Calls grow to change how ESG risks are categorized

ESG risks should be defined as financial risks by regulators in upcoming changes to several European regulations, some money managers say.

Current proposals, they say, are not sufficiently explicit in defining the financial impact of environmental, social and governance risks on investment performance.

Two European regulators, the European Securities Markets Authority and the European Commission, asked money managers in December to share their views on how to incorporate ESG factors into their processes in three European regulations: the Alternative Investment Fund Managers Directive, Undertakings for Collective Investment in Transferable Securities Directive and the Markets in Financial Instruments Directive. The consultation ends Feb. 19, but managers will get a chance to voice their opinions in a public hearing scheduled for Feb. 4.

The effort to include such requirements in the regulations follows the EC's overall initiative to standardize ESG disclosure — part of its action plan for financing sustainable growth — launched in June. With the action plan not expected to be fully implemented until 2020 at the earliest, sources said, coming under scrutiny now is how all money managers doing business in Europe define ESG factors and manage those risks for institutional assets, as well as how they supply information to their clients.

ESMA is seeking feedback in order to define interim standards that are expected to make their way into the three directives by April 30. The EC wants to approve amendments to the directives before elections to the European Parliament are held May 23, sources said.

These interim rules will set out how money managers should run and report on ESG portfolios until the policy under EC's action plan is completed.

ESMA has proposed six general organizational requirements for managers to:

Incorporate ESG risks within organizational procedures, systems and controls.

Consider resources and expertise required to integrate ESG risks.

Clarify responsibilities of senior managers in integration of ESG risks.

Identify conflicts of interests in the investment value chain arising from integration of ESG risks and factors.

Consider ESG risks when selecting and monitoring investments for investors.

Include ESG risks in risk management policies explicitly.

Money managers interviewed for this story supported the proposals, but singled out that the amendments are not dealing with the financial impact of ESG risk to the degree they expect.

"What ESMA has proposed is fair," said Fiona Frick, CEO of Unigestion in Geneva. "I guess it is not too prescriptive on how managers should integrate and manage ESG."

However, she and other money managers warned ESG risks have not been defined as "material" in ESMA's proposed amendments to the directives. This could lead to the financial impact of ESG risks being overlooked, they said.

Missing in the proposal

Ana Harris, global head of equity portfolio strategists, indexing at State Street Global Advisors in London, warned "the principle of materiality is missing" in the proposal.

"We would welcome further clarity on the principle of materiality," Ms. Harris added. "We believe that it's necessary to draw a clear distinction between risks to the performance of an investment from ESG considerations, and risks to environment and society from investments."

Under generally accepted accounting principles, provisions of an accounting standard don't have to be included in a financial statement if an item is considered immaterial.

But ESG impact on a portfolio's performance is material, Ms. Frick said, adding ESG "has a much bigger effect on the share price than before the global financial crisis."

Mike Everett, ESG investment director at Aberdeen Standard Investments in Edinburgh, said "the regulators need to encourage money managers to use (financial) impact, not just ESG impact. That's important," he added.

Money managers also would like to see a different definition of "sustainability risk" in the updated directives.

ESMA's proposal to amendments of the UCITS and AIFM directives' delegated acts defines that risk as "the risk of fluctuation in the value of positions in the fund's portfolio due to ESG factors." But, Ingrid Holmes, head of policy and advocacy at Hermes Investment Management in London, said: "We think it should be amended to the risk of a significant decrease in the value of positions in the fund's portfolio due to unmanaged ESG risk." (Under delegated acts, the EC has the power to specify how managers should comply with the directive.)

"We would envisage ESG risk being reported at a (portfolio) company level as part of an integrated annual report with a focus on narrative reporting on ESG risks," she said.

More costs

ESG integration into existing regulation will mean additional costs to money management firms as they will be required to report their progress to regulators and supply additional information to clients. Those costs also will depend on the existing level of integration of ESG factors into firms' internal processes.

"To do this well, firms that are not already systematically integrating ESG factors will need to hire staff with more qualitative skills and expertise who are able to understand ESG issues and work alongside the investment teams to integrate ESG factors into investment processes in a meaningful way," Hermes' Ms. Holmes said.

Luba Nikulina, global head of manager research at Willis Towers Watson PLC in London, said: "ESMA's approach is generally sensible."

"Various managers are at the forefront of integration and the regulation is introducing it to the more general market. That's positive. But buying (ESG) expertise is an additional cost," Ms. Nikulina said.

But even for the largest managers, the inclusion of ESG as part of broader money management regulation will require them to redefine their processes and relationships with other firms in the investment chain to meet reporting requirements, sources said.

Martin Parkes, managing director within the global public policy group at BlackRock (BLK) Inc. (BLK) in London, said in a telephone interview that integration of ESG under the directives will require managers, including BlackRock, to come up with scalable solutions that could be reported. BlackRock is planning on raising these points to the regulators in its response to the consultation.

"We are talking to our distribution (chain): advisers, alternative distribution channels such as investment fund platforms and wealth managers to make sure what processes they have in place," Mr. Parkes said. As an adviser or discretionary manager "you have to make sure that you have a suitable, scalable portfolio so you can efficiently report back to the client on success and returns on a regular basis, which means building a process (of measuring ESG risk) that you can repeat year after year, " he said.

"Suitability means matching the risk appetite of the client and their investment. You need to be able to measure ESG risks to link them back to the client preferences."

He added: "This is a two-stage process. As well as reviewing the level of ESG integration in investment processes for UCITS and AIFs to meet client disclosure requirements, managers will be also required to engage with the client to find both the financial and ESG outcomes that (clients) are looking for.

Other concerns

Another area of concern that ESMA's proposals don't specifically address is how money managers will be required to engage with investee companies.

Aberdeen Standard's Mr. Everett said: "(Portfolio) companies will have to provide details of their investment policy (to money managers) and how they link investment decisions to liabilities. We will then have to show how (these companies) do it and how we manage voting" on behalf of clients."

Unigestion's Ms. Frick said she believes the social aspect of ESG integration is especially difficult to measure.

"It is unclear what should be included in terms of ratings. And clients often leave (this part) for managers to measure," she said.

But Mr. Parkes thinks "ESMA has been careful. It has set expectations on investor preferences without being overly prescriptive. If you are too prescriptive, too soon it will be counterproductive."