Global appetite for environmental, social and governance concerns continues, of course, to grow – arguably exponentially. Governments and courts worldwide too are taking affirmative action.

In February 2020, here in the UK, the Court of Appeal ruled that plans for a third runway at Heathrow Airport were illegal, because they ran contrary to the government’s commitment to tackling climate change and to the Paris Agreement to achieve zero net emissions by 2050.

Furthermore, the regulator, the European Securities and Markets Authority (ESMA) has been consulting for the last couple of years on the inclusion of ESG risks and characteristics within the investment advice and management process.

One of ESMA’s aim is to ensure that financial risks stemming from climate change, environmental degradation and social issues are well understood by managers and end investors and subsequently addressed in the suitability of advice given.

However – and this is certainly worth reflecting on – ESMA’s chief goal of its Strategy on Sustainable Finance, published in February 2020 and adopted by the European Commission, is to ‘reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth’.

‘Transition risk’: Changing demand and behaviour

At the Dynamic Planner annual conference earlier this year, the BBC’s business editor Simon Jack asked a panel of chief investment officers, ‘What happens when governments or financial institutions will not lend to or invest in companies that don’t meet sustainable criteria?’

Two years ago, the Bank of England set out what it termed ‘transition risks’. One example was energy companies. The bank says that if government policies were to change in line with the Paris Agreement, then two-thirds of the world’s known fossil fuel reserves could not be burned.

This could result in changes in the value of investments in sectors like coal, oil and gas. The shift towards a greener economy could also impact companies which produce cars, ships and planes, the bank adds.

2020’s financial crisis, resulting from the coronavirus, highlights what happens when companies suddenly experience a global collapse in demand, thus demonstrating how transition risk could manifest itself.

This year’s coronavirus effect and experience

State-enforced quarantines the world over, designed to combat Covid-19, shut down economic activity almost overnight, resulting in a negative impact on oil and transport companies – and funds holding oil and transport stocks suffered accordingly. Conversely, ESG funds without such exposures fared better.

Legal & General’s Multi Index and 7IM’s Balanced fund have, to choose examples, both seen their ESG variants outperform in-house peers over the last 12 months to date. The funds share the same risk profile (5 on a 1-10 scale), are managed by the same teams and share the same mandates – except that the ESG variants have the ability to invest in companies with stronger ESG credentials.

Furthermore, both funds outperformed the Dynamic Planner MSCI Risk Profile 5 benchmark over the last year. While not directly caused by environmental factors, the 2020 impact on portfolios is a good illustration of risks created by exposure to industries already feeling pressure from economies transitioning to greater sustainability worldwide.

Risks accompanying negative environmental and social impacts of investments are growing as global awareness, alongside government and court actions, force markets to take them into account. But how do you help manage these risks in portfolios for your clients?

3 steps to managing ESG risk

  1. Talking to your clients about their values and the characteristics of investments they would prefer is a first step. While an industry-wide taxonomy continues to be developed, the Investment Association has done good work here with the Responsible Investment Framework. Having a conversation with clients, as part of a suitability assessment, will ensure you understand what the client is looking for.
  2. Establishing a suitable risk profile and matching the portfolio to this profile becomes even more important as ESG risks come ever more to the fore. Risk-based benchmarks such as the Dynamic Planner – MSCI indices provide a robust and relevant comparison you can employ to demonstrate the performance of a portfolio for a level of risk taken, as opposed to an unrelated index or benchmark like the FTSE All-Share.
  3. Selecting investments that reflect clients’ preferred ESG characteristics and which are matched to a suitable risk profile, mean clients are not only more likely to gain the outcome they are looking for, but they will do so in a manner that more reflects their values. When ESG risks do manifest themselves, clients and their portfolios should be better prepared.

If you are not already a Dynamic Planner user – and would like to find out more about how we can help you and your firm – please get in touch.