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InsideNow

The dawn of sustainability risk management for investment firms

As global awareness of the impact of climate change intensifies, the interplay of new regulatory and market forces is inducing material shifts in old investment management paradigms.

Authors

Sylvain Crépin - Partner - Risk Advisory - Deloitte

Gianluca Frena - Senior Manager - Risk Advisory - Deloitte

Julie Begue - Senior Manager - Risk Advisory - Deloitte

Published on 8 July 2021

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The growing market competition of environmental, social and governance (ESG) products requires investment managers to differentiate themselves—by demonstrating a credible sustainability integration approach that goes beyond mere compliance and is credible and coherent across the entire fund value chain.

Recent corporate scandals and shareholder activism actions, which translate into large regulatory fines and reputational backlashes, are reminders of the importance of solid governance and social principles. Consequently, ever-increasing numbers of investment practitioners are recognizing that ESG factors can affect an investment portfolio’s risk profile and its real return, by influencing both tail-risk and long-term profitability.

Therefore, it is pivotal that contemporary investment funds formalize the risks from climate change and broader ESG factors into an integrated sustainability risk management framework. However, putting theory into practice is still challenging for many practitioners.

A new role for risk management

The complexity of the regulations at play—fragmented across different acts and time scales, and intertwined with new sustainability disclosure processes across economic players—means the current pursuit of a gold standard for sustainability risk management is a challenging and, potentially, a mistimed undertaking. However, the application of various regulatory acts—including the Sustainable Finance Disclosure Regulation (SFDR), the EU Taxonomy Regulation, the UCITS/AIFM directives, and the Non-Financial Reporting Directive (NFRD)—requires investment practitioners to interpret abstract regulatory requirements and translate them into their day-to-day risk management.

Investment firms can look towards the banking sector regarding the quantification of climate risks and their impact on financial assets, and the regulatory expectations in this regard—for example, in the recent CSSF circular 21/773 on the management of climate-related and environmental risks. These requirements can also give the asset management sector a taste of what may come regarding the identification, management and mitigation of non-financial risks.

Sustainability risks must be integrated into the different levels of the investment firm, affecting the three-lines-of-defense model and governance established by the top management. An effective sustainability risk framework is dependent on the recognition of its role and value as an integrated mechanism within the broader investment firm's structure.

As supervisory expectations and clients’ demands for sustainability intensify, investment firms must respond with the appropriate specialized knowledge, processes and risk tools to substantiate ESG investing claims and aspirations. Some of the practical solutions implemented by investment firms to bolster their sustainability risk mitigation include appointing dedicated risk function roles/organisms, rolling out training programs, and investing in data, risk processes and tools.

Risk management milestones

Identify

Identifying sustainability risks requires recognizing ESG events or conditions that impact portfolio assets and, in turn, discerning those that can materially affect assets' valuations. This analysis should be consolidated into a set of relevant key risk indicators (e.g., impact on credit spreads, EBITA, valuations, etc.), tools (e.g. risk scorecard, taxonomy, reports, etc.,) and processes used for ongoing risk evaluation, monitoring and reporting.

Understanding the specific dimensions of climate-related effects is essential to identify sustainability risks and the corresponding degree of materiality. For example:

  • The magnitude of physical and transition climate factors on different geographies, jurisdictions, economic sectors of activity and further company-specific ESG traits;
  • The differences between the short-, medium- and long-term effects of climate change and low-carbon economy transition and non-linear dynamics of climate scenarios, e.g., inevitable policy response, irreversible climate-change effects, introduction of taxes, orderly versus disorderly transition, etc.; and
  • The channels through which sustainability factors can influence asset valuations, e.g., direct/indirect, market, credit, liquidity, reputational, etc., and the corresponding speed of onset.

Regarding the materiality assessment, a useful approach considers the expected impact of relevant sustainability factors on the elements and assumptions used to appraise assets (e.g., growth rate, cost of capital, credit spreads, cash flow estimates, multiples, etc.). This approach connects with ESG investment valuation models that are maturing among practitioners, particularly in the context of private assets.

The recommendations of established international frameworks and supervisory guidelines are a useful starting point for practitioners to define risk drivers and viable key risk indicators. However, risk managers should contextualize and append these provisions based on the features of the specific asset portfolio.

Examples of climate-related and environmental risk drivers

*Source: European Central Bank, Guide on climate-related and environmental risks, 27 November 2020.

Evaluate

As regulatory and supervisory activities have not yet fully defined the methodologies for “practical” sustainability risk integration, different market practices are evolving to embrace these novel risk dimensions.

Typical paradigms for sustainability risk evaluation include both top-down approaches—e.g., analysis of the macro-level impact of climate scenarios, geographical and sectoral concentration, etc., and bottom-up approaches—e.g., company ESG analysis, ESG scoring, cash flow at risk modeling, etc. While a top-down approach offers a relatively simple overlook of the main portfolio risks, it may misrepresent other risks, especially considering the materiality of company-specific social and governance factors on portfolio performance and tail-risk.

The use of investment-level criteria—such as exclusion lists, best-in-class investing, principle-based screening and active engagement—to account for sustainability risks provides a broader, investment-based perspective.

More sophisticated practitioners are appointing advanced techniques for climate risk modeling that leverage specialized datasets, to quantify ESG impacts in complex transition scenarios and mitigate the deficiencies of standard ESG rating methodologies.

Ultimately, hybrid approaches that allow the integration of micro/macro approaches, qualitative consideration, and expert-based adjustments may be the most effective way to compensate for the inevitable constraints of current sustainability risk models and the limitations of baseline ESG data sources.

Monitor and report

The value of an established, integrated process for sustainability risk evaluation, monitoring and reporting goes beyond mere compliance. It demonstrates the firm's capacity to implement effective risk management of adverse sustainability developments and, ultimately, reduces the chance of negative financial impacts on the portfolio.

The monitoring process accounts for the magnitude, predictability and time-of-onset associated with different sustainability risks.

While the pace of change and materialization of long-term chronic climate risk factors is slow, other factors such as acute physical, social and governance risks can quickly and adversely impact investment companies. (See the “Examples of ESG incidents with significant financial impact on asset value” image for recent incidents.)

Daily portfolio activity can also breach risk limits, exclusion lists and other investment rules, which must be promptly addressed as part of the risk oversight processes.

Examples of ESG incidents with significant financial impact on asset value

The share price decline was drastic: -87% for TEPCO in March 2011, -30% for British Petroleum in April 2011, -30% for Volkswagen in 2015, and -40% for Facebook over the second half of 2018.

Regarding risk escalation, due to the analytical complexity and current limitations of quantitative indicators, investment firms should consider inserting a layer of expert and/or communal reviews into the escalation process of the sustainability risk monitoring exercise.

A rigorous reporting framework demonstrates an investment firm’s commitment to properly overseeing sustainability risks, which contributes to transparent communication with investors and evidences its risk practices ahead of supervisory inspections. As the awareness and sophistication of ESG topics escalate, institutional investors are also intensifying their scrutiny of sustainability practices within their due diligence and selection processes for their mandates.

Conclusion

In an ever-evolving regulatory and market environment, investment funds’ risk management functions must oversee climate- and ESG-related risks to safeguard portfolio returns and address the related compliance, reputational, operational and other risks for the investment firm itself.

  • Market practitioners are increasingly recognizing the benefits of robust sustainability risk management frameworks on the risk-adjusted returns of the fund, as well as the investment fund itself (such as higher resilience and competitiveness).
  • Investment funds must be prepared to present a credible approach on sustainability risk integration to anticipate the growing demand and sophistication of retail, institutional investor and supervisory authorities.
  • As the methodologies and tools for sustainability risk evaluation evolve, market practitioners are progressively improving their modeling approaches with quantitative features that allow practical risk monitoring.

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