Why and how investment firms should integrate sustainability risks in their risk management process

In 2018, the EU Action Plan for financing sustainable growth promulgated a set of new regulations with the objective to reorient capital flows to sustainable investments, mainly through transparency and the management of climate and sustainability risks. 

 

These new regulations compel companies and financial market participants to face complex concepts and difficult challenges to implement them. Chief among them has been how to identify sustainability risks and how to integrate them in risk management processes. The definition of sustainability risks may vary according to the focus and objectives defined by the different regulations, as well as to the concepts on which they are  based, what further complicates the problem. Another challenge stems from the scarcity, consistency and reliability of data, which have made it difficult to quantify the risks involved. 

Unlike the more tangible operational risks that affect an organisation’s performance, sustainability was long considered a modest financial risk exposure. Consequently, little was done to assess the loss potential. Climate change has shifted the paradigm regarding sustainability risks, and finance professionals must now step up to play the role assigned to them in helping meet the objectives defined by the EU Action Plan. 

From climate risks to material sustainability risks 

The relevance of climate change to the risks faced by organisations became a central element of the concept of materiality. However materiality is a broad concept not limited to climate risks but that can be linked to a number of issues adversely or positively impacting a company. 

In the sustainability context, materiality refers to the environmental, social and governance (ESG) issues that can significantly impact the company both positively and negatively. Sustainability materiality is now recognised as the most critical element to design a sustainability strategic planning process. As of today, no formal financial threshold is able to be applied to determine what is or what is not material.

Firms will not be affected equally. How they will be affected will depend on factors depending on their sector of activity(ies), industry(ies), size, location and value chain. Depending on these factors, they will face different sustainable material related risks, which should then be considered differently.

For most of the firms, the key sustainability risks are generally those arising from reputation, customer loyalty and financial performance. 

Generally sustainability risks should be considered regarding their likelihood and impact over a short, medium and mainly a longer term approach with a different methodology compared to the traditional risks which are usually considered on a shorter term approach. Likelihood is as important as the impact. We have seen it with the pandemic considered as a black swan event and the recent floods that occurred in central Europe and other parts of the world, which both turned out to be low-probability likelihood events with high-impact. 

Sustainability risks and the holistic approach

This likelihood of risks illustrates the importance for businesses to have a short to long-term, flexible and comprehensive plan for sustainability rather than a plan that may be rigid and narrow in scope and vision. This also requires integrating sustainability risks within traditional risks.

Unfortunately, there is still a disconnect between traditional and sustainability risks, mainly because identifying, assessing and responding to the latter is still challenging. Another problem is that sustainability risks are still generally not considered in a holistic way rather than just being considered a separate entity. Up to the pandemic, climate risks were usually considered as the only sustainability risks, while the pandemic demonstrated that, ultimately, all risks are interconnected. 

This forced investors and financial institutions to take a broader perspective and integrate these effects into their risk analyses and management framework, and to adapt their investment strategies accordingly. 

Materiality and stakeholders’ assessment as key tools

There are several key steps that investors, asset managers and businesses should take before tackling their sustainability risks. Undoubtedly, the first should be to perform a stakeholder’s inventory, identifying the people who potentially might be impacted by a firm’s actions and to engage and communicate with them to identify and assess their main concerns

The second is to complete a materiality assessment.  Materiality assessment is the best way to identify and assess the sustainability risks along the global value chain and processes a business is exposed to, as well as the organisation’s social and environmental impacts with regards to its stakeholders concerns. This will allow an organisation to implement the key identified material sustainability issues and stakeholders concerns in the management process (e.g governance, policies, investment process and risk management). The last piece of the management process being the reporting exercise and the communication-related actions that will unfold.

It is essential for businesses and private market actors operating in a given industry to know which sustainability factors are most likely to materially impact their financial condition, their operating performance, their portfolios, their products, their stakeholders and the society at large. A materiality assessment will determine their ability to correctly evaluate risks and impacts and respond to them with regard to their business’ values, mission, risk appetite and long-term objectives. Ultimately, how an organisation responds to the identified sustainability risks and impacts and to its stakeholders will determine how effectively it preserves and creates value over the long term. 

Sustainability risks as part of the traditional risk management process

Moving forward, focusing on incorporating sustainability risks within existing organisational procedures, systems and controls is what both businesses and asset managers should do to ensure these risks are considered in investment and risk management processes. 

Rather than being seen as a separate type of risk, sustainability risks should be integrated into the traditional risk management system..

To summarise, and in conclusion, sustainability risks need to be incorporated into mainstream finance. The integration of sustainability risks within traditional risk management process and scenario analysis will help reduce uncertainties and maximise not only the shareholders value but its stakeholders value at large by having a balanced and optimal financial return and risk combination to create a “green” or “rainbow” premium while impacting positively the planet and people.

Contact us

Frédéric Vonner

Advisory Partner, Sustainable Finance & Sustainability Leader, PwC Luxembourg

Tel: +352 49 48 48 4173

Andrew McDowell

Strategy& Partner, PwC Luxembourg

Tel: +352 49 48 48 2034

Julien Melotte

Audit Partner, Industry & Public Sector, Sustainability, PwC Luxembourg

Tel: +352 49 48 48 5287