Cover Story: ESG – The Next Big Investment Theme in India

Written by Labanya Prakash Jena, CFA

Sustainable investing has come a long way – from earlier ethics-based to currently achieving a more conventional investment practice. The increasing environmental and social risk awareness leads to community and public dissent that affects companies’ financial performance and, consequently, their stock and bond prices. India witnessed an increasing number of stranded projects due to ESG issues, e.g., Coca Cola Plachimada plant, Vedanta’s mining issues in Odisha and Tamil Nadu, Satyam saga, Tata Motors Singur plant, etc. These ESG related material events suggest that survival and sustainable profitability depend on how they manage ESG risks and align financers and other stakeholders’ interests. Historically, fund managers in developing markets paid attention to corporate governance issues but ignore the environmental and social aspects of investment decision-making. However, several recent developments, which indicate the two later issues, particularly environment risk, will draw fund managers’ attention. In this article, I will outline the factors that make ESG the next big theme for India’s investment.

Sustainability Reporting and Disclosure

One of the critical challenges for fund managers to incorporate ESG risks in investment decision-making is the lack of disclosure of these risks and opportunities. The existing Business Responsible Report (BRR) disclosure rule of the Securities and Exchange Board of India (SEBI) was not adequate for investors to make an informed decision. However, SEBI’s new disclosure norm, Business Responsibility and Sustainability Report (BRSR), could be a game-changer for ESG investment. The new norm will apply to the top 1000 listed entities (by MCap) for reporting voluntarily for FY 2021 – 22 and on a mandatory basis from FY 2022 – 23. The new norm is granular and captures all the essential elements for ESG risks, which the companies need to disclose.

Moreover, BRSR’s disclosure framework is quantitative, allowing investors to measure and compare these risks across companies, sectors, and time. This enhanced ESG disclosure and reporting practice will enable fund managers to assess the real risks (read ESG risks) of corporates appropriately. The fund managers are likely to shun or downgrade those companies performing poorly on ESG metrics compared to their industry peers and over time. Moreover, other market intermediaries such as brokerage houses and rating agencies are also expected to downgrade these stocks. It is noteworthy here that there are several corporates in the developed market are voluntarily disclosing ESG risks in the globally accepted reporting frameworks such as GRI, SASB, TCFD, Integrated Reporting. These accepted frameworks could likely be mandatory for corporates in the future. Indian companies listed in international stock exchanges or borrow global capital have to follow these reporting frameworks. The companies can be penalized or rewarded in the foreign market based on their ESG risk management. 

The Emergence of ESG Rating Agencies

Several third-party agencies such as MSCI, Sustainalytics, CDP, RepRisk, and ISS provide independent ESG, climate change, and sustainability ratings on corporates. Although there is a divergence in ESG rating due to different scope, measurement, and weight of categories [i], they are highly likely to converge as these ESG rating agencies accumulate data and approach to ESG rating become standardized. The ESG rating plays an important rating in addressing the asymmetric gaps between the corporates and investors, just like credit rating. In India, the capital market’s reaction to ESG rating is significantly low compared to developed markets. The same trend was observed in the developed markets when ESG rating offering was at an early stage. As the ESG rating accumulates more data and assesses the risks more accurately, the capital market will also respond to ESG rating like developed countries. As the ESG rating is accepted as a material component in the asset management industry, the corporates with significantly low ESG rating could not be considered in the fund’s investment universe, just like low credit-rated bonds often shunned by institutional investors.

The fund ESG score is another metric that puts pressure on the fund manager to avoid negative headlines and public perception of their funds. Although the fund managers are bound by fiduciary duty to maximize investors’ return (within a risk boundary), they are mindful that bad publicity will lead to the withdrawal of funds by investors. Although fund level ESG score is non-existence in India, they are likely to be launched in India soon. Also, the foreign investors are under pressure from media and investors to shun low ESG rated companies to improve the fund’s ESG rating.

Shift in Investors’ Preferences

By the end of 2019, two ESG funds were operating in India; it increased to 10 in a span of 13 months. The surge in ESG funds reflects Indian investors’ strong demand for ESG funds even historically, ESG funds’ performance has not been spectacular. Also, the strong performance of ESG funds during the COV19 pandemic in India and abroad encouraged several mutual funds to launch ESG funds in India. The increasing awareness of ESG related risks among investors, particularly long-term institutional investors, is another reason for the surge in ESG funds in India.

The foreign investors will prefer companies with the best ESG business practices as the EU taxonomy would require them to disclose their investments as we advance. Hence, they are likely to drop companies who score poorly on ESG performance while rewarding companies with the best ESG business practices. 

There is also a shift in the investment preference of millennial investors, high net worth (HNW) millennials, in particular, has spurred the growth of ESG investment globally. The Bank of America and Morgan Stanley studies suggest that the High Net Worth (HNW) millennia are more concerned about the corporation’s ESG performance and consider this performance parameter than any other generation. Although the study was conducted in the US, it is relevant to India, too, as the youths are more concerned about the environment and society than the earlier generations. As the millennia started investing directly in equity or through the fund, they will seriously consider ESG an important factor in their investment decision making.

Signals from Policymakers and Regulators

The policymakers and regulators have taken various steps directly and/or indirectly incentivizing sustainable businesses. Alas, these steps have not been adequate to divert capital from non-sustainable to sustainable businesses. However, there are several signals from policymakers and regulators on ESG issues in businesses, particularly climate change. In 2020, the Reserve Bank of India (RBI) flagged concerns over climate change and its impact on the economy, while SEBI made BRSR mandatory in 2022-23. In association with the United Nations Development Programme (UNDP) India, the Ministry of Finance launched the Sustainable Finance Collaborative (SFC), intending to mobilize sustainable and green finance. The UNDP and Invest India also joined hands to develop the SDG Investor Map for India, which identifies 18 investment opportunities for sustainable development. Although all these steps taken so far, except SEBI’s sustainability business reporting rule, will not impact business and finance immediately. However, these steps could be signals from the policymakers and regulators to the market on the future path of policies and regulations related to sustainable business practices.

Conclusion

Investing is all about anticipating future events and price the future risks and opportunities in today’s investment decisions. ESG risk and opportunities are expected future events, which must be incorporated in the valuation of securities.

Reference Paper: [i] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”