The complexities of applying sustainability in fund management

Regulatory efforts to encourage more financial institutions to incorporate climate change risk into their business models are accelerating. Mark Carney, governor of the Bank of England, warned in a recent speech in Amsterdam that climate change was a systemic risk that will seriously destabilise the financial system. He said these challenges comprised of physical risks caused by extreme weather conditions damaging property and trade; liability risks stemming from parties who have suffered losses seeking compensation; and transition risks, whereby markets undergo a disorderly readjustment to a low carbon economy.

Carney’s comments are evidently on the same wavelength as the European Commission (EC), who in March 2018, announced an Action Plan on Sustainable Finance, an initiative designed to strengthen institutional investment into sustainable causes and assets. Regulators now see the financial services industry including fund management as being a critical cog in the fight against climate change. INDOS Financial attended the Association of the Luxembourg Fund Industry’s (ALFI) European Asset Management Conference between March 5 and 6, where sustainable finance and the EC’s Action Plan were dominant themes.

The Controversial Taxonomy

While nearly all panellists at ALFI welcomed the EC’s initiative to stimulate sustainable investing, the taxonomy envisaged under the Action Plan continues to be divisive. Of the four Action Plans published so far by the EC, the taxonomy is at the least advanced stage, although its principles are currently being discussed at a technical working group level.  The taxonomy creates a dilemma for the industry. Firstly, data on sustainability is often cited as poor as it is not easily quantifiable meaning interpretations about ESG are quite loose and varied. Amid this uncertainty, some managers have advertised their products as ESG when they are not.

Such greenwashing on the part of a handful of managers is harmful to investors and risks undermining peoples’ faith in ESG investing, which is why regulators feel it is necessary to create a taxonomy to prevent the practice. A benchmark is crucial if investors are to accurately measure managers’ ESG, but experts at ALFI warned that the taxonomy could result in unintended consequences springing up, if classifications are either too generic – allowing for greenwashing to continue unchecked – or excessively rigid thereby stifling product development. As such, the taxonomy’s contents are likely to be scrutinised heavily.

Reporting to investors

The Action Plan’s ESG disclosure requirements are also contentious not because asset managers are reticent about reporting, but because there are concerns about sustainability data. One speaker said ESG reporting by companies – particularly in emerging markets – were variable, adding that  data providers giving opinions on ESG often had different methodologies, sowing further confusion. Unless the data quality issues are remedied through standardisation or internationally accepted classifications, managers are at risk of supplying misleading or inaccurate reports to end clients under the EC’s proposed rules.

Embedding ESG in asset management

One panellist acknowledged that ESG was going to become fully integrated into the activities at asset managers. He highlighted that just as risk management is an absolute prerequisite for managers in their investment and operational processes nowadays, in time so too will sustainability. While there is some nervousness about the direction of regulatory travel inside the EU about integrating  sustainability, very few asset managers and investors at ALFI would disagree that ESG is not going to affect their businesses moving forward. 

How independent oversight can help

INDOS Financial – with its proven track record of ensuring that managers running a wide range of strategies are complying with their investment mandates – is continuing to develop an independent ESG assurance solution. The service will enable managers to demonstrate to investors and other stakeholders that they are complying with their ESG policies and investment mandates.  Through careful ESG oversight and compliance monitoring, INDOS Financial aims to play an integral role in the evolution of ESG within the asset management industry.