Although, the critics of ESG investing are of the view that higher compliance and disclosure burden put such businesses at a disadvantage to their peers, data suggests otherwise

Mohit Ralhan, Chief Executive Officer TIW Capital

ESG points to three impact factors in investing – Environmental, Social and Governance.

ESG investing seeks to invest only in those businesses which have a high level of governance standards and demonstrate responsible behaviour towards the environment, communities, customers and employees.

ESG investment is not a new concept. Its earlier avatar of responsible investing goes as far back as the period of slave trading when religious groups advocated not investing in slave labour. In modern times, responsible investing picked up in the 1970s, taking the form of not investing in companies that benefitted from the Vietnam War or the apartheid regime of South Africa.

United Nations mentioned ESG investing in its 2004 report titled Who Care Wins and since then ESG investing advanced rapidly to gain a mindshare of investors resulting in the maturity of ESG frameworks. This also coincided with increasing awareness about climate change concerns, renewable energy sources and green technologies.

According to various industry estimates, more than 20% of global investments are likely to incorporate ESG components by 2026.

However, the ESG style, especially in the Indian stock market is still in its infancy. But given the increased awareness among investors, push for increased transparency by regulators and incentives for businesses to adopt sustainable practices, ESG investments are likely to increase rapidly in India as well.

There are multiple ways in which fund managers leverage ESG factors.

While some screen out stocks that have low ESG scores, others only consider stocks that score high on ESG while even others may look to add businesses that see improvement in their ESG ratings over time. This should not be confused with impact investing where return maximization might not be the goal of the fund manager. Impact investing tends to be more philanthropic in nature while ESG investing keeps the twin goals of return and impact at the same pedestal, wherein the long-term returns are driven by the creation of positive impact.

Proponents of ESG believe that businesses that score higher on ESG tend to be less risky and hence are able to create higher value for shareholders over the long run. Although the critics of ESG investing are of the view that higher compliance and disclosure burden put such businesses at a disadvantage to their peers, data suggests otherwise.

Broadly, research literature remains in favour of ESG style. A study done by NYU Stern Centre for Sustainable Business and Rockefeller Asset Management to examine the relationship between ESG and investment performance on more than 1,000 research papers in 2015-2020 found that 59% of studies showed similar or better performance for ESG relative to conventional investment approaches, while only 14% found negative results. The study also concluded that the ESG investing style provides better downside protection during times of social and economic crises.

Indian mutual fund industry has also witnessed a sharp rise in AUM under schemes classified as ESG. As of 7th July 2023, there were 10 ESG funds with Rs  10,491 crores in AUM. This is up from Rs 3,605 crores as of Mar 2020. The most notable surge in AUM happened in FY 2021, as ESG funds experienced growth of more than 200% vs the previous year. This remarkable increase was primarily due to numerous new launches throughout FY-2021.

There was increased investor interest as well, as companies scoring higher on ESG were better able to navigate the pandemic and the ensuing lockdowns. The median return of these 10 mutual fund schemes was 17.8% over the last 1 year. The best-performing fund delivered 24.7% while the worst-performing fund delivered 14.2%.

However, much longer timeframes cannot be considered as most funds were launched only 2 to 3 years back. Since ESG investing is expected to create positive alpha over longer time frames, we need to wait for a few more years to conclude the investing success of ESG in India.

One way to overcome this hurdle is to look at the performance of an index like Nifty 100 ESG, which has a base date of 1st Apr 2011. The Nifty100 ESG Index employs a weighting mechanism, where the weight of each constituent is determined by its ESG risk score and free-float market capitalization. This ensures that companies with sustainable practices carry more influence in the index.

As of June 30, 2023, the Nifty 100 ESG Index exhibited a five-year return of 13.68%, closely aligning with the return of 13.72% observed in the Nifty 50 index over the same period. The correlation between the Nifty 100 ESG Index and Nifty 50, stood at 0.98 over the last five-year period. This implies that the performance of ESG-focused companies has closely followed the benchmark.

Additionally, a beta of 0.96 suggests that the Nifty 100 ESG Index has exhibited slightly less volatility compared to the Nifty 50. Similarly, the Nifty 100 ESG Sector Leaders Index delivered 12.86% with a beta of 0.94 over the last five years.

One of the issues facing fund managers is the lack of a standardized framework to evaluate companies on ESG factors. SEBI has taken several steps to streamline ESG disclosures, ratings and investing practices.

To strengthen ESG reporting and disclosures for corporates, SEBI has introduced a new reporting structure called the Business Responsibility and Sustainability Report (BRSR). The top 1,000 listed companies are now required to submit the BRSR, which includes an assessment of material ESG risks and opportunities, strategies to mitigate or adapt to those risks, and the financial implications associated with such risks.

SEBI also aims to standardize ESG ratings through a regulatory framework that mandates accreditation for all rating providers. Under this framework, only credit rating agencies and research analysts will be eligible for registration as ESG rating providers with SEBI.

Rating providers will have to disclose the factors and methodology they deploy to arrive at the rating. Additionally, ESG Rating Providers (ERPs) will have to consider India-specific parameters when assessing ESG ratings, acknowledging the unique environmental and social challenges faced by the country.

To encourage more product offerings for the end investors, SEBI has allowed AMC to launch multiple schemes governed by ESG factors. These schemes will be required to invest at least 65% of their AUM in listed entities that undergo assurance on BRSR core parameters.

Furthermore, AMCs are also mandated to provide enhanced disclosures on voting decisions, specifically emphasizing environmental, social, and governance factors.

SEBI’s initiatives to provide clearer guidelines and promote responsible investing practices are expected to enhance investor confidence in ESG funds. This will also encourage mutual fund houses to introduce new products for different social and environmental causes. With a more structured and regulated approach to ESG, investors will be able to make informed decisions and contribute to sustainable and responsible investment practices in the country.

Investing is not only about returns but also about impact. As the concerns about the sustainability of our planet continue to increase, the ESG style of investing will continue to increase its share of capital allocation.