Integration of sustainability risk:
changing the mindset to develop new opportunities
To ensure the transition to a low carbon society and to reach global objectives in reducing climate change impacts, companies will need to integrate sustainability risks within their risk management approach.
Laurent Berliner - Partner - Risk Advisory - Deloitte
Francesca Messini - Director - Risk Advisory - Deloitte
Gianfranco Mei - Director - Risk Advisory - Deloitte
Julie Castiaux - Senior Manager - Sustainability Expert - Deloitte
Sofia Melucci – Analyst – Risk Advisory - Deloitte
Published on 2 July 2019
While nowadays companies from varied industries find themselves facing the challenge to adapt their activities to the regulatory, market, and customers’ pressure on sustainability, a range of opportunities are also knocking at their doors.
Sustainability matters expose companies to both risks and opportunities. By integrating better non-financial risks, investments will reach a longer-term stability; it will revisit the investment decision process and demonstrate accountability to investors.
Despite the recent effort to identify climate-related risks through the provision of guidelines on Climate-related Financial Disclosure1, there is still an urgent need to set reporting requirements on sustainability-related risks and its related monitoring of activities on the financial market. The level of risks and opportunities vary depending on the kind of company and on the sector in which they operate.
Although there are still lots of questions on what sustainable finance is, things are on the move at the EU level as they are working on the clarification of sustainability-related risks and how they will be translated into concrete disclosure requirements.
1 Created by Financial Stability Board toward a dedicated task force - TCFD with the purpose to provide guidelines to companies in improving climate-related financial disclosure.
Over the last few years, the EU regulations have been evolving with regards to the disclosure of sustainability-related information (e.g. The Non-Financial Reporting Directive (2014/95/EU) (NFRD) and The Action Plan on Financing for Sustainable Growth published by EU Commission in March 2018. The European Commission towards the Technical Expert Group (TEG) and with the support of ESMA European Securities and Markets Authorities are preparing a new set of regulations and propose amendments to delegated acts under directives related to MiFID II, IDD, UCITS and AIFMD with regards to the integration of sustainability risks and sustainability factors.
The ambitious targets set by the EU for 2030 and 2050, the Paris Climate Agreement in 2015, and the United Nations Sustainable Development Goals (SDG’s) demonstrates the willingness to tackle climate-related issues and to ensure the transition to a more responsible and sustainable society.
In the future, the amended version of the NFRD will guide the various industries on how to integrate the climate-related financial risks within their management and disclosure process. The Technical Expert Group of the EU Commission proposed the alignment between the TCFD recommendations and the NFRD.
IN THIS CONTEXT, THE MANDATORY INFORMATION TO REPORT WILL BE
- Description of how climate-related issues might impact the company’s business model and how its activities might affect climate change
Policies and due diligence processes
- Description of the Board’s oversight of climate-related risks, opportunities and impacts, including its knowledge and expertise
- Management role in assessing and managing climate-related risks, opportunities and impacts
- Systems and processes in place for identifying and assessing climate-related risks and impacts, and how they are integrated into the overall risk management framework
Outcomes of policies
- Monitoring and assessment of the company’s development, position, performance and impact as a result of its policies
Principal risks and their management
- Assessment of climate-related risks and opportunities identified over the short, medium and long-term, providing a forward looking evaluation
- Processes in place for identifying and managing climate-related risks
- Impact of the company on climate change mitigation and/or adaptation
Key performance indicators
- Set up of non-financial key performance indicators relevant to the particular business
- Sectoral and company-specific KPIs (Key Potential Indicators)
In addition, the consultation document presented supplementary disclosure information that companies should consider to disclose.
It should be noted that the organizations targeted by the NFRD are the Public Interest Entities, listed companies, banks and insurance undertakings, and other companies identified by Member States with more than 500 employees. In-scope banks and insurance companies that perform investing and asset management activities should include the impact of those activities in their reporting2.
Although the non-listed Asset Managers and the Private Equity asset owners are not concerned by the NFRD, on 18 April, the European Parliament adopted a text on the “Disclosures relating to sustainable investments and sustainability risks” that should enter into force beginning of 2021. This new regulation introduced the disclosure obligations over the existence of a sustainability risks policy and transparency over the consideration of the adverse impacts of investment decisions on sustainability factors. Concretely, for the funds that are recognized as ESG funds (funds integrating Environmental, Social and Governance characteristics), there will be requirements to demonstrate the application of a sustainability-related risk assessment. In addition, the sustainable funds having a positive social or environmental impact, will have to monitor and demonstrate the achievement of the related impact.
In addition, ESMA is currently proposing to amend the UCITS and AIFMD directives to integrate the sustainability risk and sustainability factors.
2 Asset managers and asset owners can be considered in the NFRD’s scope only if listed or as part of a listed group.
Therefore, we can expect that practices on sustainability risk considerations and disclosure will soon become mainstream for all organizations. The objective is to facilitate the investors’ decisions, to ensure better management of long-term risks but also a better market stability and the achievement of the climate change objectives towards a better investment orientation.
All these future changes will involve an adaptation in the governance of the financial institutions and by professionals. We believe that the success of the change in the investment mindset will require a strong position from the managing/governing bodies supported by a mature regulatory framework in order to clearly identify and outline their responsibilities. To support that aim, awareness and education on what sustainability, climate change and non-financial performance are, should be developed for all market players.
A key role would also be played by the control functions such as Risk Management, which will develop a dedicated process and framework to adequately define, identify, assess, manage and report the relevant sustainability risks exposure including internal limits and stress testing scenarios.
A particular focus is on the integration of the physical climate (e.g. flooding, drought, and sea level rise) and transition risks (e.g. policy, liability, technology) within the already implemented risk management system and the related risks indicators. The key challenge we foresee in setting up adequate indicators to manage these risks, is the valuation of the potential losses linked to these exposures especially because of the limited data/information available in the market.
The role of the Compliance Officer would be equally important. The monitoring of sustainability risks should be included in the compliance charter and in the multi-year, compliance-monitoring plan, setting the control activities that need to be performed on a risk-based approach. Lastly, the role of the third line of defense, i.e. the Internal Audit will be important to provide comfort to the management and governance bodies to ensure that sustainability risks are identified, assessed, and monitored.
When it comes to the fund industry composed of various service providers, sustainability will be part of the initial and ongoing due diligence performed by the delegators. They will be able to identify the types of conflicts of interest whose existence may damage the interests of a UCITS/AIF or its investors.
The due diligence activities will then integrate the sustainability risks and factors. The risk exposure may be considered higher, by definition, for the key actors of the fund industry such as the Investment Advisors or Portfolio Managers. The sustainability risk management process is a complex exercise and will involve all the stakeholders of the fund value chain to avoid that non-compliance with the sustainability guidelines and regulation by one of the relevant stakeholders, could jeopardize the whole risk management process and lead to high reputation damage.
Due diligence activities to be performed on services providers, in this sense, should not be limited to the delegated tasks but should also take risk management procedures implemented by the delegates to manage their own sustainability risks exposure into account.
The success in the development of more sustainable and responsible activities will lie in better connection between the corporate and financial worlds. How the companies will understand and integrate sustainability risk management within their daily processes; how it will be monitored and reported to stakeholders; and how the financial industry will rely on this information and be able to address its investment decision-making process accordingly will all be important. All of this has a common objective: to increase the positive impact and achieve global climate commitments to limit global warming to 2°C.
Following the recommendations of the TCFD, more and more companies are now proposing concrete greenhouse gas emissions reduction targets aligned with the 2°C objectives. Some of them are going a step further by developing scenario analysis demonstrating how an increase of the global temperature of 2°C will affect their financial capabilities. For example, aviation activities may be impacted by the increase of fuel cost as well as by the occurrence of extreme weather events causing multiple flight cancellations. In the agribusiness, an increase in drought and flood scenarios may impact directly the production, the food cost, and the capabilities to deliver quality product. Conversely, climate change may bring new business opportunities such as development of agriculture or the development of tourism activities in some countries.
Over the coming months, it will be key that risk management processes integrate the climate’s physical and transition risks, so as to allow the different organizations to be in a position to continue relying on a strong, reliable, and complete risk management process .
Organizations that will integrate those risks and opportunities today will be able to stabilize their transition over the coming years and to address new market demand in a new model of society.
Shaping the future of investment strategy
While the positioning of decision-makers on climate-related issues and the transition towards a more responsible society took a significant step forward in 2015, it was 2018 that saw the start of a new wave of action driven by citizens.