Is ESG complaince a new normal?

Responsible investing is gaining momentum as social consciousness among various groups of investors is on the rise. Across the investor spectrum, i.e. from institutional to High Networth Investors (HNI’s) to retail investors, are becoming more mindful of and embracing ESG investing. As a result, the investors value the companies striving towards better ESG compliance. The COVID-19 crisis has intensified discussions about sustainability and the financial system, acting as a catalyst for this theme. It looks like this phenomenon is not incidental and is here to stay and become an integral part of investing framework eventually. According to a report, ESG-mandated assets could make up half of all managed assets in the United States by 2025. Bloomberg has forecasted global ESG assets to hit $53 trillion by 2025.

ESG stands for Environmental, Social, and Governance. It is a form of socially responsible investing that prioritizes financial returns alongside a company’s impact on the environment, its stakeholders and governance practices. It involves using ESG factors to evaluate companies, and the data can be integrated into the investment process when deciding what equities or bonds to buy. It is based upon the growing assumption that the financial performance of organizations is increasingly affected by environmental and social factors.

The Environmental component addresses how a company affects the planet like greenhouse gas emissions, carbon footprint, renewable energy practices, to name a few. The Social component broadly covers issues affecting employees, customers, consumers, suppliers, and the local community and finally, the governance component broadly relates to the board, leadership effectiveness, and business ethics.

There is no clear-cut answer as to why ESG companies may do better. However, if a company works towards identifying the various risk that its businesses faces and works towards mitigating it, its operations and profits more secured. The result is fewer business disruptions with more reliable and comparable financial results over time. Thus lower downside risk for shareholders. 

In India, the ESG theme is at a nascent stage, and hence there are limited options to invest as of today. However, there has been a slew of ESG focussed funds launched in India recently, with many more ESG funds lined up; the trend seems to be catching up in India. Many mutual fund houses provide access to ESG themes; however, most were launched in 2020 (Table A). The traction is building in the PMS/AIF category, with houses like Avendus, Philip Capital offering ESG themes and other prominent houses with similar offerings in the pipeline.

In an emerging country like India, engaging in an ESG theme will allow more and more companies to be ESG compliant, which will lead to sustainable growth for future generations and lead to the creation of wealth for the companies and their shareholders. In fact, in India, the Nifty ESG 100 index has delivered equal or more returns than broader nifty indices.

It is important to note that during upcycles, the domestic ESG theme has relatively done better leading to overall better returns from August 2018 till June 2022. Refer Table C

Also, the regulatory initiativein ESG space is a welcome move as it aims to establish links between the financial results of a business with its ESG performance. The framework proposed by SEBI is in line with the international standards and will help to serve as a single resource for sustainability reporting by listed companies. It applies to the top 1000 listed companies by market capitalization for reporting on a voluntarily for FY2021–22 and a mandatory basis from FY2022–23. It enhances disclosures on ESG standards by Indian companies and is heartening to see.

While investing in ESG space, Investors should be mindful of specific finer points of companies like disclosure of information and standardisation of data on ESG of any company is still evolving; one has to understand the methodology used by the funds for evaluating companies, limited track records of the ESG funds, expense ratios and lock-in time or exit load to name a few. It looks today that ESG compliance will become a new normal and will play a significant role in the coming days. Investors should use it as a guiding framework for constructing a long-term portfolio and should not be driven only by performance as there will/can be times when it will/may perform poorly. For ESG dedicated funds, one can start with 5% of overall allocation and gradually go up to 15%. Investors should do their own research and understand the investment objectives and their alignment with the risk profile before investing in such products.