ESG investing: Integration of sustainability risks

Marta Zadravec

Investing in sustainability is no longer a trend, the ESG considerations are becoming the norm. Growth of ESG investing in Europe became a focus for investment companies. Management companies have been typically concerned with assessing and monitoring the financial risks associated with the investments acquired by funds which they manage. However, from 10 March 2021 onwards, all management companies will be required to provide information on their websites about their policies on the integration of sustainability risks into the investment decision-making process.

During the pandemic, we experienced higher inflows from ESG investing strategies. Public scrutiny of how businesses are responding to the COVID-19 pandemic is bringing renewed attention to the importance of corporate transparency on sustainability issues.

ESG Legislation

ESG investing integration will require portfolio management teams and risk teams within management companies to assess how sustainability risks are integrated into the investment decision-making process. ESG investing decision will cover what is applicable to each fund under management and to update due diligence policies accordingly. Information on such policies must then be disclosed on the management company’s website.

Under the SDFR, all management companies (regardless of whether or not they manage ESG funds) will be required to revise their remuneration policy to explain how this policy is consistent with the integration of sustainability risks. Given the deadline of 10 March 2021 for disclosing this information on their websites, management companies should now conduct an assessment on how sustainability risks are integrated into remuneration structure.

Legislation and all the necessary information can be found on the Official journal. While legislative measures are about to take action, this is a clear indicator of how the European Commission is committed to sustainability.

According to recent research by Morningstar, over 10 years, the average annual return for a sustainable fund invested in large global companies has been 6.9% a year, while a traditionally invested fund has made 6.3% a year.
The Morningstar researchers noted that sustainable funds are longer-lasting than their peers.

Examples of ESG Investing Criteria

ESG examples are often interlinked, and it can be challenging to classify an ESG issue as only an environmental, social, or governance issue, as the table below shows.

Source: CFA Institute, illustration by Venturexchange

As more environmental, social and governance issues are arising, the modern investor will reevaluate traditional investment approaches.

The New Normal

Disclosures on ESG factors will become standardized and widespread by the end of the decade. According to Morningstar, funds that integrate environmental, social and/or governance (ESG) factors registered record growth in Q1 2020 that eclipsed the previous watershed moment in Q4 2019.

Registered data on ESG investing growth showed a good path for sustainable investors and could serve as a proof point of how investors can trust ESG funds in turbulent markets.

Within 36 months there will no longer be a perceptible distinction between sustainable and traditional investing. ESG investing transforms the way corporate sustainability is used by developing new disclosure expectations for material sustainability.

Growing research suggests that ESG factors have contributed to long-term financial performance. Therefore, incorporating Environmental, Social and Governance factors into decision-making frameworks is fundamental to managing new and emerging risks.

If you are looking for advice to incorporate ESG strategy and how to communicate it to various stakeholders, contact us. Our team at VX Associates can help with ESG due diligence, gathering sustainability and ESG key performance indicators (KPIs), industry benchmarking, identifying risks, proposing action plan, monitoring and reporting on performance.