FIS and industry experts discuss key regulations and considerations for integrating climate and sustainability risk measures with investment strategy.
RISK STRATEGIES FOR A WORLD GONE GREEN
WHITE PAPER
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Climate change, sustainability and environmental, social and governance (ESG) regulations are driving global investment firms to rethink their approach for growth. Indeed, with the expanding green movement and rise of eco-conscious millennials participating in global markets today, firms risk losing all credibility if they don’t scale toward a demonstrable, sustainable finance model.
In a recent FIS webinar ‘Climate Risk and Sustainability Risk Measures in Investment Strategy,’ a panel of industry experts discussed the emerging trends in sustainable finance and how firms can integrate ESG compliance with traditional investment strategies. The panel included:
A New Investment Climate
Let’s Solve Climate and Sustainability Risk
What a difference a century makes
Global Chief Operating Officer, Sustainable Investing, Citi Global Wealth
As the world of climate science and finance enter the same arena, fund managers, advisers, banks, corporations and sovereigns would all do well to recognize the risks and rewards.
As we enter 2021, there’s a lot more
information
for actuaries to navigate – and luckily,
a lot more computing power to manage it all.
& complexity
As we continue our path through this pandemic, it’s apparent that modeling must adapt—and adapt fast—to assimilate new and increasing data sets. Actuaries will need to not only model the impact of the novel coronavirus over the next five years, but also make sure that their models and solvency plans are effective enough to handle another global health crisis, no matter what form it takes.
Below are just some of the questions that actuaries must address in a new generation of risk models, scenarios and simulations.
To learn more, visit our dedicated Regulation and Risk website, or our Trading website. Alternatively, speak to one of our solutions advisors on email getinfo@fisglobal.com.
The Global ESG Regulatory Landscape
A New Investment Climate
The Case of Alpha Centauri
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Product Regs
Are your solvency models strong enough?
Europe, Asia and the Americas stand at different yet evolving positions on the ESG regulatory map. Product, prudential and disclosure regulations tend to skew heavily toward the prevailing local view of climate change and sustainability, with Europe being the strongest advocate for ESG investing and the Americas lagging until most recently.
In Europe, Sustainable Finance Disclosure Regulations (SFDR) are already impacting portfolio management regarding fund products and discretionary strategies. EU taxonomy is the technical language demarking industrial activities which meet the EU’s standard on environmental and social objectives.
MiFID has also evolved to integrate ESG and sustainability elements, affecting alternative fund managers in-scope of Alternative Investments Fund Management Directive (AIFMD) specifically, while mutual fund managers must answer to the Undertakings for the Collective Investment in Transferable Securities (UCITS) regulatory framework in Europe. Companies affiliated with a stock exchange in Europe will be required to report under the Non-Financial Reporting Directive (NFRD) / Corporate Sustainability Reporting Directive (CSRD). Whilst in the U.K. such listed companies and in-scope financial organizations are required to report key metrics aligned with the Task Force on Climate-Related Financial Disclosures (TFCD).
In APAC, cooperation among governments, regulators and investors is fragmented. In Japan, institutional investors are starting to address ESG and climate-related initiatives, while in China, new emission targets are shaping investments after President Xi’s announcement to achieve net-zero status
by 2060.
The U.S. having only recently rejoined the Paris Climate Agreement, is still behind Europe and Asia. North America particularly will be more heavily influenced by regulation than investor behavior to change, while in Latin America, progress lacks due to the absence of governance reforms, industry standards and a limited market for sustainable investments.
The Global ESG Regulatory Landscape
all of which are heightened with a remote workforce.
governance
Not only were largely office-based infrastructures under extreme pressure, but the pandemic also raised concerns about:
security
scalability
Fund Managers Advisers / DPMs Insurance Banks Corporates Sovereigns
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ESG Regulatory Landscape – Global
Should there be flat additions for mortality, or should older age groups and impaired lives be affected differently?
Could excess deaths be spread out over a number of years?
And ultimately, should there be a stronger correlation between mortality and the economic fallout of a pandemic?
This simple model needs to be revisited
for internal risk management purposes.
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In consultation with Financial Conduct Authority’s Climate Financial Risk Forum (CFRA), the UK Department of Work and Pensions (DWP) is taking steps to improve governance and reporting activities relative to climate risk. Obligations for UK pension schemes reporting over £5B in assets are effective October 2021, raising accountability levels to new heights.
Further, as socially driven millennial investors increasingly participate in family and wealth management decisions, managers will be expected to include ESG and sustainable criteria in supporting investment recommendations. A 2020 UBS Global Family Office Report revealed that 60% of families now regard sustainable investing as important for their legacies, and 39% of offices intend to allocate most of their portfolios sustainably over the next five years.
The level of involvement across markets depends largely on access to data and improved transparency to bridge the public-private ESG gap. Listed equity and fixed income markets have benefitted from data, tools and services provided by advisors, vendors and ESG rating agencies, accelerating their adoption of consistent data collection and reporting standards.
But in private markets, independent climate risk solutions are limited. Gathering, structuring and organizing the vast amounts of private data required to report progress hinge on improving the toolsets.
Private companies make up more than 90% of global business. That said, the UN Principles of Responsible Investment (UNPRI) initiative has advanced adoption of ESG standards, adding 262 firms in Q3 2020, boosting the total of number of signatories worldwide to 3,300.
The real test will come when demands for ESG considerations increase. Complete due diligence and investor reporting requirements have yet to take effect as measurable ESG impact metrics remain unclear.
According to a 2021 Limited Partner (LP) Perspective Study from Private Equity International, 88% of investor LPs accounted for ESG considerations as part of their due diligence, compared with 80% the prior year. IHS Markit’s LP Footprint Project, analyzing 163 LPs across Europe, North America and Asia found that 63% of LPs researched have public ESG policies, 59% have signed on with PRI, and 40% publicly publish annual ESG reports.
The pressure is on for private market managers to adopt ESG standards, differentiate their offerings and provide portfolio transparency through impact reporting. As a more harmonized set of standards emerges, more firms are expected to enhance their portfolio monitoring and reporting with ESG and climate-risk management processes.
Different Rules for Different Asset Classes
The Global ESG Regulatory Landscape
Even now, the pandemic’s impact on mortality rates isn’t well understood. In the first half of 2020, many experts believed that the majority of COVID-19 deaths were linked to underlying health conditions and seen essentially as bringing forward deaths from future years. As a result, it was assumed that future populations would then be slightly healthier, causing the average mortality rate to fall in subsequent years.
That school of thought is already becoming dated. Now, discussions center more on the effects of social isolation on mortality, delays in routine screening for cancer and early cancer diagnosis, so-called “long COVID” and the socio-economic consequences of a lockdown-induced recession. These impacts are not well understood yet but have the potential to increase mortality rates.
What’s the outlook on excess mortality?
Review the resilience of your solvency platform and framework
Despite the combined influence of SFDR, TCFD, EU Taxonomy, CSRD, NFRD and other noble forms of governance, the process is only in its infancy. Indeed, it will take coordination among governments, regulators, banks, managers, investors and corporations to harmonize a globally recognized set of ESG standards.
In the UK, the Stewardship Code of 2020 has helped define standards of conduct for asset owners, managers and service providers. It offers a framework for responsible allocations, management and oversight to create long-term value for clients, while also benefiting society and the environment. The code recognizes the diverse approach of firms striving to meet the standards without compromising individual business models or strategies.
However, where high ESG standards are imposed, firms can also be put at a disadvantage when competing for deals. A framework of incentives will need to be developed to create a culture of inclusiveness, where larger organizations are incentivized to help smaller players, and governments provide fiscal advantages to firms attaining certifiable green status.
In private markets, managers will be called upon to support smaller portfolio companies in capturing data, building sustainability programs and delivering meaningful reports. The “carrot and stick” incentives may also include links to executive performance and pay, improved market pricing, pricing concessions, tax benefits or additional charges and penalties for non-compliance.
By definition, however, the COVID-19 outbreak is actually a white-swan event: not the first of its kind and therefore predictable and actually likely to occur at some point.
The Need for Regulatory Standards
Many managers overstate or misrepresent their green credentials to gain a competitive edge in the current market; the incentive to do so is certainly there.
According to Bloomberg Intelligence, global ESG assets will reach $53T by 2025, representing over a third of the global Assets Under Management (AUM).
Morningstar reports investments in sustainable products at a record high in Q4 2020, with Europe accounting for 80% of the flow, followed by the U.S. at 13.4%. A record high 196 new sustainable fund offerings in the same quarter brings the global total of such funds to 4,153. Given the current state of ESG investing greenwashing has become common.
Examples of greenwashing include vaguely stating or misstating organizational buy in, lack of information regarding metrics or overstating the magnitude of impact. As well, firms with a strong ESG marketing message tend to draw attention; seeking a positive public image without substantiation has become all too prevalent.
A ranking of 75 leading global asset managers in 2020 revealed that while all 75 were signatories to the UNPRI, 51% showed little evidence of ESG integration across assets, suggesting that many use the initiative as a “tick box” exercise.
Such lack of consistent data, ESG standards or performance metrics can undermine investor confidence and lead to reputational damage or even litigation. As long as there are no harmonized regional or global standards that can be independently audited – some framework for transparency, consistency and oversight – firms with the most marketing firepower most often will dominate. That is, unless regulators prevent it and ensure accurate reporting and also develop harmonized standards.
As investors become more sophisticated, building a comprehensive ESG review criteria that holds managers to account and calls out misleading statements, is vital to establishing a level playing field going forward.
The Matter of Greenwashing
Regulation has traditionally led insurers’ robust approach to solvency, with Solvency II driving stronger governance and control of modeling results. Now, critically, insurers must look deeper and consider all of the aspects of their solvency models that haven’t worked as well.
You must also ask yourself serious questions about the changing nature of the workplace in the pandemic. Will what started off as emergency lockdown measures become a more permanent shift and keep many staff working from home or remotely more often? Should cloud computing and SaaS-based platforms form part of your protection against future challenges to business continuity?
The Case of Alpha Centauri
Email us to find out more
Let’s solve insurance risk with flexibility and control
When it comes to capital management, you need to know that your reserves can withstand the very worst-case scenarios: extreme, black-swan events that would otherwise cause insolvency.
Demonstrating how sustainable investments not only achieve non-financial aims but also enhance a strategy’s risk-return will be a key to achieving ESG and climate-oriented goals in the future.
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Martin Sarjeant, senior vice president, Product Management, Insurance, FIS
But many of the assumptions that make up risk models
are best estimates.
Alpha Centauri (AC), an independent multi-asset management boutique founded in 2005 and based in Hamburg, Germany, offers a snapshot-in-time at how the industry is coping with change. According FIS panelist, Ulf Füllgraf, AC Managing Director, all of AC’s investment and index strategies, including ESG and climate-related investments, hinge on understanding the underlying economic drivers.
Look at the stresses and combinations of stresses that you are running on your models. How did any pandemic modeling you carried out compare to actual COVID-19 results and would it have protected you in previous pandemics? Or should the stresses be higher and more explicitly targeted?
In terms of solvency, it’s important to gauge how well your stochastic and stress tests on models actually protected your company. What’s more, could you have survived any additional shocks after the initial market falls in March? By focusing on reverse stress testing, you can uncover any hidden risks and vulnerabilities that may also cause insolvency.
Assess stress testing
Consider layering on several mortality scenarios, but be prudent and make sure you underestimate for annuitant mortality and overestimate for life assurance mortality.
Some basic assumptions should also be made in the stresses about the pattern of mortality either worsening due to increased deaths from COVID-19 or the impact of long-COVID improving because of improved public health, hygiene and resistance to future viruses or flus.
However, remember that at this stage there is still a danger of over-modeling, overthinking and spurious accuracy, with not enough data or knowledge to support more complex models.
Rethink mortality assumptions
Tying back to your solvency platform and framework, actuaries need to be able to answer senior managers’ most fundamental questions, fast. At the start of the pandemic, C-suite executives were desperate to know what could happen next, the impact on their solvency ratio and whether risk teams could model all this remotely.
To consistently provide a rapid response in these circumstances, you need a risk platform that is well governed, scalable and accessible in the cloud, with the flexibility to model changes quickly.
Deliver timely information
Solvency modernization is now a reality for insurers around the world, with many countries echoing the spirit and format of Solvency II and the upcoming Insurance Capital Standard.
Beyond compliance, these supervisory guidelines are helping create a stronger insurance sector and improving protection for policyholders and the overall management of insurance companies. What better reasons to modernize solvency through both your technology and your risk modeling framework?
Push ahead to meet new solvency requirements
What are the systematic or specific sources of risk and return?
However, there are still clear lessons
to learn and much room for risk management to improve going forward.
previous
The Matter of Greenwashing
Solvency modernization is now a reality for insurers around the world, with many countries echoing the spirit and format of Solvency II and the upcoming Insurance Capital Standard.
Beyond compliance, these supervisory guidelines are helping create a stronger insurance sector and improving protection for policyholders and the overall management of insurance companies. What better reasons to modernize solvency through both your technology and your risk modeling framework?
Push ahead to meet new solvency requirements
Tying back to your solvency platform and framework, actuaries need to be able to answer senior managers’ most fundamental questions, fast. At the start of the pandemic, C-suite executives were desperate to know what could happen next, the impact on their solvency ratio and whether risk teams could model all this remotely.
To consistently provide a rapid response in these circumstances, you need a risk platform that is well governed, scalable and accessible in the cloud, with the flexibility to model changes quickly.
Deliver timely information
Consider layering on several mortality scenarios, but be prudent and make sure you underestimate for annuitant mortality and overestimate for life assurance mortality.
Some basic assumptions should also be made in the stresses about the pattern of mortality either worsening due to increased deaths from COVID-19 or the impact of long-COVID improving because of improved public health, hygiene and resistance to future viruses or flus.
However, remember that at this stage there is still a danger of over-modeling, overthinking and spurious accuracy, with not enough data or knowledge to support more complex models.
Rethink mortality assumptions
Look at the stresses and combinations of stresses that you are running on your models. How did any pandemic modeling you carried out compare to actual COVID-19 results and would it have protected you in previous pandemics? Or should the stresses be higher and more explicitly targeted?
In terms of solvency, it’s important to gauge how well your stochastic and stress tests on models actually protected your company. What’s more, could you have survived any additional shocks after the initial market falls in March? By focusing on reverse stress testing, you can uncover any hidden risks and vulnerabilities that may also cause insolvency.
Assess stress testing
Regulation has traditionally led insurers’ robust approach to solvency, with Solvency II driving stronger governance and control of modeling results. Now, critically, insurers must look deeper and consider all of the aspects of their solvency models that haven’t worked as well.
You must also ask yourself serious questions about the changing nature of the workplace in the pandemic. Will what started off as emergency lockdown measures become a more permanent shift and keep many staff working from home or remotely more often? Should cloud computing and SaaS-based platforms form part of your protection against future challenges to business continuity?
Review the resilience of your solvency platform and framework
That said, some firms may be treating the COVID-19 pandemic as a black-swan event because they hadn’t allowed for it in their risk models. While it’s these insurers that most urgently need to take a closer, more critical look at their risk management processes, it’s down to every organization to think beyond COVID-19 and model truly extreme, black-swan events.
Nikhil Chouguley
Founder,
Reframe Capital
Benjamin Lamping
Managing Director,
Alpha Centauri Investment Management
Ulf Füllgraf
ESG Regulatory Landscape – Global
Prudential Regs
Disclosure Regs
europe / UK
asia
americas
Type of Firm
SFDR
EU Taxonomy
AIFMD / UCITS
MiFID
Green Lending
SP/Derivatives
Data
PRA Climate Risk
EU Pillar 3
NFRD / CSRD
EU Green Bonds
CSRD
EU Taxonomy
TCFD
MAS ESG Guidelines
HK – ESG Circular
SEC Risk Alert - Greenwashing
Evolving Investor Requirements
Founder, Reframe Capital
Benjamin Lamping
"
21.5B
net U.S. sustainable fund inflows in Q1 2021. Source: Morningstar
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With so much information available, there is arguably a danger of being overwhelmed by data. Selecting the right source and utilizing the right tools will go a long way toward making better decisions. But to avoid misconceptions and misrepresentation, several issues must be addressed before an accurate scoring system can be put in place. These are:
Evolving Investor Requirements
Even now, the pandemic’s impact on mortality rates isn’t well understood. In the first half of 2020, many experts believed that the majority of COVID-19 deaths were linked to underlying health conditions and seen essentially as bringing forward deaths from future years. As a result, it was assumed that future populations would then be slightly healthier, causing the average mortality rate to fall in subsequent years.
That school of thought is already becoming dated. Now, discussions center more on the effects of social isolation on mortality, delays in routine screening for cancer and early cancer diagnosis, so-called “long COVID” and the socio-economic consequences of a lockdown-induced recession. These impacts are not well understood yet but have the potential to increase mortality rates.
What’s the outlook on excess mortality?
Green credentialing in international markets will hinge on reliable data. Finding a reliable source of quality data to measure non-financial performance will be the key.
Even the largest, most sophisticated investor groups struggle to effectively gather clean data surrounding carbon impact. With portfolios spanning many positions across multiple assets, regions, vehicles and business lines, getting to the truth will not be easy.
There are limitations in accessing private markets’ data. Some data sets are entirely unstructured, posing further challenges to measuring performance. And while some performance criteria may be relatively simple to measure, such as the use of carbon emissions on climate impact, others can be more difficult to quantify, such as a firm’s climate change mitigation plan.
With each industry presenting its own unique features and characteristics, there is no single, consistent, standard metric by which firms can report, measure and compare compliance.
It will take ESG benchmarks to initially define the standards but this is only the start. Mapping ESG performance to specific UN sustainable development goals (SDGs) will require a broader environmental and socio-economic perspective. Managers will have to report non-financial criteria impacting the financial value of an asset before ESG investments are viewed as attractive alternatives in competitive markets.
Good Data Holds the Key
The Global ESG Regulatory Landscape
FALSE
TRUE
YOU’RE RIGHT!
TRY AGAIN!
There is no standardized approach to ESG investing.
Ensuring relevance and consistency in reporting frameworks for ESG disclosure
Opacity of subjective elements in ESG scoring
Improving alignment with materiality and performance
Transparency of ESG product alignment with sustainable finance objectives related to financial and social returns
Public and regulatory engagement
We’ve moved to a crucial time in our demographic cycle where social and environmental responsibilities are driving investor decisions. Climate change and the protection of ecosystems is a global language and it’s here to stay.
"
"
Global Chief Operating Officer,
Sustainable Investing, Citi Global Wealth
Nikhil Chouguley
It’s a tall order for even large firms to embrace, which leads to the next major consideration - cost.
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of consumers think companies should actively shape ESG best practices.
Even now, the pandemic’s impact on mortality rates isn’t well understood. In the first half of 2020, many experts believed that the majority of COVID-19 deaths were linked to underlying health conditions and seen essentially as bringing forward deaths from future years. As a result, it was assumed that future populations would then be slightly healthier, causing the average mortality rate to fall in subsequent years.
That school of thought is already becoming dated. Now, discussions center more on the effects of social isolation on mortality, delays in routine screening for cancer and early cancer diagnosis, so-called “long COVID” and the socio-economic consequences of a lockdown-induced recession. These impacts are not well understood yet but have the potential to increase mortality rates.
What’s the outlook on excess mortality?
In some respects, the way in which the ESG landscape is evolving serves larger, more established firms, and to the detriment of smaller ones. There is a huge cost to accessing, storing and leveraging data to meet regulatory and investor requirements. In public markets, where data is somewhat commoditized, the cost of compliance is lower. But in the greater private market, managers do not enjoy a level playing field.
Large intermediaries can form working groups to guide industry practice and regulatory engagement, which creates bias against smaller firms in need of support. Until adaptable standards are developed that recognize such constraints, emerging and niche managers will continue operating at a disadvantage.
Managing the Cost of Compliance
The Global ESG Regulatory Landscape
0
%
Source: PwC 2021 Consumer Intelligence Series
FALSE
TRUE
correct!
TRY AGAIN!
It is easy to measure and monitor ESG performance.
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previous
Solvency modernization is now a reality for insurers around the world, with many countries echoing the spirit and format of Solvency II and the upcoming Insurance Capital Standard.
Beyond compliance, these supervisory guidelines are helping create a stronger insurance sector and improving protection for policyholders and the overall management of insurance companies. What better reasons to modernize solvency through both your technology and your risk modeling framework?
Push ahead to meet new solvency requirements
Tying back to your solvency platform and framework, actuaries need to be able to answer senior managers’ most fundamental questions, fast. At the start of the pandemic, C-suite executives were desperate to know what could happen next, the impact on their solvency ratio and whether risk teams could model all this remotely.
To consistently provide a rapid response in these circumstances, you need a risk platform that is well governed, scalable and accessible in the cloud, with the flexibility to model changes quickly.
Deliver timely information
Consider layering on several mortality scenarios, but be prudent and make sure you underestimate for annuitant mortality and overestimate for life assurance mortality.
Some basic assumptions should also be made in the stresses about the pattern of mortality either worsening due to increased deaths from COVID-19 or the impact of long-COVID improving because of improved public health, hygiene and resistance to future viruses or flus.
However, remember that at this stage there is still a danger of over-modeling, overthinking and spurious accuracy, with not enough data or knowledge to support more complex models.
Rethink mortality assumptions
Look at the stresses and combinations of stresses that you are running on your models. How did any pandemic modeling you carried out compare to actual COVID-19 results and would it have protected you in previous pandemics? Or should the stresses be higher and more explicitly targeted?
In terms of solvency, it’s important to gauge how well your stochastic and stress tests on models actually protected your company. What’s more, could you have survived any additional shocks after the initial market falls in March? By focusing on reverse stress testing, you can uncover any hidden risks and vulnerabilities that may also cause insolvency.
Assess stress testing
Regulation has traditionally led insurers’ robust approach to solvency, with Solvency II driving stronger governance and control of modeling results. Now, critically, insurers must look deeper and consider all of the aspects of their solvency models that haven’t worked as well.
You must also ask yourself serious questions about the changing nature of the workplace in the pandemic. Will what started off as emergency lockdown measures become a more permanent shift and keep many staff working from home or remotely more often? Should cloud computing and SaaS-based platforms form part of your protection against future challenges to business continuity?
Review the resilience of your solvency platform and framework
Working Better Together
By definition, however, the COVID-19 outbreak is actually a white-swan event: not the first of its kind and therefore predictable and actually likely to occur at some point.
When it comes to capital management, you need to know that your reserves can withstand the very worst-case scenarios: extreme, black-swan events that would otherwise cause insolvency.
But many of the assumptions that make up risk models
are best estimates.
Given that most of the industry still operates in silos, greater coordination is needed to establish commonly acceptable goals and standards that serve all participants. Several recent actions suggest that the industry is already moving in this direction.
The Matter of Greenwashing
Risk Management
ESG and factor investing as satellites: danger of “optimized island solutions”
Nearly 50% of active risks in institutional portfolios are “uncompensated“
All Institutions
Endowments
Insurance
Corporate Pensions
Financial Services
Family Offices
Public Funds
45%
46%
49%
45%
42%
49%
41%
34%
40%
28%
36%
22%
27%
31%
21%
14%
23%
19%
35%
25%
29%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Source: Northern Trust Asset Management’s “The Risk Report”. Provides insights gained from analyzing hundreds of institutional portfolios totalling more than US$200 billion in assets over the past 4 years. October 15, 2020.
Uncompensated risks
Stock selection risk
Compensated factor risk
The International Organization of Securities Commissions (IOSCO) issued a disclosure covering matters of greenwashing, potential regulatory approaches, policies and practices on how to potentially achieve convergence on climate risk and ESG standards. The work offered a basis for recommendations on data and provider ratings, along with educational initiatives to bring more players into the mix.
The Sustainability Accounting Standards Board (SASB), a U.S. non-profit organization, and the International Integrated Reporting Council, formed the Value Reporting Foundation to help set global standards for ESG reporting and measurement methodologies.
The SASB and the International Integrated Reporting Council (IIRC) joined with the Carbon Disclosure Project, Climate Disclosure Standards Board and Global Reporting Initiative to set a new standard for climate-related financial disclosures.
The International Financial Reporting Standards Foundation, which oversees the International Accounting Standards Board, also published universal sustainability reporting guidelines intended to pave the way for a non-financial audit and assurance framework.
Despite the progress, challenges remain. Standards between general and limited partnerships on ESG reporting have yet to be harmonized. As investors continue to develop their own internal methodologies and metrics in the interim, often at considerable cost, conformance to any standard will be met with some level of resistance.
Broad ESG and climate change considerations have no economic investment value of their own. Given individual values, principles and beliefs on one side and economic materiality on the other, ESG information should be seen as an added component to investment decisions, not as a sole driver.
"
"
Managing Director,
Alpha Centauri Investment Management
Ulf Füllgraf
If the strategy exposes investors to impacts on individual companies, what is the source of alpha?
In the case of systematic risk, is the risk priced and paid for in the form of true risk premia or is it unpaid, as is the case in sector risks?
?
In the firm’s 2017 study, “The Search of Climate Smart Investments,” AC found that climate risk is already priced and paid for in European equity markets. Further, the study uncovered a “low carbon-factor” in European equities that, when incorporated into risk models, proved only a low correlation to other “pure” factors in European equities, causing, perhaps, a small tilt to more defensive factors, such as low volatility/beta.
Based on the research, AC developed “long only” equity strategies that offer carbon footprint reductions of around 80%, compared to its classic benchmark strategies and long/short strategies with an already negative carbon footprint. At AC, all strategies exhibit tracking error or volatility levels of around 5%, consistent with the firm’s core belief that investors must take active risk but avoid “intended risks” to succeed in ESG and climate-related investments.
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Take the Holistic View
Risk Management
By definition, however, the COVID-19 outbreak is actually a white-swan event: not the first of its kind and therefore predictable and actually likely to occur at some point.
Today’s expanding green movement is causing global investment firms to rethink their approach to growth. But how do you strike the right balance between risk and return?
Survey the global ESG regulatory landscape and determine what gaps you have in gathering, structuring and organizing the data it takes to compete. With the right information, you can more accurately model and measure climate and sustainability risk and offer your investors the returns and the green status they seek in today’s evolving, environmentally conscious global marketplace.
With only a limited history on which to view ESG and climate-related investing, a holistic view on risk and reward is the safest path forward.
Most ESG indices and ETFs are output-oriented, tending to leave much unintended risk on the table. Investors, on the other hand, base decisions on outcome-oriented data, placing more importance on performance and risk factors than asset allocation.
So, it follows that in many cases, ESG and climate-related investing, at least for now, represents a set of “optimized island solutions” that potentially result in return drag and uncompensated risk in the context of a larger, diversified portfolio.
To minimize factor alignment problems within risk models, a Principal Component Analysis (PCA) approach is recommended. It should support a diverse set of investment strategies and regulatory regimes, including pre-trade analysis, forward-looking stress tests, risk attribution, risk analysis, risk monitoring and risk reporting, with multi-asset-class factor modeling capabilities built in.
ESG and factor investing as satellites: danger of “optimized island solutions”
STAT: $21.5B net U.S. sustainable fund inflows in Q1 2021. Source: Morningstar
STAT: 88% of investor LPS accounted for ESG considerations as part of their due diligence, compared to 80% the prior year. Source: 2021 Limited Partner (LP) Perspective Study. Private Equity International
STAT: 63% of LPs researched have public ESG policies, 59% have signed on with PRI, and 40% publicly published annual ESG reports. Source: HIS Markit’s LP Footprint project
STAT: 60% of families now regard sustainable investing as important for their legacies. Source: 2020 UBS Global Family Office Report
STAT: 83% of consumers think companies should actively shape ESG best practices. Source: PwC 2021 Consumer Intelligence Series
STAT: Investments in sustainable products were at a record high in Q4 2020, with Europe accounting for 80% of the flow, followed by the U.S. at 13.4%.
Source: Morningstar
WHAT’S YOUR CLIMATE RISK STRATEGY?
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Let’s Solve Climate and Sustainability Risk
To learn more about FIS Solutions, visit our dedicated Regulation and Risk microsite, or our Trading microsite. Alternatively, speak to one of our solution advisors. Contact us on email getinfo@fisglobal.com.
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Webinar
“Climate Risk and Sustainability Risk Measures in Investment Strategy”
With special thanks to our guest speakers and white paper contributors:
Nikhil Chouguley, global chief operating officer, sustainable investing, Citi Global Wealth.
Benjamin Lamping, founder, Reframe Capital.
Ulf Füllgraf, managing director, Alpha Centauri Investment Management.
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The Case of Alpha Centauri
The Matter of Greenwashing
The Global ESG Regulatory Landscape
A New Investment Climate
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Risk Management
ESG and factor investing as satellites: danger of “optimized island solutions”
Read now
Let’s Solve Climate and Sustainability Risk
To learn more, visit our dedicated Regulation and Risk website, or our Trading website. Alternatively, speak to one of our solutions advisors on email getinfo@fisglobal.com.
©2021 FIS FIS and the FIS logo are trademarks or registered trademarks of FIS or its subsidiaries in the U.S. and/or other countries. Other parties’ marks are the property of their respective owners. 1572680
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Alpha Centauri (AC), an independent multi-asset management boutique founded in 2005 and based in Hamburg, Germany, offers a snapshot-in-time at how the industry is coping with change. According FIS panelist, Ulf Füllgraf, AC Managing Director, all of AC’s investment and index strategies, including ESG and climate-related investments, hinge on understanding the underlying economic drivers.
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What are the systematic or specific sources of risk and return?
If the strategy exposes investors to impacts on individual companies, what is the source of alpha?
In the case of systematic risk, is the risk priced and paid for in the form of true risk premia or is it unpaid, as is the case in sector risks?
In the firm’s 2017 study, “The Search of Climate Smart Investments,” AC found that climate risk is already priced and paid for in European equity markets. Further, the study uncovered a “low carbon-factor” in European equities that, when incorporated into risk models, proved only a low correlation to other “pure” factors in European equities, causing, perhaps, a small tilt to more defensive factors, such as low volatility/beta.
Based on the research, AC developed “long only” equity strategies that offer carbon footprint reductions of around 80%, compared to its classic benchmark strategies and long/short strategies with an already negative carbon footprint. At AC, all strategies exhibit tracking error or volatility levels of around 5%, consistent with the firm’s core belief that investors must take active risk but avoid “intended risks” to succeed in ESG and climate-related investments.
Broad ESG and climate change considerations have no economic investment value of their own. Given individual values, principles and beliefs on one side and economic materiality on the other, ESG information should be seen as an added component to investment decisions, not as a sole driver.
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Managing Director,
Alpha Centauri Investment Management
Ulf Füllgraf
Take the Holistic View
Today’s expanding green movement is causing global investment firms to rethink their approach to growth. But how do you strike the right balance between risk and return?
Survey the global ESG regulatory landscape and determine what gaps you have in gathering, structuring and organizing the data it takes to compete. With the right information, you can more accurately model and measure climate and sustainability risk and offer your investors the returns and the green status they seek in today’s evolving, environmentally conscious global marketplace.
With only a limited history on which to view ESG and climate-related investing, a holistic view on risk and reward is the safest path forward.
Most ESG indices and ETFs are output-oriented, tending to leave much unintended risk on the table. Investors, on the other hand, base decisions on outcome-oriented data, placing more importance on performance and risk factors than asset allocation.
So, it follows that in many cases, ESG and climate-related investing, at least for now, represents a set of “optimized island solutions” that potentially result in return drag and uncompensated risk in the context of a larger, diversified portfolio.
To minimize factor alignment problems within risk models, a Principal Component Analysis (PCA) approach is recommended. It should support a diverse set of investment strategies and regulatory regimes, including pre-trade analysis, forward-looking stress tests, risk attribution, risk analysis, risk monitoring and risk reporting, with multi-asset-class factor modeling capabilities built in.
The Case of Alpha Centauri
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Solvency modernization is now a reality for insurers around the world, with many countries echoing the spirit and format of Solvency II and the upcoming Insurance Capital Standard.
Beyond compliance, these supervisory guidelines are helping create a stronger insurance sector and improving protection for policyholders and the overall management of insurance companies. What better reasons to modernize solvency through both your technology and your risk modeling framework?
Push ahead to meet new solvency requirements
Tying back to your solvency platform and framework, actuaries need to be able to answer senior managers’ most fundamental questions, fast. At the start of the pandemic, C-suite executives were desperate to know what could happen next, the impact on their solvency ratio and whether risk teams could model all this remotely.
To consistently provide a rapid response in these circumstances, you need a risk platform that is well governed, scalable and accessible in the cloud, with the flexibility to model changes quickly.
Deliver timely information
Consider layering on several mortality scenarios, but be prudent and make sure you underestimate for annuitant mortality and overestimate for life assurance mortality.
Some basic assumptions should also be made in the stresses about the pattern of mortality either worsening due to increased deaths from COVID-19 or the impact of long-COVID improving because of improved public health, hygiene and resistance to future viruses or flus.
However, remember that at this stage there is still a danger of over-modeling, overthinking and spurious accuracy, with not enough data or knowledge to support more complex models.
Rethink mortality assumptions
Look at the stresses and combinations of stresses that you are running on your models. How did any pandemic modeling you carried out compare to actual COVID-19 results and would it have protected you in previous pandemics? Or should the stresses be higher and more explicitly targeted?
In terms of solvency, it’s important to gauge how well your stochastic and stress tests on models actually protected your company. What’s more, could you have survived any additional shocks after the initial market falls in March? By focusing on reverse stress testing, you can uncover any hidden risks and vulnerabilities that may also cause insolvency.
Assess stress testing
Regulation has traditionally led insurers’ robust approach to solvency, with Solvency II driving stronger governance and control of modeling results. Now, critically, insurers must look deeper and consider all of the aspects of their solvency models that haven’t worked as well.
You must also ask yourself serious questions about the changing nature of the workplace in the pandemic. Will what started off as emergency lockdown measures become a more permanent shift and keep many staff working from home or remotely more often? Should cloud computing and SaaS-based platforms form part of your protection against future challenges to business continuity?
Review the resilience of your solvency platform and framework
Despite the combined influence of SFDR, TCFD, EU Taxonomy, CSRD, NFRD and other noble forms of governance, the process is only in its infancy. Indeed, it will take coordination among governments, regulators, banks, managers, investors and corporations to harmonize a globally recognized set of ESG standards.
In the UK, the Stewardship Code of 2020 has helped define standards of conduct for asset owners, managers and service providers. It offers a framework for responsible allocations, management and oversight to create long-term value for clients, while also benefiting society and the environment. The code recognizes the diverse approach of firms striving to meet the standards without compromising individual business models or strategies.
However, where high ESG standards are imposed, firms can also be put at a disadvantage when competing for deals. A framework of incentives will need to be developed to create a culture of inclusiveness, where larger organizations are incentivized to help smaller players, and governments provide fiscal advantages to firms attaining certifiable green status.
In private markets, managers will be called upon to support smaller portfolio companies in capturing data, building sustainability programs and delivering meaningful reports. The “carrot and stick” incentives may also include links to executive performance and pay, improved market pricing, pricing concessions, tax benefits or additional charges and penalties for non-compliance.
Working Better Together
Given that most of the industry still operates in silos, greater coordination is needed to establish commonly acceptable goals and standards that serve all participants. Several recent actions suggest that the industry is already moving in this direction.
The International Organization of Securities Commissions (IOSCO) issued a disclosure covering matters of greenwashing, potential regulatory approaches, policies and practices on how to potentially achieve convergence on climate risk and ESG standards. The work offered a basis for recommendations on data and provider ratings, along with educational initiatives to bring more players into the mix.
The Sustainability Accounting Standards Board (SASB), a U.S. non-profit organization, and the International Integrated Reporting Council, formed the Value Reporting Foundation to help set global standards for ESG reporting and measurement methodologies.
The SASB and the International Integrated Reporting Council (IIRC) joined with the Carbon Disclosure Project, Climate Disclosure Standards Board and Global Reporting Initiative to set a new standard for climate-related financial disclosures.
The International Financial Reporting Standards Foundation, which oversees the International Accounting Standards Board, also published universal sustainability reporting guidelines intended to pave the way for a non-financial audit and assurance framework.
Despite the progress, challenges remain. Standards between general and limited partnerships on ESG reporting have yet to be harmonized. As investors continue to develop their own internal methodologies and metrics in the interim, often at considerable cost, conformance to any standard will be met with some level of resistance.
Risk Management
ESG and factor investing as satellites: danger of “optimized island solutions”
Source: Northern Trust Asset Management’s “The Risk Report”. Provides insights gained from analyzing hundreds of institutional portfolios totalling more than US$200 billion in assets over the past 4 years. October 15, 2020.
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Compensated factor risk
Stock selection risk
Uncompensated risks
21%
23%
35%
29%
25%
19%
14%
45%
46%
49%
45%
42%
49%
41%
34%
40%
28%
36%
22%
31%
27%
All Institutions
Endowments
Insurance
Corporate Pensions
Financial Services
Family Offices
Public Funds
Nearly 50% of active risks in institutional portfolios are “uncompensated“
The Need for Regulatory Standards
That said, some firms may be treating the COVID-19 pandemic as a black-swan event because they hadn’t allowed for it in their risk models. While it’s these insurers that most urgently need to take a closer, more critical look at their risk management processes, it’s down to every organization to think beyond COVID-19 and model truly extreme, black-swan events.
By definition, however, the COVID-19 outbreak is actually a white-swan event: not the first of its kind and therefore predictable and actually likely to occur at some point.
When it comes to capital management, you need to know that your reserves can withstand the very worst-case scenarios: extreme, black-swan events that would otherwise cause insolvency.
But many of the assumptions that make up risk models
are best estimates.
Green credentialing in international markets will hinge on reliable data. Finding a reliable source of quality data to measure non-financial performance will be the key.
Even the largest, most sophisticated investor groups struggle to effectively gather clean data surrounding carbon impact. With portfolios spanning many positions across multiple assets, regions, vehicles and business lines, getting to the truth will not be easy.
There are limitations in accessing private markets’ data. Some data sets are entirely unstructured, posing further challenges to measuring performance. And while some performance criteria may be relatively simple to measure, such as the use of carbon emissions on climate impact, others can be more difficult to quantify, such as a firm’s climate change mitigation plan.
With each industry presenting its own unique features and characteristics, there is no single, consistent, standard metric by which firms can report, measure and compare compliance.
It will take ESG benchmarks to initially define the standards but this is only the start. Mapping ESG performance to specific UN sustainable development goals (SDGs) will require a broader environmental and socio-economic perspective. Managers will have to report non-financial criteria impacting the financial value of an asset before ESG investments are viewed as attractive alternatives in competitive markets.
FALSE
TRUE
YOU’RE RIGHT!
TRY AGAIN!
There is no standardized approach to ESG investing.
Good Data Holds the Key
With so much information available, there is arguably a danger of being overwhelmed by data. Selecting the right source and utilizing the right tools will go a long way toward making better decisions. But to avoid misconceptions and misrepresentation, several issues must be addressed before an accurate scoring system can be put in place. These are:
Ensuring relevance and consistency in reporting frameworks for ESG disclosure
Improving alignment with materiality and performance
It’s a tall order for even large firms to embrace, which leads to the next major consideration - cost.
Transparency of ESG product alignment with sustainable finance objectives related to financial and social returns
Opacity of subjective elements in ESG scoring
Public and regulatory engagement
Evolving Investor Requirements
We’ve moved to a crucial time in our demographic cycle where social and environmental responsibilities are driving investor decisions. Climate change and the protection of ecosystems is a global language and it’s here to stay.
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Global Chief Operating Officer,
Sustainable Investing, Citi Global Wealth
Nikhil Chouguley
of consumers think companies should actively shape ESG best practices.
Source: PwC 2021 Consumer Intelligence Series
0
%
In some respects, the way in which the ESG landscape is evolving serves larger, more established firms, and to the detriment of smaller ones. There is a huge cost to accessing, storing and leveraging data to meet regulatory and investor requirements. In public markets, where data is somewhat commoditized, the cost of compliance is lower. But in the greater private market, managers do not enjoy a level playing field.
Large intermediaries can form working groups to guide industry practice and regulatory engagement, which creates bias against smaller firms in need of support. Until adaptable standards are developed that recognize such constraints, emerging and niche managers will continue operating at a disadvantage.
Managing the Cost of Compliance
Many managers overstate or misrepresent their green credentials to gain a competitive edge in the current market; the incentive to do so is certainly there.
According to Bloomberg Intelligence, global ESG assets will reach $53T by 2025, representing over a third of the global Assets Under Management (AUM).
Morningstar reports investments in sustainable products at a record high in Q4 2020, with Europe accounting for 80% of the flow, followed by the U.S. at 13.4%. A record high 196 new sustainable fund offerings in the same quarter brings the global total of such funds to 4,153. Given the current state of ESG investing greenwashing has become common.
Examples of greenwashing include vaguely stating or misstating organizational buy in, lack of information regarding metrics or overstating the magnitude of impact. As well, firms with a strong ESG marketing message tend to draw attention; seeking a positive public image without substantiation has become all too prevalent.
A ranking of 75 leading global asset managers in 2020 revealed that while all 75 were signatories to the UNPRI, 51% showed little evidence of ESG integration across assets, suggesting that many use the initiative as a “tick box” exercise.
Such lack of consistent data, ESG standards or performance metrics can undermine investor confidence and lead to reputational damage or even litigation. As long as there are no harmonized regional or global standards that can be independently audited – some framework for transparency, consistency and oversight – firms with the most marketing firepower most often will dominate. That is, unless regulators prevent it and ensure accurate reporting and also develop harmonized standards.
As investors become more sophisticated, building a comprehensive ESG review criteria that holds managers to account and calls out misleading statements, is vital to establishing a level playing field going forward.
FALSE
TRUE
correct!
TRY AGAIN!
It is easy to measure and monitor ESG performance.
The Matter of Greenwashing
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In consultation with Financial Conduct Authority’s Climate Financial Risk Forum (CFRA), the UK Department of Work and Pensions (DWP) is taking steps to improve governance and reporting activities relative to climate risk. Obligations for UK pension schemes reporting over £5B in assets are effective October 2021, raising accountability levels to new heights.
Further, as socially driven millennial investors increasingly participate in family and wealth management decisions, managers will be expected to include ESG and sustainable criteria in supporting investment recommendations. A 2020 UBS Global Family Office Report revealed that 60% of families now regard sustainable investing as important for their legacies, and 39% of offices intend to allocate most of their portfolios sustainably over the next five years.
The level of involvement across markets depends largely on access to data and improved transparency to bridge the public-private ESG gap. Listed equity and fixed income markets have benefitted from data, tools and services provided by advisors, vendors and ESG rating agencies, accelerating their adoption of consistent data collection and reporting standards.
But in private markets, independent climate risk solutions are limited. Gathering, structuring and organizing the vast amounts of private data required to report progress hinge on improving the toolsets.
Private companies make up more than 90% of global business. That said, the UN Principles of Responsible Investment (UNPRI) initiative has advanced adoption of ESG standards, adding 262 firms in Q3 2020, boosting the total of number of signatories worldwide to 3,300.
The real test will come when demands for ESG considerations increase. Complete due diligence and investor reporting requirements have yet to take effect as measurable ESG impact metrics remain unclear.
According to a 2021 Limited Partner (LP) Perspective Study from Private Equity International, 88% of investor LPs accounted for ESG considerations as part of their due diligence, compared with 80% the prior year. IHS Markit’s LP Footprint Project, analyzing 163 LPs across Europe, North America and Asia found that 63% of LPs researched have public ESG policies, 59% have signed on with PRI, and 40% publicly publish annual ESG reports.
The pressure is on for private market managers to adopt ESG standards, differentiate their offerings and provide portfolio transparency through impact reporting. As a more harmonized set of standards emerges, more firms are expected to enhance their portfolio monitoring and reporting with ESG and climate-risk management processes.
net U.S. sustainable fund inflows in Q1 2021. Source: Morningstar
Evolving Investor Requirements
Demonstrating how sustainable investments not only achieve non-financial aims but also enhance a strategy’s risk-return will be a key to achieving ESG and climate-oriented goals in the future.
21.5B
Founder, Reframe Capital
Benjamin Lamping
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Different Rules for Different Asset Classes
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ESG Regulatory Landscape – Global
Fund Managers Advisers / DPMs Insurance Banks Corporates Sovereigns
Product Regs
Prudential Regs
Disclosure Regs
europe / UK
americas
asia
SFDR
NFRD / CSRD
MAS ESG Guidelines
SEC Risk Alert - Greenwashing
EU Green Bonds
EU Taxonomy
AIFMD / UCITS
HK – ESG Circular
MiFID
Green Lending
CSRD
EU Taxonomy
TCFD
PRA Climate Risk
EU Pillar 3
SP/Derivatives
Data
Type of Firm
all of which are heightened with a remote workforce.
scalability
security
governance
Not only were largely office-based infrastructures under extreme pressure, but the pandemic also raised concerns about:
Europe, Asia and the Americas stand at different yet evolving positions on the ESG regulatory map. Product, prudential and disclosure regulations tend to skew heavily toward the prevailing local view of climate change and sustainability, with Europe being the strongest advocate for ESG investing and the Americas lagging until most recently.
In Europe, Sustainable Finance Disclosure Regulations (SFDR) are already impacting portfolio management regarding fund products and discretionary strategies. EU taxonomy is the technical language demarking industrial activities which meet the EU’s standard on environmental and social objectives.
MiFID has also evolved to integrate ESG and sustainability elements, affecting alternative fund managers in-scope of Alternative Investments Fund Management Directive (AIFMD) specifically, while mutual fund managers must answer to the Undertakings for the Collective Investment in Transferable Securities (UCITS) regulatory framework in Europe. Companies affiliated with a stock exchange in Europe will be required to report under the Non-Financial Reporting Directive (NFRD) / Corporate Sustainability Reporting Directive (CSRD). Whilst in the U.K. such listed companies and in-scope financial organizations are required to report key metrics aligned with the Task Force on Climate-Related Financial Disclosures (TFCD).
In APAC, cooperation among governments, regulators and investors is fragmented. In Japan, institutional investors are starting to address ESG and climate-related initiatives, while in China, new emission targets are shaping investments after President Xi’s announcement to achieve net-zero status by 2060.
The U.S. having only recently rejoined the Paris Climate Agreement, is still behind Europe and Asia. North America particularly will be more heavily influenced by regulation than investor behavior to change, while in Latin America, progress lacks due to the absence of governance reforms, industry standards and a limited market for sustainable investments.
The Global ESG Regulatory Landscape
To learn more, visit our dedicated Regulation and Risk website, or our Trading website. Alternatively, speak to one of our solutions advisors on email getinfo@fisglobal.com.
Let’s Solve Climate and Sustainability Risk
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for actuaries to navigate – and luckily,
a lot more computing power to manage it all.
& complexity
information
As we enter 2021, there’s a lot more
As the world of climate science and finance enter the same arena, fund managers, advisers, banks, corporations and sovereigns would all do well to recognize the risks and rewards.
Climate change, sustainability and environmental, social and governance (ESG) regulations are driving global investment firms to rethink their approach for growth. Indeed, with the expanding green movement and rise of eco-conscious millennials participating in global markets today, firms risk losing all credibility if they don’t scale toward a demonstrable, sustainable finance model.
In a recent FIS webinar ‘Climate Risk and Sustainability Risk Measures in Investment Strategy,’ a panel of industry experts discussed the emerging trends in sustainable finance and how firms can integrate ESG compliance with traditional investment strategies. The panel included:
Managing Director,
Alpha Centauri Investment Management
Ulf Füllgraf
Founder,
Reframe Capital
Benjamin Lamping
Global Chief Operating Officer,
Sustainable Investing, Citi Global Wealth
Nikhil Chouguley
A New Investment Climate
TCFD
TCFD
