This publication is also available in Dutch.
Together with Zanders, AF Advisors hosted a round table on sustainability risks for asset managers, a challenging topic for the entire industry. A summary of the round table can be found below.
Learning to manage sustainability risks has been one of the key challenges for financial organizations. This topic is gaining momentum because of the European Commission’s Sustainable Finance Action Plan and associated regulatory changes. One of the new requirements is that asset managers must incorporate sustainability risks in risk management and reporting as of August 2022. This means that these risks must be measured, assessed and mitigated. However, this is not an easy task due to a lack of uniformity in risk management approaches and lagging data quality.
This prompted AF Advisors and Zanders to organize a round table on the subject. The importance of managing sustainability risks for the asset management sector became clear due to the large turnout. Parties that manage a total of no less than EUR 2.5 trillion in assets were at the table, a broad selection of the largest asset managers active in the Netherlands. This attendance led to good, in-depth discussions. The discussion was preceded and inspired by a presentation from one of the attendees on how they mitigate, assess and monitor sustainability risks. Two hours of lively discussion is difficult to summarize but we would like to share a few interesting take-aways. Note that these take-aways do not necessarily represent the views of all the participants, though are merely an overview of the topics that were discussed.
Financial risk management departments increasingly in the lead
While a few years ago, sustainability risks and the management of these risks were still the task of responsible investing teams in many organizations, this task is increasingly being taken up by financial risk managing departments as sustainability risk can be better quantified. This shift leads to new techniques and new requirements for data. Where previously exclusions were an important method for many parties, an integrated portfolio approach is emerging.
Lack of uniformity in the assessment sustainability risks
The two main problems in managing sustainability risks are the lack of uniformity in approaches and limited data quality and availability. Limited data quality is a well-known topic, especially for alternative asset classes. Specialized data vendors will be required to address these issues.
Important to realize however is that sustainability risk is such a broad and infant concept that it is open to many interpretations. This means that the way in which sustainability risks are assessed can still differ considerably between parties. This may be desirable in the longer term for an emerging but important area, as this enables the development and later convergence towards the best sustainability risk management techniques. In the short term, however, this leads to little standardization and different use of terminology. This is especially problematic in a multi-client environment with varying clients’ needs. Enforced communication by the regulator can therefore lead to outcomes that are hard to compare and interpret for clients. Listing definitions used and an explanation of the methodologies used is vital in communication on sustainability risks to clients.
ESG risk ratings are most popular concept despite drawbacks
The most frequently mentioned way in which sustainability risks are monitored is by means of environmental, social and governance (ESG) risk ratings. For example, by comparing a portfolio’s ESG scores with the scores of a corresponding benchmark and by limiting deviations. By using these ratings, environmental, social and governance factors are included. The major drawback of this approach is that it is partly backward looking. Participants agreed, due to the long horizon over which most risks materialize, traditional (backward looking) risk models might not be the most suited.
Most forward-looking data is available for climate risks. In addition to the use of ESG scores, a climate risk methodology is therefore desirable.
Not only European legislation that matters
Next to European regulation, it is also important to account for emerging global initiatives and other regulation and reporting frameworks. US regulations such as US SDR can impact organisations and the approaches to sustainability risks to some extent. Global initiatives such as TCFD and TNFD are likely to influence and affect organisations risk management processes as well. Potential overlap must be analysed so that an asset managers can face the challenges efficiently.
Sustainability risks can be defined and monitored at various levels of an organisation. Portfolio managers should take them into account in the selection of investments. Second line monitoring and independent assessments must be in place. Important to realize is that this is not a topic that only affects the investment and risk management teams. The legislation explicitly places responsibility for managing sustainability risks on board level and requires internal reporting, controls and sufficient internal knowledge of the topic.
Sustainability risk management is an important topic that will keep asset managers busy over the coming years. It is expected that this field will evolve over time, it was even referred to as a ‘journey’. The deadline of MiFID, AIFMD and UCITS in August 2022 is an important first regulatory milestone but will certainly not be the last. With the organisation of the round table, we hope to have assisted parties in getting a better understanding of the topic and to contribute to their journey.