How are ESG issues impacting the wealth management sector today? What has been achieved so far, what are the opportunities and threats, and what is still to be done?
In 2020, according to the World Economic Forum, nine out of ten global economic risks were linked to environmental aspects. If this institution sees these as the most likely factors to impact the shape the future of the world, then it is safe to assume that it will shape and influence investments strategies too. This is the rationale behind placing ESG at the center of today’s risk management approach for tomorrow.
Sustainable investments that, in addition to traditional financial parameters, take into account various ESG criteria, have experienced impressive growth in the last few years. So, while ESG has been around for quite some time now, the importance of ESG investing has recently come to the surface for a wider audience. The European Green Deal and climate change awareness are both factors that have created a new perspective to investing, where ESG is either added as an additional risk metric or is used to be compliant with the client’s sustainability preferences.
Today asset and wealth managers no longer face whether to take into account the above-mentioned sustainability criteria in their investment process, but rather how to do it consistently and accurately.
The EU Sustainable Finance Disclosures Regulation (‘SFDR’) Taxonomy regulation comes with two main articles which are related to product disclosures:
- Article 8 of the SFDR applies to financial instruments which promote environmental or social characteristics.
- Article 9 of the SFDR applies to financial instruments which have sustainable investment as their objective and a specific category that has as objective the reduction in carbon emissions.
Where to start with including SDFR into the investment process?
Let’s first look at how sustainability has been incorporated in the past, as many banks and financial institutions have been factoring in sustainability for a long time now. The most common way to date has been via the inclusion of an indicator at the financial instrument level, which was present in the EMT template section Client Objectives and Needs since 2019 - the so-called ‘Intended Compatible With Clients Having ESG Preferences’ flag. This is a first step and a simple way to allow both client profiling and instrument classification to include ESG in the investment process.
As of 2021, this has been replaced with an instrument characteristic: ‘Intended Compatible With Clients Having Sustainability Preferences,’ where next to ESG, additional and more general sustainability objectives could be captured. The above possibilities scratch the surface of including sustainability in investment decisions.
Pitfalls
From this initial foundation, what is now needed is a deeper and broader notion of sustainability, and this is where ESG scores and ratings come into play. With this, ESG information is issued and harvested from companies on a recurring basis. This has been done already, as large ESG data sets can be obtained from commercial data providers; however, we see several pitfalls in this approach.
First of all, the companies choose what they disclose. This naturally creates conflict, as no company wants to have a bad score, whether it’s ESG or Credit or NPS score.
Secondly, the information provided by companies is used by data providers in their proprietary ESG scoring, and rating frameworks, which means comparing results from different providers is extremely difficult.
Thirdly, the information is somewhat outdated, as company reports are issued yearly. As sustainability goals and objectives have tight timelines, the lag in frequently updated information hinders the process. To overcome this pitfall, new players in the News and Social domain are launching near-time ESG insights. Social information is quick but can be biased, and therefore the trust levels on information via social channels can be low.
The way to overcome these pitfalls is through regulation and reporting standards, which is never a quick route. Still, as investment management is largely built around trust, it is the only way to keep faith in ESG initiatives.
Extra indicators from 2022
Besides these pitfalls, the next evolution in this domain is the inclusion of ESG and Sustainability impact information in European MiFID Template (EMT) 4.0. Fifty quantitative disclosures will be added, which include a core set of mandatory indicators and additional environmental/social factors to assist in identifying other impacts.
Indicator examples are:
- Carbon footprint
- Natural species and protected areas
- Energy consumption intensity
- Deforestation
- Insufficient whistleblower protection
These changes will broaden the scope of client preferences within the investment decision process. Not by accident, this nicely falls together with the trend of hyper-personalisation.
Next Steps
Banks and other financial institutions will have to assess how to efficiently start using or extend the usage of sustainability information.
To begin with organisations, the following steps should be considered:
- Make policy decisions that shape a compliant framework around SDFR, including the level the firm wants to offer sustainability to its clients. • Assess which products are in scope for articles 8 & 9.
- Determine the data needs and providers available to fulfill the needs.
- Organise internal processes and responsibilities required to meet the disclosure requirements.
- Select the right software package to implement the policy & data, including sustainability impact assessment for portfolio and reporting requirements
What solution(s) does your company offer the market that addresses ESG issues, and how do they help wealth management firms manage their increasing obligations in this area?
The Objectway Wealthtech Suite supports the entire sustainable investment lifecycle. The supported lifecycle contains the following high-level circular steps:
- Capturing client ESG preferences via client profiling
- Integrating multiple data sources to assign ESG score
- Suitability evaluation
- Suitability what-if scenarios
- Real-time sustainability monitoring, and
- Reporting disclosure including ESG
Client Profiling
Collecting client sustainability preferences through a specific ESG questionnaire, in addition to the traditional one, is fundamental to acquire information that is sufficiently granular and consistent for a thorough suitability assessment. The captured needs and preferences of the client should be used for suitable model and stock selection, for example, when an investor doesn’t want exposure in high ESG rated stocks or an investor wants to have a cap of 25% of their portfolio in medium and high ESG rated securities.
Data Sources
Implementation of reliable, traceable, and robust data is essential to properly manage ESG components within an investment process. This data then requires elaboration through a data quality system to allow, for example, customisation management of the issuer's rating construction. ESG data available from data providers comes by way of ratings and scores: the ratings can be used in exposure calculations, and the scores in portfolio ESG compounded scores.
Suitability Evaluation
ESG integration within the MiFID II models requires the definition of specific controls in addition to those already required for the adequacy and appropriateness checks. This means incorporating a set of suitability controls that are both MiFID II and ESG compliant. The suitability rules are automated, and breaches of ESG thresholds are flagged in real-time monitoring.
The evaluation includes, for instance:
- Improvement or decline in overall portfolio sustainability
- Weak ESG areas in the portfolio, which are subject to recommendation
- Matching of ESG areas to UN Sustainability Development Goals (SDG)
- Evaluation of the 50 core and additional indicators in peer groups and portfolio segments
Suitability What-If
Functionality that provides predictive ESG measures assists in the portfolio’s diagnosis and the execution of actions aimed at the automatic generation of an optimal portfolio in terms of risk and ESG through the generation of higher quality investment proposals.
The recommendation process and semi-automated investment proposal generation is a step where hyper-personalisation can add real benefit. Depending on the level of sophistication in the client preferences, some self-learning algorithms are used to give the best possible recommendation to the client and then the STP execution of the recommendation via market orders.
Real Time Sustainability Monitoring
A sustainable book of business requires the execution of automated checks and controls. This includes, for example:
- Client preferences on ESG vs actual investments in portfolios
- Company investment policy on exposure levels in ESG scores or ratings
- Change in instrument ESG rating or scores
- Change and impact on ESG Controversy or ESG Social scored
Customer Reporting
Updating clients on the alignment of their portfolios with ESG criteria and adopted investment choices, in addition to complying with the transparency regulatory requirements, aims to show the benefits arising from the ESG integration.
ESG analytics can be included within such reports, for example
- Direct exposure to ESG ratings, ESG controversy, ESG momentum
- Indirect (Look Through) ESG exposures
- Historical evolution of ESG exposure
- ESG predictions based on historical evolution-
- Fulfillment of client agreements on ESG
- Portfolio and Client ESG score
Objectway’s Wealthtech Suite leverages leading-edge technology, such as cloud computing, and is designed with a set of open APIs returning all the information related to sustainability. These can be used in any eco-system where sustainability information is required to enrich the client experience or to include sustainability factors in decision-making processes.
This article was originally part of our Wealth Tech Views ESG Report. Click here to access the full report.
