical opposition” to investing. In the context of pension schemes, it could be that if an investment does not perform as well as hoped, members may mount a challenge if non-financial factors have played a part in decision making. At that point, attention will no doubt fall on the decision-making process.
Greenwashing / disclosure claims
This is particularly relevant to defined contribution / personal pension schemes. The Financial Conduct Authority (FCA) has proposed an anti-greenwashing rule that requires all regulated firms to ensure that sustainability-related representations, naming and marketing are clear, fair and not misleading, as well as consistent with the sustainability profile of products. In particular, the FCA has proposed that there should be restrictions on how certain sustainability terms such as “ESG”, “Green” or “Sustainable” can be used in the names and marketing of products which don’t qualify for the sustainable investment labels. Furthermore, the FCA introduced its ESG Sourcebook in January 2022 which outlines climate-related disclosure rules that will affect asset managers and asset owners. Those affected by such legislation should ensure awareness of their obligations in this area and compliance.
Takeaways
Pension scheme trustees and operators should ensure that they understand their ESG obligations and identify the ESG litigation risks that may affect their scheme. They should ensure that processes for monitoring developments in this area are in place. They should ensure that they have robust decision-making processes and appropriate audit trails of decisions, and they should take advice if there is doubt as to what is required in this rapidly evolving area.
What is clear is that trustees should not see their ESG obligations as merely a tick box exercise or something that can be outsourced to consultants and advisers; trustees should retain ownership and responsibility. TPR noted in the ExxonMobil case, it “serves as a warning to trustees about the importance of having proper governance and oversight where third parties are carrying out tasks on their behalf.” Trustees should feel confident enough to question and challenge their advisers where appropriate, for example in relation to climate scenario analysis where TPR has explained the role of trustees in driving change in this area.
We are well placed to advise on ESG issues in relation to pension schemes of all types and sizes. If you would like to explore this topic further, please contact us. We have launched a Pension Schemes ESG Tool, helping trustees and sponsoring employers understand their ESG obligations.