Between armed conflicts, climate disasters, fast-fashion players involved in the forced labor of Uighurs, etc., financial players can no longer afford to consider the anticipation and monitoring of controversies an afterthought in their investment strategy.
A controversy refers to the involvement of a public or private issuer in ESG-related incidents. As with Orpea, which saw its share price fall by 93% in 2022, any controversy surrounding environmental, social or governance issues has a direct impact on a company's value. This in turn puts pressure on investors with positions in controversial assets: to mitigate reputational and financial risks, portfolio positions often have to be sold quickly, despite potential liquidity problems.
In the case of the Orpea controversy, asset management company Mirova decided to sell its 4% stake at a loss.
The risk exists in all economic sectors, with controversies occurring in varying degrees of frequency and severity depending on the industry: textile, food, real estate, IT services, etc.
Financial players have a fundamental responsibility not only to take controversies into account, but also to be able to anticipate them. Improper management of controversies can compromise the financial viability of a portfolio, and have a significant impact on reputation.
Most asset management companies implement a controversy monitoring process for these reasons, but also to remain consistent with their sustainability commitments.
There are currently no regulations requiring management companies to take controversies into account according to a specific framework.
Whether in Article 29 of the French Energy-Climate Law or SFDR regulations, no requirements on this topic have, to date, been defined.
Only the AMF (French Financial Markets Authority) mentions the subject in its DOC-2020-03 recommendation, stating that management companies with a focus on extra-financial reporting should adopt policies aimed at preventing and verifying controversies. However, this remains a recommendation, and no further details are provided.
On the other hand, it is worth noting that a growing number of labels are incorporating the treatment of controversies into their criteria:
From this overview, it is clear that more and more organizations are recommending that controversies be taken into account. There is, however, currently no framework specifying what needs to be included in a controversy management process.
As part of the 2nd part of its Sustainable Finance Barometer (to be published in January 2024), WeeFin has evaluated the level of transparency and ambition of asset management companies based on a sample of 75 ESG funds. One of the areas covered by this analysis is controversy management. The results show a genuine interest on the part of management companies in integrating controversies into their investment process, although practices are not yet sufficiently robust:
Anticipating controversial issues remains the best way to avoid investing in controversial activities.
Firstly, while the implementation of an ESG rating methodology, or the use of a proprietary method from a generalist ESG data provider, allows companies to be more easily compared with one another, aggregating multiple raw indicators into ESG scores inevitably leads to a loss of information. Moreover, the wide range of environmental and social themes within a score makes it difficult for investors to read and understand changes in the score. Selecting the most relevant indicators for each activity must therefore become a key point of ESG analysis for an investor.
Mastering granular data therefore makes it possible to anticipate controversies by pinpointing any potential cause for alarm: for instance, when turnover is high, when waste levels in the environment are rising steadily, when there are a large number of accidents in the workplace, etc.
Lastly, anticipating controversies can be achieved through engagement: an ongoing dialogue with invested companies can effectively help anticipate a potentially controversial sensitive issue.
Monitoring is the first necessary step to any controversy management process. It requires players to draw on a wide range of data sources, with diverse sources of information being key to minimizing the risk of blind spots.
Once the data has been collected, players need to analyze and understand it to correctly assess the likelihood and severity of a controversy. Understanding data means digging into the methodology of suppliers or sources to find out definitions, details on data points and coverage information (among other insights). This then enables the cross-comparison of data and its implementation in the controversy identification process.
To identify and anticipate controversies, management companies can draw on a wide variety of sources, including:
Data and controversy analyses should result in a classification. Depending on the methodology of the data providers, this classification may be based on controversy themes, levels of severity, risk of exposure to controversies, or any other means of prioritization deemed relevant by the asset management company.
This classification must be integrated into the strategy of the asset management company prioritizing the management of controversies with a certain level of severity or within a specific sector.
The escalation plan is a set of procedures set up to regulate the selected controversy, encourage the invested company to take corrective action, and divest should the situation not improve. An escalation plan may therefore include stages of dialogue initiation, dialogue reinforcement, monitoring, management procedures, right through to portfolio exit.
All these stages must be planned and set within a predefined timeframe. Similarly, the issuer's improvements or progress must be quantified.
This escalation plan is often closely linked to the engagement policy, as shareholder engagement and dialogue are invaluable tools for identifying and managing controversies.
In its policy, asset management company La Financière Responsable implements three levels of action when a controversy is detected. The company may remain in the portfolio without further action if the controversy is deemed to be minor, or it may be placed on watch or excluded from the portfolio if information on the controversy demonstrates its severity. These placement under watch or portfolio exclusion processes are well-defined within limited timeframes ranging from 3 to 6 months.
The asset management company can use controversy monitoring information to establish conditions under which it considers that the controversy no longer presents a risk, and that the escalation plan can be interrupted.
The asset management company must organize regular (biannual, quarterly) committees to discuss prioritized controversies and decide on specific actions to be taken.
These committees and any decisions taken must be recorded to ensure the auditability of the controversy management process.
Asset management company INOCAP Gestion has decided to present controversies rated as severe or very severe by its supplier MSCI to the committee. Moreover, if a controversy is detected via broker research or other sources of information, it is up to the ESG analyst to determine the level of severity of the controversy, which will be presented to the committee if it is deemed severe, very severe or if there are any doubts.
In addition, the asset management company must consider cases of conflicts of interest between the asset management company and the issuers that are subject to controversy, and prepare any necessary procedures should the situation arise.
To facilitate the implementation and application of a controversy management policy, the first step for asset management companies is to find the right tools.
The ESG Connect platform addresses this very issue by offering a module which is entirely dedicated to controversy management. Starting with the integration of controversy data, this module aims to support analysts and managers in controversy classification, analysis and decision-making. ESG Connect allows you to anticipate and manage controversies using all of the above steps.
Watch the video below for a demonstration of ESG Connect's functionalities.
