“Toto, we are not in Kansas anymore”
As Dorothy stepped out of her ruined house in Oz, she realised that she had gone from a dull, grey, black and white Kansas to a technicolour Oz. I am not sure how many people in the funds management arena realise it, but we are fast approaching a world where every exposure in their portfolio not only has a specific risk, but now has 13 different ESG risk factors. These will be aggregated on the individual ESG risk factor, and the portfolio on an aggregate basis will now be reported to their respective regulators. And this will undoubtedly become public information.
I appreciate that I come from a risk management background, but this note will not be about risk management. This is about data management, a daily hades for far too many in the risk management community. Whilst I intend to consider the risk management implications of ESG at a later time, lets first look at the data issues. Firstly, where will we get the data required in the legislation? For European companies (issuers of both equities and bonds) we are going to see a breakdown of turnover (and possibly Cap-Ex and Op-Ex) into the 13 categories, when the non-financial are compelled to comply with SFDR. For those companies not covered by the legislation (i.e The World ex the EC), a significant amount of work will have to be done by financial companies to estimate, in an objective manner, the information required to make them compliant with the SFDR. And then this information must be integrated with all the other exposure information of any given security in a portfolio. This is a significant problem and not one to be undertaken lightly. At RiskSystem we are working with Ideal Ratings[1], in order to give our clients access to a comprehensive set of SFDR data so that they ensure on-going compliance with the legislation across all of their funds.
However, the data issue is not just limited to data acquisition. There are also non-trivial issues regarding the treatment of derivatives, indices, collective investment schemes etc. As an example it is my experience, that things not dis-allowed, are effectively allowed. In initial guidance, contracts for difference, CFD’s are specifically considered in-scope for the SFDR. No mention is made of Total Return Swaps (TRS) or Credit Default Swap (CDS). There are a wide range of derivative products that give exposure to underlying issuers. These need to be considered properly and in a single integrated fashion, to identify what are in-scope for the SFDR and the correct methodology for determining their underlying ESG exposures. A sort-of CESR 10-788 (which dealt with the appropriate methodology for treatment of derivatives in a UCITS for leverage calculations) for the ESG age would be a much appreciated document from the regulators.
There is still over six months before this becomes a requirement. However, given the potential problems in acquiring a full data set and the assumptions that will need to be made to assemble and integrate the data, work should already have been initiated to understand the scope of the ESG challenge at each sub-fund. The long lead-in is important because only once you have a full data-set can the risk management implications of the ESG revolution even be considered, and these will not be trivial, given the tsunami of interest from legislators, regulators and investors.
[1] https://www.idealratings.com/

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