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Due Diligence Questions at the Dawn of the Era of Sustainability

Experts from Refinitiv, Panarchy Partners and Deep Learning Investments respond to audience questions on due diligence challenges following recent webinar.

Roughly halfway through moderating the recent webinar ‘Due diligence in the era of sustainability’, I realised two things. First, we probably should have titled the discussion ‘Due diligence at the dawn of the era of sustainability’, to better reflect the scale of the transition now being undertaken by firms in the financial markets and most other sectors on the economy. Second, we definitely should have allowed more time for questions, to accommodate the unquenchable thirst for information among the 1,000-plus audience who signed up to listen to our panel of experts.

Questions poured in, panellists shared their insights, thoroughly yet briskly, but our ‘hard stop’ left a number issues less-than-comprehensively explored – such is the breadth of the areas impacted and the depth of the interest shown. This article attempts to make some amends, by calling again on the expertise of our highly qualified and experienced panellists. But this time, they answer questions posed directly by CIOs, analysts, compliance officers and risk managers from diverse financial institutions, located across the globe, rather than those prepared in advance by me.

In part, the concerns expressed in the audience’s questions reflect the challenges highlighted in the original webinar agenda: the scope of the changes to the regulatory landscape; their impact on business processes for investors and their service providers; and the search for data sources and analytics tools to help teams make informed decisions and maintain compliance with rules aimed at ensuring environmental, social and governance factors are given their due weight.

Undoubtedly, a growing awareness of the need to invest and conduct business on a more sustainable basis is having a wide range of regulatory impacts across the finance sector. Central banks and prudential regulators, for example, have highlighted the need for banks, insurers and other major asset owners to fully reflect the potential impact of climate-related risks on their balance sheets.

Institutional investors are being expected to conduct more detailed due diligence when selecting their asset management and other service providers, and analysing the risks contained within their underlying investments. Corporates and asset managers are being requested to provide more detailed reporting and disclosure to shareholders and investors on a dizzying range or risks, often having to provide certain types of data for the first time. Some of the requirements are mandatory, some voluntary, and others on a journey from one to the other.

Exponential increase

No wonder there is strong demand for more information on how to handle the apparently exponential increase in regulatory and other reporting requirements in the era of sustainability. Elena Philipova, head of global ESG proposition at Refinitiv, insists that not everything has changed.

“The processes, partners and information sources which investors currently use to stay on top of the changing regulatory landscape should also be utilised to stay on top of regulatory changes related to sustainable finance as well,” she says. “A lot of regulation is currently in development. There are a lot of moving parts. As with other areas of compliance, collaboration is important.”

At the same time, it is important to understand the underlying aims of any major addition to the existing regulatory framework in order to operate successfully under it. Referring to the disclosure and taxonomy regulations under the EU Green Deal, Philipova says regulators are primarily looking to create a framework which provides the incentives and tools needed to enable investors to assess ESG risks.

“I don’t see these regulations being enforced with the aim of penalizing organisations,” she says. “The primary objective is transparency and standardisation. Right now, there are a lot of disharmonised approaches and definitions. The regulations seek to bring those methods closer together and improve data availability and transparency.”

Greater availability of information on the ‘real-world’ implications of capital allocation, financing and investment decisions beyond financial performance, will lead to action and accountability. The transparency provided by the new framework will change behaviour, driving capital toward sustainable investment opportunities.

“If the market does not shift itself, regulators will have to steer it via incentives or penalties. These might come in the form of carbon pricing or other forms of taxation, but there may also be opportunities for lower funding costs, which we’re already seeing in the form of sustainability linked-bonds, for example,” says Philipova.

Some webinar attendees wondered if this incentives-based approach to sustainability-based regulation would deliver change with sufficient speed, given the urgency of certain climate-related risks, suggesting a swifter move to punitive carbon taxes.

Munib Madni, founder & CEO of sustainability-focused fund manager Panarchy Partners, notes that the lack of international consensus has left a patchwork of approaches with “massive” differences between national carbon credit schemes.

“But there has been progress through other means,” he says. “The EU Green New Deal includes new standards for the energy efficiency of new buildings, which has parallels in other countries, including Australia, which are driving change in use of materials and resources across multiple sectors. Carbon taxes are often seen as just a way for governments to increase revenue, but a lot can be achieved in heavy-emitting or polluting industries through new standards, whether agreed at an industry level or imposed by legislation.”

Balancing outcomes

The differing pace of regulatory change across jurisdictions is just one of the challenges thrown up by the migration to a more sustainability-led approach to finance and investment. There is, of course, a compelling need to factor in a wider range of considerations, but this ESG integration exercise require firms to consider multiple business processes and relationships in a new light. When taking greater account of the environmental and social impacts of existing investments, for example, how does one balance potential negative outcomes? The incremental withdrawal from existing investments raises the question of stranded assets, admits Madni, many of which will have social liabilities.

“During this transition period, asset owners may increasingly look for risk analyses from asset managers or investee companies which model the social and environmental impacts of keeping a mine open, for example,” he explains. “As a condition of their continued support, investors might look for a mine operator to provide alternative job avenues for workers as operations gradually wind down, perhaps also involving governments. This also applies to plantations which are causing deforestation but providing employment; solutions will require inputs from policy-makers, not just asset owners.”

The challenges of transition vary across departments, business models and investor types. Whilst regulatory obligations may differ, just as important may be governance and ownership structures, as well as access to resources. These can limit an entity’s ability to thoroughly research the exposures to ESG risks implicit in investment or other business decisions, but may also yield greater flexibility or focus.

Prompted by an audience question, Rajeev De Mello, chairman of the Investment Management Association of Singapore’s Development Committee, addresses the challenges facing family offices. “Many family offices see the transfer of wealth to the next generation as part of their mission and seek to invest in a way which reflects their family values. They also have more freedom than other large investors to make trade-offs between returns and ESG-related investment goals,” he observes.

“But a typical family office may not have the resources or scale to drive change at investee companies or even implement change in their own investment strategies without external help from large wealth management providers. Nevertheless, they could work with a niche provider on an area of personal interest, such as ocean pollution,” says De Mello, also Managing Director at Deep Learning Investments.

It’s not only family offices which face resource constraints. All firms are weighing up the extent of due diligence required to fully ensure ESG risks of investment, financing or business are understood and managed. Refinitiv’s Philipova sees this as an evolution of existing practice.

“In our current due diligence processes, we ask questions to help us assess the financial stability of our partners and stakeholders,” she notes. “By not asking for non-financial information to assess the risks resulting from those ESG-related issues and externalities we are closing our eyes to a huge risk pool that could have significant implications on the ability of those firms to thrive or even exist in the short term.”

In this respect, integrating ESG into investment and other decisions is a realisation of a shift in the types of risks we all face. “Now, the vast majority are grouped under sustainability-related themes,” she says, pointing out that the top five risks in the World Economic Forum’s Global Risk Report for 2020 were all environment-related for the first time.

Closing the data gaps

Questions of data inputs inevitably lead on from acceptance of the need for a wider perspective on due diligence. In the areas where regulatory and investor focus has been most intense, such as greenhouse gas emissions, progress has been significant if not yet sufficient.

The lack of disclosure to date on scope 3 emissions has hurt our ability to have a comprehensive understanding of the key risks faced by a number of industries, says Philipova. “Non-comparable information makes it harder for firms or their investors to properly assess or manage the risks,” she adds. “European sustainable finance regulatory texts already reference scope 3 data disclosure, meaning more companies will have to capture and report it more accurately. Also, data providers such as Refinitiv are developing proxies to quantify scope 3 impacts, covering production, distribution and consumption-related emissions. Within the next few months, I expect a great improvement in data availability and estimate models for scope 3 emissions.”

As well as carbon footprint, measurement is getting smarter in areas such as water usage, energy intensity, waste disposal and production circularity, says Madni, asserting that firms now need to move beyond monitoring and start managing more proactively.

Nevertheless, he accepts that even the best-resourced fund managers and investors cannot conduct granular supply chain analyses on every firm in their portfolio, nor perhaps should they. After all, you don’t check the accounts of every branch of every firm you invest in; you rely on the auditors. “One of the things we ask for is a firm’s organisational structure to understanding where the buck stops for sustainability issues,” he says. “Is the CEO or CFO on the sustainability committee, for example, or are they so far removed they can later claim ignorance on a particular issue?” Madni argues that fund managers should look at whether the board of directors and c-suite have skin in the game and understand the organisation infrastructure behind sustainability claims. Then, look at pay structures to see whether the c-suite are incentivised or penalised in relation to monitoring and managing ESG outcomes. “At that stage, you can then begin to look at the materiality of their ESG issues, including with reference to their supply chains,” he says.

Armed with decades of experience as a fixed-income investor at firms including Pictet and Schroders, De Mello points out the differing but no less challenging issues facing bond investors when looking to conduct ESG-related due diligence on their portfolios. Typically, bond investors are looking to spread risk over a wide range of instruments, meaning engagement and coverage are both challenges. They naturally have a long-term outlook, which lends itself to a sustainability-led approach, as they look to avoid not only default events, but risks which could cause damage to returns through widening spreads.

More so perhaps than equity investors, they are highly reliant on external data sources, informing in-house analysis with a ‘bedrock’ of data from credit ratings agencies for credit scores and now specialist ESG providers for ESG scores.

“Insufficient coverage can be a problem. A bond fund portfolio manager who is looking to fill a diversified portfolio with names in specific sectors, currencies and countries may struggle to source ESG ratings at the scale he or she requires,” says De Mello. “A further problem is the difference in views that can often be reflected in the ESG scores of different providers. Of course, there are differences between credit rating agencies too, but the level of dispersion between ESG scores is very large, as organisations including the IMF have noted.”

The use of third-party data has compliance implications too, notes De Mello. If investors are deciding between funds based on their ESG scores, a fund manager’s compliance officer needs to ensure any internal scoring mechanisms are comprehensive, precise and properly documented. And if a fund is being marketed on the basis of an external source, then questions arise about how that provider was selected and the nature of the due diligence and documentation. “The processes used by ratings agencies to provide credit ratings have a clear and demonstrable track record in predicting downgrades and default, they are highly regulated, especially following their role in the global financial crisis, but that’s not yet the case for providers of ESG scores, whether third party or internal,” he observes.

Alternative sources

Partly driven by the need of firms to respond to regulatory developments, the pace of innovation among data providers shows know sign of letting up. There is great interest – not least among webinar attendees – in the potential of alternative data, using digital technology breakthroughs to offer new perspectives. Refinitiv’s Philipova says alternative data sources can provide additional insights and signals, potentially providing a more comprehensive view of an entity or asset or investment opportunity, thus ending valuable support during the due diligence process.

“Geo-spatial data is currently not able to serve the investor use cases at scale,” she notes. “But there are some important insights that can be obtained from such data sets which are not available via conventional data sources. It can enable us to map physical assets, e.g. facilities, buildings, properties, mines etc. to environmental risks, such as flooding, and fires, and more broadly speaking help due diligence process to be more targeted in terms of potentially material risks.”

Philipova sees regulation largely as a response to data gaps, but asserts that pressure from the market – and asset owners in particular – has been the most powerful force to date in closing such gaps, and urges stakeholders to redouble their efforts, through engagement with partners and providers.

Stakeholders will continue to have questions as their due diligence processes evolve in step with the changes wrought by the era of sustainability. The challenges should not be under-estimated, but it’s important also to recognise the upside, says Philipova.

“With such a transformative and fundamental shift in the economy, there will be a lot of opportunities,” she observes. “These regulations are not designed to increase burdens and costs. Their aim is to enable markets to flourish and grow and deliver the economic, social and environmental stability and prosperity that we need.”

The webinar was held on September 30 and co-sponsored and hosted by Refinitiv and Regulation Asia, sister publication to ESG Investor.

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