This article was written together with Eleonora Cambone.
The rise of ESG (Environmental, Social and Governance) and Sustainable investments is undebatable, and the figures testifying this are clear as day: as of December 2018, there are 2,816 European responsible investment funds domiciled in Europe with a total assets under management (AuM) of EUR 496 billion. This is a 27% increase in the number of funds and 12.5% in AuM. Due to new subscriptions, funds created in 2018 will likely increase their AuM in the coming years.
The increased popularity is fueled not only by changing dynamics from the investors' perspective (e.g. rise of millennial investors and increased climate change awareness), but also from regulatory push. Upcoming legislation is predicted to bring disruptions and new challenges: it's time for asset managers to fasten their seatbelts for a challenging journey.
UCITS & AIFM Directives
Following the European Commission's Action Plan on Sustainable Finance, ESMA has provided technical advice with a consultation paper on the delegated acts that will amend the legislation. Asset managers will mainly be impacted by the amended UCITS (Commission Directive 2010/43/EU) and AIFM (Commission Delegated Regulation EU 231/2013) directives that bring changes to three main areas: Organizational Requirements, Operating Conditions, and Risk Management.
- Sustainability risks to be integrated in the investment decision-making procedures and organizational structure
- Ensure that ManCos/AIFMs have the proper resources (skills, knowledge and expertise) to effectively integrate sustainability risks
- Senior Management is responsible for the integration, including implementing the investment policy, ensuring valuation policies and procedures are adequate, approval of internal procedures for investment decisions, risk management policy
- Conflicts of interest linked to the integration of sustainability risks to be identified, managed and mitigated (identification to include conflicts arising from remuneration or personal transaction, and between funds with different investment strategies managed by the same ManCo/AIFM)
- Due diligence on investments enhanced by taking into account sustainability risks and the principal adverse impact on sustainability factors
- Risk Management policy to comprise procedures to enable ManCo/AIFM to assess sustainability risks
What challenges do asset managers face?
One of the major concerns for ManCos and AIFMs is ensuring that employees have the competencies to ensure compliance with the regulation.
To achieve this, there are two options: either to rely on in-house skills, through recruitment and providing appropriate training and knowledge-building; or outsourcing, with the appropriate delegation oversight framework tailored to the size and strategy of the business.
Senior management will also be expected to integrate sustainability risks across the business through implementation of internal controls that ensure an accurate and truthful integration of the risks. Additionally, ad-hoc due diligence processes will need to be developed with new questionnaires and screening updated to include sustainability risks.
Several policies (e.g. Conflicts of Interest and Risk Management), as well as the overall governance framework, must be updated to assess the new sustainability risks arising from remuneration, personal transactions and 'greenwashing', to name just a few.
Sustainability risks must not be ignored
If mismanaged, these risks, could bring about major disruptions for an asset manager's business model. In fact, ESG risks are highly interlinked with traditional risks such as valuation risk. Failure to account for issues arising from climate change could likely provide an asset valuation that does not entirely mirror the reality. A proper risk management framework for ESG could be a significant game changer and enabler in an ever-evolving landscape.
Top four pillars of risk management framework
ESG factors should be mapped to a particular level of risk, likelihood of occurrence, interdependence with other risks and how the risk factors affect the realization of the business strategy and objectives. ESG risks should stand side by side other prominent risk factors (e.g. market risk and liquidity risk) in the risk matrix.
Qualitative & Quantitative risk measurement
The results of the Risk Profiling exercise should lead to a risk classification enabling the measurement of such risks. It can be supported by external and reputable ESG risk indicators:
- Environmental – e.g. climate change risks, both physical and transitional
- Social – e.g. violation of workers' rights
- Governance – e.g. anti-competitive practices
A more holistic approach to the measurement could include company (or fund) stress tests and scenario analyses to investigate the resilience of specific adverse events caused by physical or transitional risks.
Monitoring & Reporting
Such risks need to be monitored on a regular basis with the appropriate tools and IT infrastructure (e.g. specific data providers and ad-hoc in-house knowledge), and should be included in existing internal reporting.
Escalation & Remediation
A proper escalation process should be in place to involve management in dealing with identified significant risks. Remediation actions could be defined keeping in mind risk-bearing capacities and appetites.
2021 – the year for ESG?
We must remember that complexities are not simply down to the challenges. With ESG comes a veil of uncertainty brought by a regulation that is yet to be finalized, and whose implementation timeline is vague. Data accuracy and providers are still not mature enough for the market, and resources in terms of expertise are scarce. It's certainly no easy feat for Asset Managers to get ahead of the competitors in this kind of environment.
We predict that 2021 will see ESG legislation become applicable and Asset Managers will need to demonstrate the adequacy of their business models in terms of sustainability risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.