FMLC Paper on Fiduciary Duties

The Financial Markets Law Committee (FMLC) published its much anticipated paper on fiduciary duties on 6 February which provides further clarity on the role of climate and related sustainability risks for investors. To us, there are two particularly interesting findings:

1. Pension scheme trustees should be taking into account sustainability factors such as climate change, assuming they consider them to be financially material. This clarifies the position in an earlier Law Commission report, which could have been interpreted to mean that further tests have to be met.

2. Pension scheme trustees should consider narrative as well as numbers. The direction of travel for climate scenario modelling has been towards narrative-based models, and this provides a further fillip in that direction.

Fiduciaries *should* consider financially material climate risks

First, let’s consider the history. The 2014 Law Commission report has been treated by many as the authoritative statement on fiduciary duties until now. It offered what it described as “the key distinction” between “financial” and “non-financial” factors.

• Financial factors: The FMLC paper says: “On any view ‘financial factors’ should be taken into account”

• Non-financial factors: If it’s non-financial, it’s still possible to incorporate it, but there are more tests to pass. “In general, non-financial factors may be taken into account if two tests are met: (1) trustees should have good reason to think that scheme members would share the concern; and (2) the decision should not involve a risk of significant financial detriment to the fund.”

A lot has changed in the world of responsible investment since 2014. Was it suitable for the Law Commission to firmly say that climate change counts as a financially material risk? At the time, they didn’t; it would perhaps would have been unreasonable to expect them to anticipate the massive progress the ESG sector has made since then.

The FMLC paper hinted at this more strongly, noting “The second thing to have in mind is how broad “financial factors” are today.” The paper doesn’t go so far as to say that climate change *is* a financially material factor, but it clearly opens the door for pension scheme trustees to:

1. Explore how material they believe climate change to be.

2. If they believe it’s material, to treat it as a financial factor, meaning that they have an obligation to take it into account.

This was not specific to climate change – the same logic applies to any other sustainability factor.

It is appropriate to use narrative-based climate scenarios

The logic outlined thus far could still lead to asset owners not considering climate change to be financially material. For example, they may consider climate scenario modelling results and decide that this was not material. This would be particularly likely if decision-makers were looking at climate scenario models which focused on the most easily quantifiable implications of climate change, and missed the more complex risks.

The FMLC addresses this directly, by highlighting the role of both “numbers and narrative”. Its wording is very clear in stating that:

• “Sometimes financial factors cannot be quantified but it does not follow that they lack weight”, and

• “Rigorous qualitative and not simply quantitative consideration is now more important in the pension sector.”

This suggests that using quantitative climate scenario modelling without incorporating qualitative or narrative-based considerations will increasingly be seen as a thing of the past.

Should you have any questions, or wish to discuss further please get in touch.