The growth of ESG and sustainability in the funds industry has caught the attention of regulators who are making it hard for asset managers to keep up with them. Regulators are clearly concerned about the threat of greenwashing, the availability and credibility of ESG data, and the multitude of assessment methodologies that make it difficult to compare different ESG funds. The introduction of the EU’s Sustainable Finance Disclosure Regulation (SFDR) aims to set clear standards for entity and product level ESG reporting. However, other requirements are coming under MiFID II in addition to the UK’s own Sustainability Disclosure Regime from the FCA. There is also a growing recognition that ESG factors represent significant investment risks. All of this translates into many new risks which raise questions for investors, asset managers and fund boards:
- How are firms managing sustainability risks and do they have the right data?
- Are fund boards tracking the investment and operational risks posed by climate and other ESG factors?
- Is the asset manager’s current risk reporting framework effective and able to track sustainability-related risks?
With many questions still to be answered, we consider five sustainability related risks that asset managers should be investigating now.
1. Credibility of Sustainability Risk Oversight and Ownership
In a recent sustainability risk survey conducted with asset managers, Alpha found 80% of respondents already incorporate sustainability risks into their risk appetite or plan to do so in the next twelve months.
However, when the same group of respondents were asked about ownership of sustainability risks only 20% felt that ownership ultimately rested with the board. This is likely to be a concern for regulators who want evidence of robust risk ownership, challenge and knowledge from boards.
As graph 2 sets out below, there is no clear consensus in the market on who should own sustainability risk. This puts the onus on firms to be able to explain how their own approach and risk framework is appropriately designed and effective at overseeing sustainability risks and their potential impacts to the organisation.
2. Voluntary Code Risks
There have been numerous public statements from asset managers on sustainability commitments: as of the end of May 2022, the Net Zero Asset Managers initiative had 291 signatories with a combined USD 66 trillion (£55.4 trillion) in AUM. More recently, we have seen headlines suggesting that some firms may be exploring how to de-register from such commitments. It’s clear that committing to an ambitious target and operationally delivering on these initiatives is easier said than done. We identified that 60% of the respondents to our sustainability risk survey did not yet have a plan in place to assess how they will meet commitments to voluntary codes and pledges. This will increasingly become an issue for investors who are looking for asset managers that align with their own commitment to these voluntary codes.
3. Sustainability risk Within ‘Three Lines of Defence’
Asset management and fund boards are increasingly seeking positive affirmations from senior management on greenwashing. The dilemma that firms face is that the business area managing sustainability risks is often also providing assurance effectiveness. More than 40% of our respondents assigned both sustainability risk management and the responsibility for providing assurance over sustainability risks with the same business area. This is also likely to raise the attention of regulators as they seek to understand how firms are applying ‘Three Lines of Defence’ principles to ensure appropriate levels of segregation / independence whilst challenging technical ESG subject matter.
4. Managing the Risks Associated with ESG Data
Asset managers are still in the process of determining how to manage and monitor sustainability risks from a data perspective. Understanding which data points to capture, particularly when sustainability-related data often lacks standardisation and coverage, is making the process particularly difficult for control functions within first- and second-line functions. Simplified metrics, such as an overall ESG score, can misconstrue the complexity of sustainability issues and give a false sense of security to its consumers. Some fund boards are finding their oversight of sustainability risks is dependent on the data provided to them rather than having a clear idea of what data is needed to effectively understand and oversee how sustainability risks can be crystallising within a fund or at the asset manager level.
5. Introducing Double Materiality into Risk Frameworks
When assessing sustainability risks, asset managers and fund boards need to apply a more holistic approach, which includes consideration of ‘double materiality’. In other words, effective sustainability risk management requires assessing both:
- the impact of sustainability factors (external and internal) on the firm’s own performance and operations; and
- the sustainability-related impacts that the firm’s business and investment activities may have externally impacts on biodiversity, supply chains, waste, society and the environment.
Firms need to begin to embed the ‘double materiality’ concept into their existing risk frameworks, provide training to equip their teams (first, second and third lines) with the right skillsets and begin to identify and understand where potential gaps / keys areas of risk may be present within their business processes and investment related activities.