Disclosing sustainability risk in portfolios

A key component of the EU’s new Sustainable Finance Disclosure Regulation (SFDR) requires asset managers to better disclose how they integrate key sustainability related risks in their investment strategies. Crucially, they also have to disclose the likely impact that this may have on returns of investment products. With decades of experience in ESG integration, the necessity to consider such risks in the investment process is nothing new to Robeco. But across the asset management industry, more granular disclosures are still required, and this may trip up those who haven’t prepared for it.

The new regulations broadly require asset managers to integrate sustainability risks in their portfolios, risk management processes and and governance structures throughout their entire organization. They need to be fully transparent about the incorporation of sustainability in their strategies, as well as disclosing how they integrate sustainability risks into their investment decision‐making process of individual products. This entails detailed reporting about investment processes and risk management practices, as well as on portfolios’ sustainability profiles. It is a lot of work!

Broadly speaking, sustainability risks can be defined as environmental, social or governance (ESG) factors that could cause an actual or a potential materially negative impact on the value of an investment. Well known examples range from climate-related risks such as those posed by high-carbon businesses, to significant social issues and poor governance. Importantly, such risks can materialize at the global, regional, entity and product levels, which means they occur across the whole spectrum. Similarly, different risks may affect different asset classes in different ways.

While sustainability factors can also have positive impacts (opportunities), the sustainability risks for the purpose of integration can be seen as the negative materialization of these ESG factors. Sustainability as a risk factor typically apply to all investments, while sustainability opportunities are typically relevant to the products that have an ESG objective. For asset managers, it is therefore pivotal to carefully assess the financial materiality of sustainability risks, following a proportionate and risk-based approach.

Robeco routinely integrates relevant sustainability risks into all aspects of its investment strategies across the entire range of fundamental equity, fixed income, quantitative and bespoke sustainability funds. We also integrate ESG into tailored client solutions such as mandates, and across the organization itself. This includes investment analyses and decisions, risk management, product governance and client suitability assessment processes, along with Robeco’s governance around it.

The risk that climate change poses is undisputed. The effects of global warming has risen to the top of the agenda among the media, investors and wider society, fueled by stories of uncontrollable fires and floods. We look at the financial risks posed by an investment that may contribute to, or be affected by, global warming. Following the adoption of the Paris Agreement, governments are endeavoring to transition to low-carbon and more circular economies on a global scale. The European Green Deal aims to make Europe the first climate-neutral continent by 2050. Investors are expected to play a key role in this respect, as enshrined in the EU Sustainable Finance Action Plan and the SFDR.

No – Robeco considers climate change to be an all-encompassing risk that is financially material for all its investment strategies. This is underscored by our commitment to the recommendations laid down by the Task Force for Climate-Related Financial Disclosures (TCFD), as well as our commitments to the Dutch Climate Accord. In our Net Zero Roadmap, we also made our own pledge to decarbonize all our portfolios by 2050. The transition to a low-carbon and more circular economy itself contains risks for the companies changing their business models, while physical damage caused by extreme weather impacts just about everyone. There is also the risk of litigation for weather-related damage, and insurance claims.

Robeco takes a forward-looking approach to running climate change scenario analyses that can measure risks using both proprietary tools and third-party data providers. The main problem with data is that by definition, it is backward looking. Therefore, we use more forward-looking scenario analysis such as Climate Value-At-Risk (VAR) to assess the likely impact of risks on the returns of the holdings. Yet, while assessing such risks is a great start, it is critical that investors act to mitigate these risks over the long term. To do this, our investment teams make use of a wide array the sustainability building blocks available to them, built up over our many years of experience in sustainable investing.

We already exclude companies that clearly cannot change their business models to something more climate friendly, such as thermal coal. We also now exclude those companies involved with oil sands or Arctic drilling, subject to certain thresholds. Our exclusion policy also screens out areas where we feel fundamental shifts in markets resulting from ESG-related issues will make certain activities untenable in the future. But the problem here is that once a company is excluded, it is no longer possible to engage with them to try to improve their business model. You also can’t vote against them at annual meetings, or file shareholder resolutions. Subsequently, we much prefer to mitigate sustainability risk by engaging with them. We have found this particularly effective in persuading the oil giants to move towards renewables.

Yes – we have a strong commitment to disclosing our policies, as we believe that transparency forms part of a commitment to sustainable investing. Robeco’s approach is summarized in our sustainability risk policy available on our main website. In addition, information on sustainability risk is also available in fund documentation, providing clients and investors with insight into the relevant sustainability risks on a product level. All policies about exclusions, voting, engagement and everything else are published, and usually updated quarterly where necessary, such as in our Active Ownership documentation.

While the EU regulation offers a significant shake-up, the integration of sustainability risks is an evolving field. The available data, expertise and technology to identify, measure and mitigate sustainability risks and the related ability to deeper understand them will therefore likely increase over time. What the EU regulation has done has been to both accelerate progress in this area, and make disclosures compulsory. But it’s not a perfect science. For investors, it is important to regularly review and, where relevant, recalibrate their sustainability risk integration processes in order to ensure that these remain fit with these innovations. So in that sense, it’s all still work in progress.