Ben Goss: Three steps to manage ESG portfolio risks

Dynamic Planner's CEO says environmental and social risks are growing, which makes managing them and investor preferences a pressing priority

At the time of writing, coronavirus lockdown rules in England allow six people to gather in a public space

Last weekend, however, tens of thousands gathered in cities up and down the UK, emulating those in the US and around the world in protests organised by Black Lives Matter, sparked by the killing of the African American George Floyd by police. In Bristol, the statue of slave trader Edward Colston was pulled down and thrown into the harbour.

In February, as the coronavirus pandemic was building, climate activist Greta Thunberg came to the UK to speak to a rally of 15,000 people – mostly children, skipping school at a youth strike for climate change. A little over a year ago, the west end of London and many businesses were brought to a standstill for 10 days by Extinction Rebellion protesting the climate emergency and demanding the government bring forward its carbon neutral goal from 2050 to 2025.

Government action

Not only is the activist mood around the world on environmental and social issues growing but governments and courts are taking action and these actions are having significant financial impacts. In February, for example, the Court of Appeal ruled that plans for a third runway at Heathrow were illegal because they did not take into account the government’s commitments for tackling climate change and were not consistent with the Paris Agreement to reach zero net emissions by 2050.

The case, which was brought by a number of groups including Friends of the Earth, is set to be appealed by Heathrow airport, which is arguing that tens of thousands of jobs will be affected.

Again, earlier this year, the government agreed to consult on a pensions solution after an Appeal Court ruling that it had forced younger members of the firefighters’ and judges’ pension schemes to take less generous schemes.

Many more of those in the younger group of judges were female and/or from a black or Asian minority background and so claims were also pursued for indirect race discrimination and a breach of the principle of equal pay. The government estimates the cost of the judgement will be in excess of £4bn.

Nor is it just national governments that are taking action. The European Securities and Markets Authority (ESMA) has been consulting for the last couple of years on the inclusion of ESG risks and characteristics within the investment advice and management process.

‘Reorient capital flows’

The aim in part is to make sure that financial risks stemming from climate change, environmental degradation and social issues are well understood by managers and the end-investor and accounted for in the suitability of any advice given. However – and this is worth reflecting on – the primary aim of the action plan on sustainable finance adopted by the European Commission is to “reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth”.

At the Dynamic Planner conference earlier this year, the BBC’s business editor Simon Jack asked a panel of chief investment officers: “What happens when governments or financial institutions will not lend to or invest in companies that don’t meet sustainable criteria?”

Two years ago, the Bank of England set out what it called ‘transition risks’ – one example being energy companies. The Bank says that if government policies were to change in line with the Paris Agreement, then two-thirds of the world’s known fossil fuel reserves could not be burned. This could lead to changes in the value of investments in sectors such as coal, oil and gas. The move towards a greener economy could also impact companies that produce cars, ships and planes, the bank adds.

Sudden loss in demand

2020’s financial crash is showing what happens when companies suddenly, globally, see a loss in demand. It thus demonstrates how transition risk could manifest itself. State-enforced quarantines around the world designed to combat coronavirus shut down economic activity and transport with a negative effect on oil and transport companies. Those funds holding oil and transport stocks suffered accordingly.

Conversely, ESG funds without these exposures did better. Legal & General’s Multi Index and 7IM’s Balanced fund have, for example, both seen their ESG variants outperform their in-house peers over the last year to date. The funds have the same risk profile (5 out of 10), are run by the same management teams and have the same mandates except the ESG variants have the ability to invest in companies with stronger ESG credentials.

Both funds have outperformed the Dynamic Planner MSCI risk profile 5 benchmark over the last year. While not directly caused by environmental factors, the 2020 impact on portfolios is a good illustration of risks caused by exposure to two industries already under pressure from economies transitioning to greater sustainability worldwide.

Three steps

The risks attached to negative environmental and social impacts of investments are growing as global awareness alongside government and court actions force markets to take them into account. So how do you help manage these risks in portfolios? Here are three steps:

* Talking to clients about their values and the characteristics of investments they would like to see is the first step. While an industry wide taxonomy is still being developed, the Investment Association has done a lot of good work with the Responsible Investment Framework. Having a conversation with clients as part of your suitability assessment will ensure you understand what the client is looking for.

* Establishing a suitable risk profile and matching the portfolio to this profile becomes even more important as ESG risks come to the fore. Risk-based benchmarks such as the Dynamic Planner MSCI indices provide a comparison benchmark you can use to demonstrate the performance of their portfolio for the risk they have taken, rather than an unrelated headline index such as the FTSE All-Share.

* Selecting investments that reflect clients’ preferred ESG characteristics and which are matched to a suitable risk profile mean clients are not only more likely to gain the outcome they are looking for but they will do so in a manner that more reflects their values. When ESG risks do manifest themselves, clients and their portfolios should be better prepared.


Natalie Kenway

Natalie is editor in chief at MA Financial covering ESG Clarity, Portfolio Adviser and International Adviser. She was previously global head of ESG insight for ESG Clarity and has been an investment journalist...