Asset Management: Integrating ESG Risk into a Risk Management Framework
The transition of environmental, social, and governance (ESG) factors from concept and investor preference to regulatory requirements poses a challenge to asset managers, particularly with regard to integrating sustainability risk factors into existing Risk Management Frameworks.
In this article we set out some of the practical considerations for asset managers, when taking a risk based approach to ESG.
On 24 May 2018, the European Commission adopted a package of measures on sustainable finance. This package included proposals aimed at establishing a unified EU classification system of sustainable economic activities ('Taxonomy Regulation'); improving ESG disclosure requirements to facilitate informed investor decision making (‘Disclosure Regulation’); and creating a new category of benchmarks which will help investors compare the carbon footprint of their investments.
On 30 April 2019, following a formal request from the European Commission and a consultation process, the European Securities and Markets Authority (ESMA) published its technical guidance (the Guidance) on proposed amendments to the UCITS directive and AIFMD directive in order to integrate sustainability risk factors. The proposed amendments relate to:
- i) Organisational Requirements: general requirements on procedures and organisation, resources, and control by Senior Management, supervisory function and governing body;
- ii) Operating Requirements: Due diligence and conflicts of interest; and
- iii) Risk management policies.
Risk Framework - Key Components:
Whilst the proposed regulatory requirement are new to firms and potentially challenging, the concept of a Risk Management Framework is not new for asset managers. We set out below, at a high level, how Sustainability Risk can be integrated into an existing framework
1. Risk Appetite Statement
Consideration should be given to Sustainability Risk in the firm’s risk appetite statement, having regard to the definition of Sustainability Risk in the Disclosure Regulation:
“An environmental, social, or governance event, or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment arising from an adverse sustainability impact.”
2. Risk Management: General Principles
The proposed amendments outlined in the Guidance would impact a number of the tools and methodologies firms use to manage risk. These include:
- Governance Structures: Ensuring Senior Management is collectively responsible for the integration of sustainability risks;
- Risk Ownership: Ensuring the firm has skills, knowledge and expertise to manage sustainability risks. The explicit designation of a qualified person for the integration of sustainability risks is not a requirement though is not a requirement;
- RCSA Principles: Firms must be in a position to identify and assess Sustainability Risks and seek to mitigate them, where possible. This includes through active engagement with investee companies;
- Compliance with Regulatory Requirements: Ensure compliance with the amended UCITS and AIFMD, the Taxonomy Regulations around offering environmentally sustainable investments, and the Disclosure Regulations on providing investors information on the sustainability on financial products; and
- Reporting: Ensure Sustainability Risks are taken into account when establishing, implementing and maintaining effective reporting within the firm and with third parties.
3. Risk Domains
The definition of Sustainability Risk refers to environmental, social and governance events or conditions, however there is no regulatory definition for these events or conditions. The Taxonomy and Disclosure Regulations make reference to the following criteria, activities, and practices in relation to ESG:
- Environment: Climate change; sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention and recycling, pollution prevention control and protection of healthy ecosystems.
- Social: Equality, social cohesion, social integration, and labour relations: and
- Governance: Sound management structures, employee relations, remuneration of relevant staff and tax compliance.
Sustainability Risk may impact other risk domains, including Governance Risk (e.g. does the integration of Sustainability Risk have the required senior management oversight) Operational Risk (e.g. impacts of environmental events on operations), Regulatory Risk (e.g. compliance with the amended UCITS and AIFMD directives) and Conduct Risk (e.g. misrepresenting the carbon footprint of an investment product to attract greater investment).
4. Risk Components
Firms should ensure that they have relevant components in relation to their Sustainability Risk domain, including policies, procedures (as proposed in the Guidance), a risk register, an obligations register capturing the amended legislation and obligations, and KRIs/MI; all of which should align to a firm’s risk appetite.
Responses to the consultation included in the Guidance called out challenges around clear and appropriate taxonomy, resource expertise, and relevant and reliable data.
The principles based approach of the Guidance, coupled with the existing principle of proportionality that is ingrained in the UCITS and AIFMD directives, should allow firms the opportunity to integrate sustainability risk and factors into their existing Risk Management Framework.
Future developments in regulation, an increase in ESG expertise in the industry and resulting improvements in available data should lead to the ongoing maturity of firm’s ESG risk management capabilities.
Geoffrey Cheasty, Senior Manager - Regulatory Risk, Deloitte