This article provides an overview of the different processes one can set in place to ensure compliance with the SFDR's requirements on the consideration of sustainability risks, as specified in Article 3 SFDR.
SFDR's requirements relating to sustainability risk require financial market participants (FMPs) to disclose information concerning their firm's policies on the integration of sustainability risks in investment decision-making processes.
As a result, meeting this requirement is contingent upon the firm integrating such sustainability risks into their processes in the first place.
Complying with this requirement is therefore going to vary in effort as this depends on your current inclusion of sustainability risks.
You will need to either draft or update a policy for the incorporation of sustainability risks into investment decision-making processes.
Second, you need to begin implementing that policy. This requires assessing the likely impacts of sustainability risks on the returns of your investment products through the use of various tools of integration as designed in your policy.
Finally, the third and final step towards compliance consists in publishing the necessary disclosures on the incorporation of a sustainability risk policy on your website.
What should be included in a sustainability risk policy?
Typically, firms include between three to four steps to address and incorporate sustainability risk into the various stages of the investment process. The specific steps are designed and described in the Sustainability/ESG Policy.
During the conception of such a framework, you will have to decide on which risk assessment tools you will be incorporating, and at which stages of the investment process. Usually, the three to four steps are the following:
1) Exclusions in the Screening Stage:
An Exclusion list usually contains economic activities that will never be considered to be included in a firm's portfolio. These vary per preference of the firm, but there are some activities that most firms can agree on:
i) Human rights denial
ii) Forced or child-labor in supply chain
iii) Destructive weapon manufacture
iv) Production of illegal products
v) Fossil fuel activities
vi) Production of tobacco, gambling, adult entertainment, and palm oil.
An exclusion list is mandatory for everyone as a minimum step towards
sustainability risk consideration.
2) ESG Assessments in the Due Diligence Stage:
Before a potential company of interest is added to a firm's portfolio, it usually undergoes a range of screenings. A part of these screenings needs to be an assessment of the company on ESG risks in general, and/or on specific risks your firm has identified as relevant.
In addition, policies need to be set in place for analysts to be able to engage with portfolio companies (PCs) and to use the information these companies obtain for analysis.
ESG due diligence screenings are recommended for entity-level.
3) Monitoring, Engagement and Risk Management in the Ownership Stage:
The sustainability performance of the portfolio companies is often monitored by the fund in the ownership phase. Certain ESG metrics are set and reviewed annually.
In addition, and to further assist with their integration of sustainability risk-monitoring processes, your firm can engage with PCs by providing them with tools to assess the materiality of sustainability risks. This is achieved through the implementation of two tools:
A climate risk/human rights risk assessment for your PCs
a. For more information on climate risk assessments, please read this article
b. To learn more about human rights risk assessments, please consult this article
Conceiving an engagement policy to assist PCs in monitoring their risks, and where relevant to help them manage any significant risks. To find further information on how to build such policies, please consult this article.
Another tool for sustainability risk integration at this stage is to incorporate the latter into the risk management policy and ensuing processes for oversight.
These steps are good to include when you want to increase your ambition
of incorporating sustainability risk into your investment process.
4) Annual Reporting:
The performance of the portfolio companies across the portfolio are summarised in a report, which is usually reviewed by an independent third party such as a consultancy, and published annually. Within it, you disclose on the results of the monitoring on the sustainability risks (and other aspects of sustainability, such as the sustainability impacts (e.g., the negative externalities) of the PCs, and how you engage with them to make sure these risks are monitored and managed.
Sometimes, these reports also include an explanation of the likelihood of sustainability risks on the return of investment products. If a firm has properly monitored (e.g., through a climate/human rights risk assessment) and engaged with their carefully screened portfolio companies, these risks can be kept low.
To get an overview of what that entails, you can find examples of sustainability reports of varying nature, this article.
If you decide to engage on monitoring risks with your companies through
risk assessments, it makes sense to disclose the results of those in an
annual report.
Hopefully this article helped you understand what incorporating sustainability risk entails for you as a fund manager and for your PCs.
After all of these processes are set in place, we will produce a disclosure explaining how your firm considers sustainability risks, and describing the various tools and policies set in place to ensure due consideration and management of those risks.
You will need to update this disclosure on your website, along with the Sustainability Impact and the Remuneration Policy Disclosures.