In Green We Trust

There’s a lot more than being just a Wall Street acronym, ESG heralds a positive change in the society, by evaluating how companies should operate in three key areas of environment, social and governance. The objective of ESG investment is to channel capital to companies that work to meet or exceed commonly established standards in each of these three realms – and keep money away from firms that don’t.

When the ESG wave hit the shores of the world’s fifth largest economy, India set sail, and the trend of sustainable investment began gaining traction very fast. “Over the next few years, ESG will become central to discussions when investors would engage with corporates in evaluating their investment opportunities,” says Amit Nigam, Fund Manager at Invesco Mutual Fund.

The ESG factors include the risks a company is exposed to on the environmental, social and governance perspectives and how well is the company mitigating these risks.

Environmental factors include how well a company reins in the pollution it causes, treats the water it exerts, or the carbon it emits. Social factors include the labour standards, workplace diversity and product impacts such as the health implications of tobacco and gambling companies, or data security for big tech firms. Governance covers corporate board structure, executive pay and prevention of bribery and corruption.

The $53.7-trillion global ESG investing, averaging an annual growth rate of 15 per cent, is still nascent in this country, with India ranking a low 117 on sustainability among 193 UN member countries. But the recent trend of the key stakeholders in the country – the government, the corporates and the investors – in exploring the domain for long-term prospect indicates a steady uptick for the sector. “It is still early days in India from an ESG funds perspective, but the launch of ESG funds has increased investor awareness,” says Kaustubh Belapurkar, Director – Manager Research at Morningstar India.

The Nifty 100 Enhanced ESG Index has outperformed the Nifty 50 Index on three-, five- and seven-year periods along with lower volatility. Roughly ESG Index has outperformed the Nifty 50 index by 1.5 to 2 per cent. The ESG Index is also less volatile.  Nifty 100 Enhanced ESG Index is designed to reflect the performance of companies within the Nifty 100 index based on environmental, social and governance score. Companies should have normalised ESG score of at least 50 per cent to form part of this index. The weight of each constituent in the index is tilted based on the ESG score assigned to the company or the constituent weight is derived from its free float market capitalisation and the ESG score, according to data sourced from the National Stock Exchange (NSE) website.

“ESG considerations represent material economic information that helps explain a company’s future beyond what can be deciphered through typical financial statements,” says Nigam, giving an insight into how and why the ESG-compliant companies outperform their peers.

The ESG principles, to put it simply, guide corporates towards better and more efficient use of resources, both natural and man-made, say experts, trying to explain why ESG stocks fare better on the bourses. This facilitates the businesses to sustain for longer – with the same “limited” pool of resources. Investors in a company stand to benefit from this extended life – as the equity compounding journey in the company can continue for longer.

ESG funds are playing an important role in creating a push for corporates to be aware of these aspects; by avoiding investments in those companies and sectors where the underlying risks in businesses due to disregard of the ESG factors is high and by engaging with corporates increasing the awareness levels. With this risk lowered, investors in such funds stand to benefit potentially from better risk-adjusted returns over the medium to long term.

Also known as social responsible investing (SRI), ESG investments have seen inflows rising more than 100 per cent – from $63.34 billion to $168.74 billion – between 2019 and 2020, according to data published by the Emerging Portfolio Fund Research Inc. A host of natural crises roiled the world during the period. After droughts, wildfires and floods, the world witnessed the outbreak of the Covid-19 pandemic at the beginning of 2020. The EPFR report indicates a rush among institutional investors to make ESG practices a must in the way businesses were to be done.  

Companies which ignored sensitivity to such issues, have faced severe threats to their business models in terms of incurring “heavy costs” to recover and realign the business models. “Negative corporate behaviour around ESG issues can hurt shareholder value while creating tangible risks for investors,” alerts Belapurkar.

One of the biggest examples of negative ESG is seen in British Petroleum (BP) Deep Horizon oil spill in the Gulf of Mexico in 2010. The 2015 diesel emission fiasco of Volkswagen had caused enormous financial and reputational damage to the auto major. More recently, Facebook’s data privacy scandal with Cambridge Analytica led to shares plunging 19 per cent, shaving $119 billion from its market value.

“ESG investors seek to avoid these risks by divesting from companies with poor practices, instead choosing best-in-class alternatives during stock selection and portfolio construction,” says Belapurkar.

Back home on the Indian turf, one would wonder how far these practices would prevail when it comes to investment. A change is evident and it’s sustainability, beyond doubt, in view of the rising threat of environmental damage, increasing social responsibilities and mandatory governance protocol.

“FPIs (Foreign Portfolio Investors) are being mandated by their own investors as well to incorporate ESG in their investment decision-making criteria,” says Arjun Yash Mahajan, Head of Institutional Business at Reliance Securities.

This makes Indian companies bound to incorporate ESG norms in their businesses at the earliest in case they want to come on the investing radar of the FPIs. The country has seen FPIs pumping in approximately $14.2 billion as of November. “Going forward, this trend of FPI investments into Indian equities may continue if Indian companies incorporate and integrate ESG parameters into their businesses,” says Mahajan.

However, analysts point out that this integration needs to be at an above normal pace, as Indian companies are still at a nascent stage of adopting ESG norms, let alone implementing them.

India is a signatory to the 2016 Paris Agreement on Climate Change. Now, with the Joe Biden administration taking over the reins of the US on January 20 and the selection of John Kerry as the climate envoy, these changes signify the pressing agenda for adhering to the Paris Accord, which was signed by Kerry himself on April 22, 2016. India’s adherence to the undertakings given at the Paris climate meet will force the Indian companies to adopt the ESG norms faster. “With more and more ESG funds being launched in India, it is only a matter of time before market regulator Sebi, in line with its peers in the US and Europe, comes up with its own standardisation of norms and disclosures of what constitutes ESG,” says Abhay Laijawala, MD and Fund Manager, Avendus Capital Public Markets Alternate Strategies LLP.

India, on account of both its vast and unique geography and its high density of population, faces very high climate change related vulnerability. It will be imperative that climate material issues, mainly carbon and urgent decarbonisation initiatives, receive the attention of regulators, while drafting regulation for ESG disclosure in India.

“Global companies that are sourcing from Indian companies are also forcing these very companies to adopt and incorporate ESG in their business processes,” says Mahajan. Foreign companies are almost restricted to buy or source products from the companies that do not comply with the norms, standards and parameters as required under the gamut of ESG-compliance.

Thus, the world is forcing India to adopt ESG and the more willingly and quickly Indian companies adopt ESG, the more beneficial it will be for them, say experts.

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MFs Evaluating Their ESG Investments 

ESG is best understood when evaluated through the lens of risk. There are examples of companies where the risk on the environment front was low, yet they damaged shareholder returns, because of poor governance practices. Investors, therefore, need to take a holistic approach when evaluating the ESG risk profile of a company.

Invesco, for example, has developed their ESG framework internally and it comprises 21 parameters spread across E, S and G. These parameters are scored on a scale of 1 to 3 (low risk to high risk), by their sector specialists, who have been evaluating respective sectors for several years, and are best equipped to evaluate these parameters as some parameters require qualitative assessments as well.

Subsequently each of E, S and G is attached a certain weightage to factor the relative importance of respective aspects for different industries and then we arrive at a unique ESG score for a company.  

“This exercise of converting qualitative aspects to a quantitative output facilitates our investment team to compare companies within a sector and even compare different sectors,” says Amit Nigam, Fund Manager at Invesco Mutual Fund.

The writer is a financial journalist