To keep your clients, you should urgently target 100% ESG research coverage of your portfolios

Most investors have a tail of holdings in their portfolios lacking ESG research or ESG risk scores. Depending on the asset class, this may represent up to 50% in the Nordics, but also a significant proportion in certain asset classes around the world. It is to a large extent about unlisted/private bond issuers, about microcaps and newly introduced companies. The global ESG research providers do not cover this segment today. This should be urgently addressed due to Fiduciary Duty. In this article we will help you understand why you should target a 100% ESG research coverage of your portfolios to keep your clients. We also suggest a solution to this.

Important distinction for sustainability aspects for investment funds – Voluntary or Mandatory?

When it comes to sustainability and investments regulated by the SFDR, which has been introduced in the EU and even Norway now, it is very important to distinguish between what is voluntary and what is mandatory. Nothing is voluntary in the SFDR, it is only a reporting regulation, but the choices relevant to the SFDR that you make for your financial products like funds can be.

Voluntary – Impact/Sustainable Investments

As a capital owner, you can decide to what extent the investments should be sustainable (SI, here in the strict SFDR definition, so it has nothing to do with ESG risk integration), it is a voluntary choice. The same applies to an asset manager. The latter will of course create financial products that will hopefully become large in terms of managed capital so that the earnings will be good. SI is regulated by SFDR article 8 (with SI pocket) and article 9 (SI). Correspondingly for voluntarily chosen promoted E and S characteristics (may include SI) which is also regulated by SFDR article 8.

Mandatory – ESG risk integration

Integrating ESG risk into investment decisions is not voluntary. It is mandatory since 1 August 2022. (See link to and text from ESMA document at the end of the article; because of point 55 in the supervisory briefing, we recommend customers to document the ESG risk integration as well, albeit in a simple way (2)). Many take far too lightly the SFDR article 6, which deals with ESG risk integration and explicit requirements to describe how this is done (it is not at all a product class as many believe and which is referred to very erroneously as “article 6 products”). SFDR article 6 is relevant for all actively managed funds. We at sustainAX work mainly with this. In order to be able to integrate ESG risks, you need to know what these risks are. You can of course do internal ESG analysis, but most people see that it costs more than buying it externally, both in money and time. Only very small capital managers without specialist resources believe that a portfolio manager can do a full ESG risk/opportunity analysis in addition to the work they already do. But since they don’t do it in reality, they do not know any better. There is a lack of both time and knowledge. We as ESG analysts at sustainAX who work with this know what it requires. It is also a point in itself that the ESG analysis is independent.

Making your ESG risk integration credible

Having 100% ESG research coverage of the portfolios is the starting point and being able to demonstrate this shows that one has access to information about what the material ESG risks for one’s investments are. And SFDR requires the associated processes of ESG risk integration in investment decisions, with a description of how this is done. And this is where education of portfolio managers comes in. We see with our clients that managers who know this are good at using our analysis and taking ESG risk elements into their decision-making processes. But claiming that you have the process underway and describing it on the internet without having access to ESG analysis of the holdings does not make sense.

For most investors, not having 100% coverage is like not having an overview of the ESG risk for all investments, then you cannot integrate these risks into your investment decisions either. It can make both regulators and institutional clients squirm in their chairs, as this is a breach of Fiduciary Duty.

ESG risk integration – Three groups of managers – Leaders, Pretenders and Laggards

We see three main groups of asset managers in the Nordics when it comes to ESG risk integration in investment decisions: Leaders, Pretenders and Laggards.

Leaders have realised that integrating ESG risk into investment decisions is just as important as integrating other risk elements. They have also long understood that it is part of Fiduciary Duty. These investors have ESG risk analysis on a large proportion of their holdings and those we work with have 100% target coverage of their portfolios. All our customers are here, and the management of these companies have full insight into and are proactive in the area. Therefore, they are also mobilising resources.

Laggards are drawn backwards into this, mainly due to a lack of knowledge. Here, ESG risk and impact are frequently mixed up. Therefore, you do not get traction and the management is not mobilising resources. On the other hand, they are forced by regulations and occasionally by customers to do something, but processes are not implemented despite texts on internet pages. We have no customers in this segment, a bit frustrating as they are the ones who need the most help. But we talk to a few investors in this group and try to help them on their way!

Pretenders lie in between these extremes, where everything apparently looks good on websites regarding ESG risk integration, where this is promoted loudly both internally and externally, but where in reality not much happens. These take perhaps the biggest risk, as they often go high on the pitch but don’t deliver. In a sense, they breach the SFDR twice, first by not doing what is required (SFDR Article 6), and then in marketing they take the risk of falsehoods (SFDR Article 13).

Where do you want to belong here?

External communication – Competitive advantage?

As you surely have noticed, there is one field in the EET that asks about % ESG analysis coverage of the portfolio. More and more asset managers communicate externally, such as in monthly reports, portfolios’ % ESG analysis coverage and ESG scores. This is mostly about showing that you have the information you need to be able to integrate ESG risk and thus respect the mandatory SFDR Article 6. So, in addition to the purely regulatory, it can also be a competitive advantage.

Where do you want to belong here?

Engagement based on ESG research

Fundamental professional ESG research is also the starting point for high quality engagement. You need to know the ESG risks of an investee company very well before challenging a CEO in a meeting on this. There can be a lot of ESG risks in the non ESG researched tail of the portfolio, as this is where we often find the small and also the private companies.

ESG risk integration – Custodian banks start to require information

For clients with funds in Luxembourg, the custodian banks are also involved in these processes and their growing SFDR requirements will be noticed in the future also in Norway. We have had as demanding DDs with some customers’ custodian banks and administrators in Luxembourg as with the asset managers themselves.

Norway and partial introduction of SFDR – No sleeping pillow!

Although the SFDR RTS (Level 2) has not been introduced in Norway, the entire SFDR has been introduced. It is therefore only Regulatory Technical Standards that have not been introduced. All the requirements from the SFDR are thus in force. It’s really an absurdity that they didn’t come at the same time, but that’s how it is now. This gives one year where you do not have as strict reporting requirements (use of templates) and where you can overlook guidance from the ESAs (Where ESMA is the most important for asset management). But SFDR article 6 and ESG risk integration have already been fully implemented in Norway, there is no delay here and nothing to hide behind.

Real regulatory risk – also in Norway already now

We have seen in Sweden, where SFDR is fully implemented as in the rest of EU, that the Financial Supervisory Authority (FI) did a “light” review of funds that are regulated by SFDR article 9 and, interestingly enough, they included these funds’ approach to SFDR article 6 at the same time. They weren’t impressed with any of them.

From the FI report:

“Is it clear how sustainability risks are integrated?

Almost all funds gave some description of the integration of sustainability risks in the investment decision, although to varying extents. In some cases, it was more about an explanation that sustainability risks are integrated than a clear description of how they are integrated in investment decisions. Certain descriptions contained so much text, with many different concepts and technical terms that the information becomes difficult for an investor to understand. FI also noted that the descriptions were generally held and were not specific to the fund in question. This need not be incorrect, but according to Esma’s guidance, it may be a warning sign for FIs to pay attention to in supervision. Overall, the information about how sustainability risks are integrated into the investment decision needs to be made clearer.” Source: FI (1)

In a recent Swedish Fund Manager Association SFDR relevant meeting, it was mentioned that FI would take a new round and that they would concentrate on the same two SFDR articles, 6 and 9. Norway is a little behind on the trail, but we know that when new rules come there are wishes to statuary some examples, where small asset managers are at risk. See also at the bottom of this email information from ESMA’s supervisory briefing (2) (Guidelines for local FSAs such as FI and Finanstilsynet).

Our best advice to asset managers

Essentially, an asset manager’s relationship with capital owners is regulated by Fiduciary Duty, and this requires the integration of ESG risk in all investment decisions. This is also very clear in SFDR/EU regulation. Therefore, 100% ESG analysis coverage of portfolios is required, the alternative is a bit difficult to explain.

On the regulatory side, it is important that SFDR article 6 is not drowning in between articles 8 and 9, it is mandatory to integrate ESG risk in investment decisions. Since you must first be able to understand the ESG risks that apply to all investments you have, you must either build an ESG analyst team yourself or buy this externally.

The latter solution, at least for fundamental ESG analysis, with an external supplier will likely be better as it will be:

• cheaper (no doubt, we can look into that together),
• more complete (independent professional ESG analysts) and
• faster (it takes at least 2 years to build a materiality framework and ESG analysis methodology, we know we have done it, plus it must be maintained, in reality only possible for larger asset managers)

Having ESG research available is not enough, the real process for ESG risk integration must also start. When we have a new customer, we take the managers through a short course to get the process started. For some customers, we have larger projects on ESG risk integration to ensure whole portfolio manager teams get the process running (both description and practice).

If you have portfolios without 100% ESG risk research and ESG risk scoring coverage and realise what we have written about in this article, we can help you! This includes help in setting up your own ESG research process!

Sources and other annexed information:

(1)Link to the FI report: https://www.fi.se/contentassets/47769b6e2402473f9052c83413e83449/fonder-hallbar-investering-mal.pdf

(2) Link to the ESMA supervisory briefing document: https://www.esma.europa.eu/sites/default/files/library/esma34-45-1427_supervisory_briefing_on_sustainability_risks_and_disclosures.pdf

(3) From the ESMA supervisory briefing document:

4 Integration of sustainability risks by AIFMs and UCITS managers 

49.The Commission Delegated Regulation (EU) 2021/1255 and Delegated Directive (EU) 2021/1270 set out that all authorised fund managers are required from 1 August 2022 to integrate sustainability risks in their portfolio and risk management processes and overall governance structure. 

50. These legal obligations will have a broad scope as even fund managers that do not offer sustainable funds will be required to comply with the new rules. 
51. While many large fund managers may have already sophisticated tools in place for assessing the impact of sustainability risks in their portfolio and risk management analyses, it can be expected that many smaller and mid-sized fund managers (especially those that do not provide sustainable funds) may struggle to comply with these new rules. 
52. It is therefore important to ensure convergent supervisory scrutiny of the effective implementation of sustainability risks by all fund managers across the EU. 
53. NCAs should verify compliance of the UCITS management companies and AIFMs with these requirements by checking the description of the manner in which sustainability risks are integrated in their investment decisions in pre- contractual fund disclosures referred to in Article 6 SFDR and ensuring that UCITS management companies and AIFMs perform a review of the relevant internal policies and procedures on a periodic basis. 
54. NCAs should verify the compliance of UCITS management companies and AIFMs with the disclosure of sustainability risk integration on websites referred to in Articles 3 SFDR by performing sample checks based on surveys and questionnaires relating to the integration of sustainability risks. 
55. The above supervisory controls should involve risk-based desk-based and/or on-site reviews of the adequate implementation and effective application of the relevant policies and procedures by the UCITS management companies and AIFMs relating to the following: 

o    –  Investment due diligence; 

o    – …