If ESG isn’t consistently understood, how do super fund CROs manage this growing risk?

Diverse investment portfolios span multiple asset classes, industries, and geographies - CROs must establish consistent policies and frameworks for the numerous risks this presents across the entire business, considering different levels of exposure and impact associated with each investment as well as non-investment activities. This is a complex enough task in its own right, however, it is being made exponentially harder by the fact that ESG is not consistently defined – or even understood – across the organisation.

Part of the challenge is that ‘ESG’ and ‘sustainability’ are broad, multi-faceted terms that are differently understood by different stakeholder groups. The terms capture a plethora of industry-based subtopics and risks and can be defined broadly depending on the lens through which they are viewed (e.g. financial, compliance). ESG is often applied differently at an asset or societal level, adding to the challenge of ESG management as asset-level ESG risks are quantifiable and organisation-specific, whereas societal-level ESG risks are more widespread and systemic.

A less appreciated issue is that individuals tasked with managing these ESG risks may not be directly in ESG roles, possibly underestimating the complexity or interconnectedness of ESG-related issues and risks. This is because they base their understanding of ESG on their own interests or experiences, making it difficult to manage whilst juggling other risks (e.g. financial, technological) as part of their remit.

While sustainability regulations are principles-based and require super funds to manage the relevant risks to their business, they provide neither specific guidance nor a sufficient level of detail in how to do this. There appears to be a conflict between what the regulations are trying to achieve and the expectations of ESG focused investors. While the regulations are designed for system level application and for the purpose of protecting member interests and returns, they do not provide detail in how to handle ESG-related risk, beyond the stipulation for super funds to consider ESG in strategy and risk management.

Strategies for effectively implementing ESG-related risk management

Effectively managing ESG risks requires integrating ESG considerations into the fund's investment decision-making processes and operations. This involves landing on universally agreed definitions, having appropriately skilled teams, conducting ESG due diligence and incorporating ESG factors into recruitment, investment analysis and monitoring. As they work through this process with the organisation, CROs and their first line of defense (1LOD) and second line of defense (2LOD) must keep in mind the need to strike a balance between managing ESG risks and achieving the fund's investment objectives.

It is the 1LOD’s role to manage all risks in accordance with the fund’s risk appetite and policies. For the 2LOD, their role is to design and develop appropriate policies and frameworks for managing risk in consultation with 1LOD, seek board approval and perform oversight of 1LOD’s implementation of policies and frameworks.

1. Define what ESG-related risks are in the context of the whole organisation

Super funds urgently need to agree on the material ESG factors impacting the sectors or countries in which they invest. This will help to prioritise (or even reduce) the list of ESG issues that could be considered for each investment. There may be a range of material factors that the market agrees will impact on a business’s performance. The materiality of other ESG factors will depend on the trustee’s investment philosophy, investment horizon, internal processes, risk appetite and performance targets.

 Having a clearer understanding of materiality, 1LOD will be better positioned to conduct a thorough ESG risk assessment and manage these risks in line with the fund’s policies. This may involve engaging with various departments, seeking input from subject matter experts and leveraging external resources to understand the broader ESG landscape.

 With a well-defined ESG risk matrix, ESG can be integrated into core risk management frameworks and practices by updating taxonomies, risk assessment processes, risk appetite statements and risk reporting mechanisms to explicitly include ESG factors. This way, super funds can ensure that these considerations are consistently addressed and monitored.

2. Build capability that supports a unified ESG strategy

Training and awareness programs are essential to achieve a unified, organisational understanding of ESG-related risks. These programs educate employees about the importance of ESG and provide guidance about how to incorporate ESG factors into business as usual and day-to-day decisions.

One key aspect of ensuring consistent understanding of ESG is to establish clear definitions and guidelines within the organisation. This may involve the following:

• Developing a comprehensive ESG policy that outlines specific criteria, metrics and goals related to environmental impact, social responsibility and governance practices.
• Defining clear ESG roles and responsibilities across the organisation. Establishing an ESG committee or working group to coordinate internal activities.
• Ensuring ESG is on the agenda at board and executive leadership team meetings.

3.  Acquire and use data to support decision-making

CROs play a role in ensuring that decision-makers have ESG data at their fingertips to support ESG risk management. Quality data is essential if ESG-related actions are to be robust and defensible – and have measurable outcomes. One important initiative to support this is developing a data dictionary for organisational ESG metrics that feed into annual reporting and ongoing monitoring of ESG progress.

Managing ESG-related risk when understanding is not fully disseminated across the organisation requires a multi-faceted strategy and approach. CROs and their lines of defense should focus on process, people, data and technology and, where needed, seek independent advice on how to build a robust ESG risk management strategy.

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These matters and other developments are discussed at Baringa’s CRO Symposium events attended by the CROs of some of Australia’s largest super funds. If you'd like to know more about this topic or Baringa's CRO Symposium, please contact us.