In the latest in our series on fiduciary duty, a look at the parallels between financial and climate change modelling.
The Law Commission report is long and complex and I suspect the UKSIF response is likely to be the same – and that wouldn’t make good copy for RI. Instead I want to pose a few thoughts about financial modelling and climate change modelling which occurred to me as I read the consultation paper, and I’ll use that to make a few points on the consultation.
Let’s start by considering what financial models are, from my layman’s perspective. The models use data, sometimes lots of it, but sometimes surprisingly small amounts. (I have been pitched investment ideas supported only by data dating from after the financial crisis, perhaps less than 1,000 data points.) What all these datasets have in common is that they are incomplete. They are incomplete because all the possible outcomes have not come to pass and aren’t therefore represented in the data. We simply don’t know what will happen to asset prices if North Korea drops an A-bomb on Japan, and the answer is not in the past history- clues perhaps from past crises, but not the answer. Statistical techniques can then be applied to the data seeking to establish patterns and relationships, and in more complex models links will be determined between different datasets. But again, because the datasets are not complete the relationships are necessarily not fully accurate.
No doubt a statistician would seek to refute me on my incompleteness point, but the financial crisis showed how financial modelling does go wrong. I can remember in particular listening to a Goldman Sachs conference call during the crisis when they said they had suffered a loss as a result of an event which shouldn’t have occurred in the life of the universe – according to their models. I don’t really need algebra or explanation after that.
What of climate change models then? I think they are conceptually the same as the financial ones, and we must recognise their weaknesses, but I think they are probably stronger because some of the relationships are more firmly grounded. The climate models also use incomplete datasets. We don’t have precise temperature or rainfall records for the earth’s history- but we have evidence from various sources that go back millennia and geologists have data that on a less precise basis go back for millions of years.This depth of record is important, but if the sceptics say the long-run data is the “wrong kind” then I think we can show very good quality data on temperature and rainfall for the past 200 years, data that go back further than closing treasury yields, closing equity market levels and closing credit spreads. [We do have closing data for gilts back to the late Seventeenth century, and for some individual UK equities.]
And as I say, since some of the relationships between climate variables derive from the laws of physics, which don’t change, those links are undeniably “harder” than the ones used in financial modelling.
Now the point of this is to consider the differences in use made between the two types of model in pensions. On financial modelling, the Law Commission shows that trustees must diversify and “are to be judged by the standards of current portfolio theory”. The financial models are thus hard-wired in. This is presumably because it is recognised that modelling is the best available way of considering and quantifying the various factors which produce diversification benefits. Modelling is also on the trustee agenda in other guises: many derivatives (all?) will be valued in part using financial models. But the models are defective; they have a central place in finance simply because there is nothing else.
What about climate models and their output? Well, the models are persuasive and they have had an impact: they have set the context for international treaties; for UK law; for individual company initiatives; and for the opinions of a substantial number of pension fund beneficiaries. But of course they as yet have no guaranteed place in investment: concern from engaged beneficiaries and climate-related legislation bracket the pension fund trustee sitting in the middle. But the Law Commission is no doubt right in its assessment of the current law as being that trustees “may” consider ESG – a proxy here for climate change – but don’t need too.
(I’m quite happy that the Commission’s view is based solely on the law; I don’t think for a minute they are biased against ESG, indeed their discussion is very open-minded).
I think the problem is linked to the way trustee duty has originated and evolved, the case law seems to focus on saying what can’t be done, not what should be. My view is that a trustee should be aware of major issues that will affect asset values in the long run, and he or she should be aware that climate change is such an issue.
At which point they should seek advice on likely climate developments which will use exactly the same techniques as the trustee uses in financial matters. It’s what happens next that is important.
Both types of model can give outcomes expressed as probabilities at a given confidence level. My experience tells me that if a set of trustees or an insurance company board was told that a significant investment or longevity risk would crystallise in (at most) 20 years’ time with a 95% confidence level then they would begin to manage that risk. Even if it did not drive immediate action the risk would be recorded on a risk register and a process of review and mitigation would be put in place. An individual or team would be given responsibility for monitoring and reporting on developments so that the decision making body was not surprised. If nothing happened in a particular period that would be reported and it wouldn’t matter: as long as the risk remained it would be managed.
What we need to happen is for the high modelled risk of potentially damaging climate change to be treated in the same way as other high modelled investment or longevity risk.
To make a case along these lines to the Law Commission will be laborious. The Commission does not make law, it reviews it.What we need to do is argue that the current law not only demands that trustees should not ignore society’s knowledge of climate change and other ESG factors, but that it is actively wrong for them not to actively consider them.
I am struck by the picture which I think I discern in the Commission report on the treatment of “modern” investment thinking: it appears to have been regarded at first as unusual and radical but has since become normal and respected by the courts.
We need the treatment of ESG to follow the same route but to be accelerated by the Commission. We need the Commission to make a comment in their final report to the effect that extrapolation of past law to a future case in the modern context would probably demand rather than simply permit the consideration of ESG factors. This is necessary because it’s clear that very few cases on fiduciary duty are ever brought. Cowan vs Scargill was 28 years ago in 1985. The law can’t continue to evolve at that pace: the climate modelling tells us we don’t have that much time – at more than a 95% confidence level.
Simon Howard is Chief Executive of the UK Sustainable Investment and Finance Association