Sustainability and its implications for risk and for the suitability of investment portfolios is now centre stage for all parties across financial services.

Environmental, social and governance factors potentially having a negative effect on the value of investments are all in the spotlight. For example, the instances of workforce standards in a company’s supply chain or business ethics are increasingly making headlines and as a result, pose material risk. There appears to be no hiding place.

Financial markets are further perturbed by transition risks tied to change in global sentiment, politics or labour policy, all of which can trigger a reassessment of an asset’s value. In the future, there are additional liability risks potentially, still to be quantified, as people impacted by climate or social change pursue compensation.

All the while, the speed of change increases as governments and investors accelerate plans to transition economies and companies toward more sustainable practices.

Rising tide, rising demand

Larry Fink’s letter to investors in January this year laid bare BlackRock’s commitment to supporting net zero greenhouse gas emissions, across its portfolio by 2050, founded on their opinion that there is now a fundamental reallocation of capital towards sustainable assets. Meantime, in 2020, we saw household names like Barclays unveil a net zero target for businesses it lends to, while similar pledges too have been made by HSBC and JP Morgan Chase, adding weight to the movement.

Against this backdrop, advice firms are increasingly talking about sustainability, its risks and opportunities, with their clients. A survey we carried out last year, revealed that 55% of advisers, more than half, discussed sustainability with clients during reviews and 83%, more than four in five, wanted more information on the sustainability of investment solutions.

Measuring ESG risk – What’s the problem?

That said, how is the industry currently measuring sustainability risk and opportunity; explaining it; and accounting for it in client portfolios and final recommendations? The short answer is there is no accepted or uniform answer yet. Why? Below are three key reasons:

  1. Lack of consistent, objective disclosure of a company’s activities in relation to ESG risks alongside the practice of ‘greenwashing’ – implying sustainable credentials for funds when the reality is different
  2. Externalities – the wider cost paid by the environment or society from a company’s activities are not simple to understand or measure
  3. Longer term, the scale, incidence and impact of potential risks are uncertain and difficult to factor in. Five years ago, then Bank of England Governor Mark Carney called this the ‘tragedy of the horizon’ as investors discounted very long-term risks

At the heart of these three issues is measurement and the need for consistent, objective assessment here. Regulators around the world are driving this agenda. From next month [10 March], EU Regulation on sustainability-related disclosures in financial services [Disclosure Regulation or SFDR] must be implemented.

UK managers distributing in the EU are already preparing for this. The UK regulator has commented they are ‘working closely with the Government and other regulators on how to implement the EU’s proposals in the UK’. Already this year, new regulations in line with the Task Force on Climate Related Disclosure, a global initiative mandated by the G20’s Financial Stability Board, demand stricter disclosures from listed companies in the UK.

As better data becomes available as a result, so fund analysis around the risks and opportunities here will improve.

Going beyond manager questionnaires and self-descriptions is important in order to create more universal models founded on publicly available information, accurately capturing historic patterns and allowing for forward-looking risk assessment without an absolute reliance on opinion. In this way, we will match the way those models take a view on risk.

ESG research available to you today

At Dynamic Planner, we have long considered a wide range of risk factors of each individual holding, when assessing the overall risk of investments. In that light, our own approach here has been to incorporate similar, whole of market ESG data from MSCI, a world leader in gathering sustainability information from public sources.

We this year made this research available to advice firms, to inform objective conversations with clients and enable them to compare investments fairly like for like. Over time, we are interested in understanding what does or does not pose risk for investments, in particular against its risk profile peer group, as we do today with liquidity and credit risk, for example.

Without doubt, we are only part way along the ESG assessment journey. From an adviser’s standpoint, the key is to adopt tools and data available today and to not let ‘perfect’ be the enemy of ‘good’ in terms of having a meaningful discussion with a client. As measurement of sustainability improves, the market will become more accurate in its risk assessments.

Read more about sustainable investing research, available today in Dynamic Planner.