ESG Investing : bright future, but a timid present

Global pension funds and other large investors are moving their money to ESG (Environmental, Social, and Governance) investing. The Indian mutual fund industry has started rolling out ESG funds too. You need to be aware.

What is ESG Investing?

The ESG investing revolves around investing in companies that score high on three non-financial parameters — environment friendliness, social responsibility, and governance. The investments focus on companies that adopt environment-friendly practices, produce products or services that influence society positively, and conduct their business ethically. 

The E-S-G Parameters

Let us look in-depth at each of the E-S-G parameters that define the companies in which the money can be invested.

Environment Empathy (E)
The melting glaciers, rise in average temperature globally have brought before us the pitfalls of global warming. The fast reducing forest cover, major rivers getting polluted, and a higher presence of pollutants in the air are all examples of ways mankind is neglecting the environment. This has resulted in erratic rainfall, droughts, and flooding at the same time in different parts of a country. However, all is not lost yet. Measures such as switching to renewable energy, increasing green cover, better waste management, and pollution treatment are all ways in which one can protect the environment. ESG Investing focuses on companies that are directly or indirectly involved with helping us protect or enhance environmental parameters.

Social Responsibility (S)
For running their business, corporates draw raw material and manpower from the area in which they operate. While engaging with these resources, it is fair to expect the companies to handle resources in a fair, optimal, and in a socially responsible manner. The Companies Act, 2013 mandates spending 2% of net profits towards social responsibility causes. Many Indian corporates have taken up initiatives in protecting the environment, helping the locals by way of providing them with quality education and medical facilities. All of these paves way for an enriching cycle for all the parties involved. ESG Investing focuses on companies that are directly or indirectly involved with social initiatives.

Corporate Governance (G)
Corporate governance is all about integrity and honesty of the management. This aspect also has the potential to adversely impact investors’ wealth creation prospects in the long run. Market regulator SEBI has from time to time brought about regulations to be adhered to by listed entities. While some companies comply with the requirements in letter and spirit, there are others that comply only as a matter of compliance. History has time and again shown that strict adherence to good policies results in sustainable growth. ESG Investing focuses on companies that have a proven record for clear and honest corporate governance.

How are the ESG Funds different?

Typically, a mutual fund looks for a good stock of a company that has potential earnings, management quality, cash flows, the business it operates in, competition, etc.
However, while selecting a stock for investment, the ESG fund shortlists companies that score high on the environment, social responsibility, and corporate governance, and then looks into financial factors.
Therefore, the key difference between the ESG funds and other funds is 'conscience' i.e the ESG fund focuses on companies with environment-friendly practices, ethical business practices, and an employee-friendly record.

Available ESG Mutual Funds in India

Currently, there are three funds — SBI Magnum Equity ESG, Quantum India ESG Equity, and Axis ESG — following the ESG investment strategy in India. Fund houses such as ICICI Pru, DSP, Aditya Birla, Kotak, and BNP have also filed draft offer documents with SEBI and are awaiting approval.

The process to shortlist ESG Funds

While there are no strict norms on what constitutes ESG companies, each fund house follows different parameters to assign scores to companies on ESG to short-list stocks.
Most funds though exclude sectors that are deemed harmful from a social perspective such as tobacco, liquor, and gambling.
On the environmental side, the fund houses check for a company’s carbon footprint, emission norms, water consumption, waste recycling, and energy practices. As an example, bottling plants or the ones which pollute air or water are given negative weights or altogether excluded.
These funds also avoid firms with poor governance that have had regulatory issues.

For portfolio construction, fund managers tend to rely on SEBI mandated business responsibility report put out by listed companies which contain extensive disclosures about adoption levels of responsible business practices. Apart from this, fund houses have internal criteria with weights assigned to the various aspects of these criteria.

Companies with a total ESG score above a certain threshold qualify for investment. 

ESG Score

ESG score is a parameter to judge whether a company is environmentally and socially sustainable or not.
This score ranges from 0 to 100 weighting the performance average on the defining factors- Environment, Society, and Governance.
When the ESG score is high, it means that the company has been performing greatly and taking suitable measures for sustainability on these factors.
However, a low ESG score denotes that the company is not taking proper initiatives on these factors and thereby, is bound to undergo losses due to regulatory punishments, natural accidents, or environmental crisis.

Why ESG Investing is important?

ESG investing is all about investing ethically for our own financial wellbeing in the long run. ESG investing is based on the idea that only pressure from large investors can force the corporate world to behave responsibly from a social, environmental, and governance perspective. 
Secondly, factors such as climate change, shifts in societal preferences, and governance issues do pose risks to corporate earnings and thus to investors in stocks. Companies that are aligned with ESG norms usually have a lower risk of losses due to these factors.
Thus, investing in firms with a high ESG score is believed to translate into enhanced value for investors in the long run.
Good deeds are rewarded sooner than later. This applies to business and investing as well. If companies follow good practices, it will eventually translate to higher profits by way of brand building and customer patronage.
Any company which follows ESG over the long term is sure to emerge as a sustainable company. That is the reason ESG investing is also known as sustainable investing.

Index for ESG Companies

The Nifty 100 ESG Index is designed to reflect the performance of companies within the Nifty 100 index based on the ESG score. As a matter of fact, the Nifty 100 ESG Index has outperformed its parent index Nifty 100 across various timeframes.

The Nifty 100 ESG Index has delivered a compounded annual return (CAGR) of 4.6, 9.3, and 7 percent in the last one-, three- and five years while the Nifty 100 index posted 4.5, 7.8, and 6.4 percent respectively. As of January 2020, the Nifty 100 ESG had 88 companies spread across 16 sectors. Fours sectors — financial services, IT, consumer goods, and energy — accounted for 74 percent of the index.

An Example

One of the best examples of a socially responsible company is that of the Tata Group. A recent example is their initiative to provide rooms at the Taj Hotel for healthcare staff members who are at the frontlines of the Covid-19 pandemic. Also, their decision to serve food to the medical staff at their workplace moved me and several others to prefer Tata products over other products. Over the long run, all of these will result in better profits and more importantly brand loyalty.

Current ESG Challenges

Globally about $2.96 trillion has been invested in funds that are managed with an ESG focus. In India though, the concept is as yet nascent. As the data available on ESG firms is limited, fund houses have devised their own methodologies to screen for ESG and procure data. The challenge is that only the top 100-150 companies by market capitalization share enough data related to ESG.

Currently, given their investment mandate and limited investment universe, the ESG-compliant funds may be similar to existing ethical funds or those that follow Shariah principles to exclude sectors such as liquor and tobacco.

However, SEBI recently mandated that the top 1,000 listed companies prepare an annual business responsibility report (BRR) starting this year. A BRR has extensive disclosures about the adoption of responsible business practices by a listed company. This may eventually expand the investment universe for ESG funds.

Way Forward for ESG in India

With regulators becoming more stringent every day, the steps that a company must take to be ESG compliant is going to get more robust in the days to come. This included environmental norms and social impact. The regulators are going to be tough on those organizations that are not following the regulations and are sure to impose penalties. A significant advantage that an ESG compliant company gets is that they will be on the safer side when the regulators come up with even more stringent rules. These companies would be in a comfortable position as they have to take a few measures to meet the requirements than the non-compliant ones who have to start from scratch. Also, the scope for the ESG compliant companies to gain significant market share would be more as their non-compliant competitors would be struggling to comply with the norms. Being ESG compliant enhances the company’s credibility and reputation several folds and is sure to attract investors due to their sustainability.

Who should invest?

- Investors with a high-risk appetite
- Investors who are willing to invest for the long term (at least 5 to 7 years)
- Investors who wish to contribute in some way to the companies that care about our society and country.

Summary

The ESG index has been in India for some time now and the companies are mostly large-cap. So, for retail investors, ESG funds are more like a large-cap scheme. They can't be a huge part of your portfolio. Also, they might be as good as your existing large-cap schemes. You may invest in ESG funds for the ethics of it. For returns though, you’ll have to wait for a longer track record.

Regards

Manoj Arora
Official Website