Asset Management: Incorporating ESG Risk into a Comprehensive Risk Management Framework

The incorporation of environmental, social, and governance (ESG) factors into regulatory requirements presents a significant challenge for asset managers. The task of integrating sustainability risk factors into existing Risk Management Frameworks requires careful consideration and practical approaches. In this article, we will explore some key considerations for risk managers who are adopting a risk-based approach to ESG.

Background

On 24 May 2018, the European Commission introduced a set of measures on sustainable finance, including the Taxonomy Regulation, which aimed to establish a unified EU classification system for sustainable economic activities. The Disclosure Regulation sought to improve ESG disclosure requirements, enabling informed investor decision-making. Additionally, a new category of benchmarks was created to facilitate investors in comparing the carbon footprint of their investments.

In response to a formal request from the European Commission, the European Securities and Markets Authority (ESMA) published its technical guidance on proposed amendments to the UCITS directive and AIFMD directive on 30 April 2019. These amendments focused on integrating sustainability risk factors and covered various aspects, including organizational requirements, operating requirements, and risk management policies.

Key Components of the Risk Framework

  1. Risk Appetite Statement

When formulating the risk appetite statement, asset managers should carefully consider sustainability risk. The Disclosure Regulation defines sustainability risk as an environmental, social, or governance event or condition that could potentially cause a material negative impact on investment value due to adverse sustainability effects.

  1. Risk Management: General Principles

The proposed amendments outlined in the ESMA guidance would influence the tools and methodologies used by asset management firms to manage risk. These include:

  • Governance Structures: Ensuring senior management collectively takes responsibility for integrating sustainability risks.
  • Risk Ownership: Equipping the firm with the necessary skills, knowledge, and expertise to manage sustainability risks. While designating a qualified person for this integration is not mandatory, it is highly recommended.
  • RCSA Principles: Identifying and assessing sustainability risks and seeking to mitigate them, where possible. Active engagement with investee companies is essential in this process.
  • Compliance with Regulatory Requirements: Adhering to the amended UCITS and AIFMD directives, the Taxonomy Regulation regarding environmentally sustainable investments, and the Disclosure Regulation, which focuses on providing investors with information on the sustainability of financial products.
  • Reporting: Taking sustainability risks into account while establishing, implementing, and maintaining effective reporting within the firm and with third parties.
  1. Risk Domains

Although the definition of sustainability risk includes environmental, social, and governance events or conditions, there is no specific regulatory definition for these terms. The Taxonomy and Disclosure Regulations provide guidance on criteria, activities, and practices related to ESG, including:

  • Environment: Addressing climate change, sustainable use and protection of water and marine resources, transitioning to a circular economy, waste prevention and recycling, pollution prevention and control, and protecting healthy ecosystems.
  • Social: Focusing on equality, social cohesion, social integration, and labor relations.
  • Governance: Emphasizing sound management structures, employee relations, remuneration of relevant staff, and tax compliance.

Sustainability risk may impact other risk domains, such as Governance Risk (ensuring senior management oversight of sustainability risk integration), Operational Risk (considering the impact of environmental events on operations), Regulatory Risk (complying with amended UCITS and AIFMD directives), and Conduct Risk (avoiding misrepresentation of the carbon footprint to attract investment).

  1. Risk Components

Asset managers should establish relevant components within 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 key risk indicators/management information. All these components should align with the firm’s risk appetite.

Conclusion

The feedback received during the consultation on the ESMA guidance highlighted challenges related to taxonomy, resource expertise, and reliable data. However, the principles-based approach of the guidance, combined with the principle of proportionality inherent in the UCITS and AIFMD directives, provides asset managers with an opportunity to integrate sustainability risk and factors into their existing Risk Management Frameworks.

With future regulatory developments, increasing ESG expertise within the industry, and improvements in data availability, firms can continue to enhance their ESG risk management capabilities. By embracing these changes, asset managers can navigate the evolving landscape and contribute to sustainable finance practices.

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