Integrating sustainability risks - Implications of the ESMA consultation paper on the integration of sustainability risks and factors

The private equity sector has been increasingly adopting responsible investment practices, with investors being the initial driving force. According to the Global private equity survey conducted by PwC in 2017, 60% of all private equity firms questioned (111 general partners from 22 countries) stated that they have incorporated ESG (Environmental, Social and Governance) factors within their initial screening process. 44% of them aim to align their sustainability efforts to the UN Sustainable Development Goals.

In the meantime, there have also been developments at regulatory level over the past year, with the European Commission recommending clear actions to direct funding towards sustainable investments. Following the publication of an EU Action Plan on financing sustainable growth in March 2018, the European Commission put these recommendations into legislative proposals in May 2018. One such proposal is to integrate sustainability risks and factors into the UCITS and AIFM Directives [1].

In this context, the European Insurance and Occupational Pensions Authority and ESMA were requested to give their technical advice on the proposed changes to these Directives, upon which ESMA published a consultation paper in December 2018 asking for public feedback.

The consultation paper includes recommendations on the integration of the sustainability risks into the investment decision process, due diligence and risk management processes, meaning that it could affect Management Companies (ManCos) managing private equity funds in Europe. The consultation paper suggests integration via a “high-level principles-based approach”, in line with the integration of other risks, considering also the ongoing process of several other legislative changes such as the provision of a clear EU-wide taxonomy on environmentally sustainable activities (expected by June 2019 according to the latest progress report of the Technical Expert Group on Sustainable Finance).

By 19 February 2019, market players are asked to comment on the questions asked regarding the proposed regulatory changes, which will then be published following the end of the consultation period. A final technical advice will then be submitted to the European Commission by April 2019.

ESMA proposes changes (found here) that will cover the necessary resources, responsibilities, conflicts of interest, due diligence requirements and risk management integration.

In this article, we have examined the consultation paper to point out the uncertainties and challenges of which  we believe ManCos should be aware.

In the consultation paper, the measures for effectiveness and adequacy of sustainability risks are still unclear. This will most likely remain the case until at least the first part of an EU sustainability taxonomy discloses more information on only climate-change mitigation and adaptation for the main source sectors. However, this will still leave ManCos with the issue of what might be considered as sufficient by the regulator regarding the processes and procedures to be laid out. According to ESMA, AIFMs must integrate sustainability risks and factors across conventional processes. This raises the question whether these shall be integrated separately as a new layer above all existing processes or if this entails integrating sustainability risks into the existing processes and functions. If so, this will require employees to build up additional skill sets in order to fully perform their changing roles.

Incidentally, according to a 2017 Intertrust research on the private equity market, the lack of appropriate skills and knowledge at staff and general-partner level ranks as one of the top three obstacles cited by private equity firms to integrating sustainability or ESG factors. Moreover, considering that an uninformed general partner or staff member responsible for integrating sustainability risks is in itself a risk, ESMA’s recommendation leaves major questions unanswered. For example, it does not clearly state who exactly is in charge when it comes to integration: will it be the general partner at fund level, management at ManCo level or a designated risk officer? The consultation period will show what market practitioners deem appropriate for a designated qualified person to be responsible for integration.

The materiality for financial returns of the sustainability risks also poses an essential challenge for ManCos. Even though such risks might be identified, it might also be difficult for AIFMs to identify indicators that monitor the extent of their impact.

This also leaves a lot of room for interpretation regarding the level at which sustainability risks should be integrated. Many large asset managers offer a wide variety of investment funds including “sustainable” investment products. The question here is do these sustainability risks concern the overall service offering of a ManCo or is the integration effective and to be disclosed at vehicle level? Even the principle of proportionality may not sufficiently aid AIFMs on this matter.

The consultation paper proposes sustainability risks to be considered in line with other risks labelled separately from other financial risks. Again, we must raise the issue of the materiality of sustainability risks. With a clear lack of an EU-wide taxonomy, it will be difficult to define what is material and then measure the monetary impact of these risks. As a result, it remains unclear which relevant key performance indicators (KPIs) need to be applied to monitor the risks. Is there a set of KPIs that can be applied universally? What adjustment need to be made to tailor to sector-based differences? This might lead to a wide range of sustainability risks applied among AIFMs.

If we think about sustainability risks on a broader scale, it is possible to ask whether they need to be seen separately from the other risks, rather than having an influence on all other risks, e.g. through climate change. Sustainability risks cannot therefore be  considered separately, but must be considered in an integrative matter influencing financial risks, such as market, credit and liquidity risks.

Overall, the proposed amendments appear to be a first step to aligning mainstream business with the EU’s Action Plan on financing sustainable growth in order to channel funding towards environmentally and socially responsible investments. Additionally, due to an overall increase in demand from conscious investors, mainly millennials, the supply of the respective products is lagging behind[1]. In this case, it seems reasonable that integrating sustainability is most effective when fully integrated into existing procedures and processes instead of adding a separate sustainability layer[2].

In particular, private equity firms are facing increased demand from limited partners to proactively deliver on managing sustainability risks. As such, an overarching ESG framework only makes sense when fully integrated at each level of a business cycle in order to satisfy the obligation of limited partners. As a result, designing and publishing an investment policy will be considered inconsequential if general partners cannot deliver on their promises.

For the further development of this regulatory change, the outcome will remain unclear until the expected final technical advice is published in April 2019, which will be closely monitored by ManCos, AIFMs and PwC.

[1] https://www.pwc.com/gx/en/sustainability/publications/assets/pe-survey-report.pdf

[2] https://www.esma.europa.eu/document/consultation-paper-integrating-sustainability-risks-and-factors-in-ucits-directive-and

[3] https://www.ft.com/content/bee35fee-6d91-3031-918c-6d6b25c08dbf

[4] https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/from-why-to-why-not-sustainable-investing-as-the-new-normal



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