ESG regulation - are you operationally ready?

As the public policy agenda for sustainable investing continues to unfold, asset managers are finding themselves under pressure to implement new requirements set out by incoming regulation. Various initiatives are nudging firms to integrate Environmental, Social and Governance (ESG) factors into their investment propositions and decisions, and to report on the sustainability performance of certain funds. With this comes changes to ESG policies, the controls and governance to implement those policies, and a more central role for ESG data on investee companies. In this blog, we consider these key operational impacts in further detail, together with some of the actions firms should take to respond.

In response to the incoming requirement under the EU ESG disclosure regulation and the Stewardship Code to integrate sustainability factors into investment decision-making, asset managers will need an ESG policy setting out clear procedures for considering sustainability. At the outset, firms should determine who is accountable for the policy, and which internal stakeholders need to contribute to its design. Reasonable steps should be taken by individuals accountable for the policy to review it on a regular basis, documenting any subsequent amendments and the rationale for them. Firms will also need to determine the appropriate level at which ESG integration takes place, i.e. whether by asset class, fund or at firm level. The regulations, as they stand, appear to allow for flexibility on this, but firms should think through how to approach the task in the most meaningful way.

When thinking about systems and controls in the context of their ESG policy, firms should look to ESMA’s recent technical advice to the European Commission on the incorporation of sustainability issues into MiFID II, UCITS directive and AIFMD. A key message from the advice is that firms need to to embed ESG considerations into their approach to meeting organisational obligations. Establishing an appropriate governance framework will be particularly important here. Some firms are choosing to delegate responsibility for overseeing ESG integration to an existing investment committee, while others are establishing a dedicated structure with a clear mandate to oversee and report to stakeholders on the progress of integration. Firms will ultimately need to opt for the structure that best fits their existing operating model, but should recognise that an ESG integration programme which is more closely aligned with BAU decision-making processes is likely to be more successful.

More broadly, an effective integration process will rely on an institutional culture which places sufficient emphasis on long-term decision-making. In practice, this means having the right people on the ground, with relevant skills and expertise to grasp ESG concepts. Those staff will need to appreciate the implications of sustainability factors for investment returns, and help to promote a widespread understanding internally of the firm’s approach in this area. Many fund managers have already doubled or tripled their ESG headcount in order to help with this, and others have rolled out comprehensive training to instill awareness of how best to integrate ESG into investment processes, including at board level.

Effective integration of sustainability into firms’ investment decision-making will need to be supported by data. This will be essential in enabling relevant teams and individuals to understand the ESG credentials of investee companies. The more advanced firms will be looking to develop ESG data tools to ingest company-level ESG information, which can be assessed against tailored metrics, providing an investment overlay to aid risk identification and analyse implications for long- term investment returns. The tool could also be used to produce reports on the sustainability performance of funds, thereby meeting key requirements in this area across a number of pieces of regulation. While data has a vital role to play in supporting judgements and performing forward-looking analyses, firms should take care to strike a balanced approach between data analysis and active stewardship, engaging with investee companies on a regular basis to monitor progress against future targets and objectives.

While the regulatory agenda on sustainable investments continues to evolve, it’s clearly having a major impact on firms' operating models, spanning design of ESG policies, implementation of those policies through robust systems, controls, governance and procedures, and gathering and assessing data. This brings complexity and challenges, but getting on the front foot and tackling these now will be essential for firms’ ability to address the changes resulting from the regulatory agenda in this space.

Lucas Penfold

Lucas Penfold | Manager
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Leo Donnachie | Senior Associate
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