The global cost of extreme weather attributable to climate change is estimated at $143bn per year over the past 20 years, according to a 2023 study in scientific journal Nature. Despite this, US state pension funds are “not taking adequate steps to reduce climate-related financial risks”, finds a new report from three environmental organisations.

“Far too few state pensions are taking adequate steps to address climate-related financial risks and protect their members’ hard-earned savings, raising serious concerns about their execution of fiduciary duty – the obligation that financial institutions have to act in their clients’ best interest,” finds the report by Sierra Club, Stand. earth and Stop the Money Pipeline.

State pension funds have a responsibility to account for these risks, not only because they oversee huge sums of public money but also because they are particularly exposed to “climate-related and other systemic risks” as “diversified and long-term shareholders”, the non-profits argue. State pension funds ought to be “the first [institutional investors] to incorporate such considerations into their stewardship practices”, they say.

The report assesses 19 pension funds representing more than $2trn in collective assets across three metrics: their climate-related proxy voting guidelines (which outline criteria pension staff use to address shareholder resolutions); climate-related proxy voting records; and finally, their transparency on the above.

Each fund was given a grade from A to F based on these differently weighted factors. Just three state pension funds – all from New York City (NYCERS, TRS, BERS) – received an A- grade; one fund, the California State Teachers Retirement System, or CalSTRS for short, received a B-; while ten got C-D grades and a further six received the lowest possible grade, an F.

As proxy voting guidelines are “one of a pension’s strongest tools for corporate governance”, the report authors attribute a 75% weighting to this metric. The three New York City funds are among those praised by the report’s authors as having relatively strong proxy voting guidelines on climate change, due to their incorporation of language that “recognizes the system-wide risks from the climate crisis, and allude to how that impacts their voting decisions”.

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For example, New York City pension funds state in their 2023 filings that they have a “fiduciary duty to mitigate the systemic and company-specific risks that climate change poses to our portfolio”, and note that their net-zero goals are “designed to mitigate the systemic risks of climate change to our investments and the real economy”.

However, these examples of good practice are few and far between, with too many funds failing to make this link between climate change and financial risks, the report finds. Even if they score well on proxy guidelines, most funds fail to demonstrate that they are “taking a comprehensive approach to managing and mitigating climate-related risks across their entire portfolios”, the report’s authors argue.

The anti-ESG movement versus pensions

The question of how far pension funds should take into account climate risks became a topic of contention in 2022, in the midst of the anti-ESG (environmental, social and governance] backlash, where Republican state senators imposed a series of laws restricting state investments in financial institutions that boycotted certain companies on ESG grounds. This included (but was not limited to) banks that restricted fossil fuel investments off the back of net-zero targets.

By January 2023, almost half of US states either had some type of anti-ESG legislation in place or had put blacklisting ESG action high on their legislative agenda, according to research from think tank Ceres.

As part of the ESG backlash, a handful of state officials argued that ESG investing, which requires the consideration of “non-pecuniary factors”, would diminish pension funds’ ability to maximise returns, notes a 2023 report from US think tank the Roosevelt Institute. It argues that “the truth, however, is that ignoring ESG considerations is exposing workers’ pensions to enormous financial risks”.

Indeed, research published last year by a coalition of non-profits – the Sunrise Project, As You Sow and Ceres – suggests that all taxpayers (not just pension fund clients) risk losing out on hundreds of millions of dollars of public funding thanks to these laws, in part because of potential losses caused by reduced competition, with the five largest underwriters exiting the market.

As further evidence of taxpayer losses due to anti-ESG policies, the Roosevelt Institute's report points to a case in Indiana where fiscal analysts estimated that proposed legislation requiring the state to divest from funds that use ESG analysis would result in a loss of nearly $7bn in returns over a decade.

As such, the Roosevelt Institute argues that a fundamental flaw in the anti-ESG narrative is that framing climate risks as putting “ancillary interests before investment returns” assumes that “fossil fuel companies will continue producing returns consistent with fiduciary duty indefinitely, even if companies fail to align their behavior with the emissions reductions necessary to avert an unsafe level of global warming”.

The idea that avoiding fossil fuel investments is already a real, rather than “ancillary”, interest is supported by a February 2024 analysis from the Institute of Energy Economics and Financial Analysis, another think tank, which finds that in 2023, “the fossil fuel sector once again lost ground compared to the market as a whole”, with the sector posting an annual loss of almost 5%.

Climate: a new type of financial risk for US pensions

Sierra Club, Stand. earth and Stop the Money Pipeline’s report focuses on 19 pension funds in states where a state financial officer has indicated it is a “priority issue to protect against climate risk”, meaning their failure to do so is unlikely to be a direct result of political lobbying.

Instead, report authors Jessye Waxman and Allie Lindstrom tell Energy Monitor in an interview, pension funds are generally speaking “pretty consistently opposed to anti ESG legislation”, which is “expensive and difficult [to comply with]”. Nonetheless, “the relative newness of climate risk” should not be used as an excuse to ignore it, they add.

One reason pension funds may be underestimating climate risk is that they rely on flawed modelling – there is a “huge disconnect” between the economic studies relied on by consultants commissioned to calculate the impact of global warming on members’ portfolios, and what scientists expect from global warming, claims a 2023 report by the think tank Carbon Tracker.

For example, modelling provided by a handful of investment consultants to pension funds (as well as central banks and other investors) implies that “significant global warming will cause a relatively small fall in the annual rate of economic growth until 2100” that report finds – while there is a wealth of evidence to suggest the opposite. One study by the world’s largest asset manager, BlackRock, suggests that if no action is taken to mitigate climate change, global economic output could fall by 25% in the next two decades.

Another issue to keep in mind is that modelling the financial impacts of climate change is extraordinarily complicated, with current climate stress test methodologies used by banks criticised by some as “not fit for purpose”.

A key reason for the “disconnect” between the “benign” findings of stress tests carried out by the European Central Bank and other institutions from the Network for Greening the Financial System and those from scientific bodies like the IPCC is their failure to account for severe economic shocks caused by climate change, according to a 2023 paper authored by analysts from CitiBank and the Commonwealth Bank.

US state pension funds could better insulate themselves against climate-related financial risks. This includes strengthening state pension codes to incorporate systemic risks into the definition of fiduciary duty; incorporating climate risk management and mitigation into state fiduciaries’ assessment of their investment portfolio and their corresponding portfolio management decisions, including proxy voting; engaging asset managers and proxy advisors on climate-related risks; and supporting policy efforts to mitigate against climate risks.

Another clear option available to responsible asset owners is joining the UN-convened Net Zero Asset Owner Alliance, a global investor initiative committed to net-zero portfolios by 2050. Currently, CalPERS is the only state pension fund of the 19 cited in Sierra Club’s report that is a member.

“We shouldn’t have to wait for a major financial crash that would negatively impact clients' portfolios in order [for pension funds] to act [on climate risks],” the report's authors tell Energy Monitor. “A responsible fiduciary should know this risk is coming... financial actors [should] recognise and be more proactive about risk management on climate so that we don't have a climate-induced, 2008-style financial crash,” they conclude.