Over the last decade, there has been a growing recognition of the fact that businesses have a responsibility not just towards its owners or shareholders, but towards all its stakeholders – customers, employees, suppliers, local communities and so on. The concept then found its way to the world of investing, giving rise to the practice of socially responsible investing (SRI). “SRI typically employs a screening-out criteria and will eschew investments based on certain ethical guidelines – for example, avoiding investing in tobacco producers or makers of arms and ammunitions,” explains Salil Desai, who is part of the investments team in Marcellus Investment Managers.
One offshoot of SRI is environment, social and governance (ESG) investing. “In ESG investing, unlike SRI, there are no blanket exclusions. Instead, it is a framework to first evaluate a company’s ESG practices and risks and then using this evaluation to analyse the company’s value. The idea is that because a risk exists, it does not mean investors should completely avoid investing in the company. Rather, the risks should be incorporated while assessing the value of the company,” adds Desai.
Although a noble mission, practising it is not easy. “There are unique challenges in assessing compliance of the same by companies as well as in balancing the conflicts that routinely arise amongst the three aspects of ESG. However, these challenges do not take away the fact that responsible investing is imperative,” says Lalit Kumar Dangi, MD, Libord Finance.
“While there is no doubt that ESG investing is important, practising it is far from easy and leads to some inconvenient challenges and outcomes – not just for the individual practitioner or fund manager, but also for the economy or society in which the fund manager operates or invests in,” observes Pavan Kumar Vijay, MD, Corporate Professional.
The first challenge is the absence of standards that define ESG compliance and that allow comparative benchmarking for investors.
Direct impact
Governance, the ‘G’ in ESG, is arguably the more straightforward and least challenging aspect of this mode of investing. As a shareholder, one is very obviously concerned with issues such as the composition of the board, the structure of the audit committee, transactions with related parties, levels of executive compensation and other aspects of governance that impact the interests of minority shareholders. “These issues more directly impact the functioning of the company, and in turn have a bearing on the financial performance. As a result, focusing on governance comes more naturally to investment managers,” adds Dangi.
The environment and social aspects are in some ways closely related to each other – pollution, for instance, is a serious social menace due to its immediate as well as long-term health hazards. However, in many other ways, both these aspects are also in conflict with each other, which make assessing and factoring in the environment and social aspects in investing peculiarly challenging. “The challenge manifests in two ways. First, analysing the financial impact of ‘E’ or ‘S’ is not easy.
And the second, probably more serious issue, is managing the inherent conflict between ‘E’ and ‘S’. This issue is part of a more universal debate on managing development while protecting the environment,” adds Desai, pointing out to an example of a coal-based power project seeking to raise funds for a new plant. In India, an average household receives 20.6 hours of electricity, with some rural areas getting as less as 16 hours a day.
“An ESG fund will probably not invest in such a project and this decision will comply with the ‘E’ part of ESG. But will it be a responsible decision to deny funding to a project that will help in reducing power outages and load shedding in a country where an average household goes without power for 4-6 hours every day? Obviously depriving a large section of the population with access to electricity is not socially responsible,” observes Desai.
How does a fund manager balance these two conflicting objectives? One could say that by refusing to fund a coal-based power project, the fund manager is indirectly forcing the project developer to consider setting up power capacity using greener renewable energy. However, in a country where base load power itself is in deficit, increasing dependence on renewable energy has the potential to exacerbate power supply problems and even threaten grid stability. Wind power generation is not steady and solar power is unavailable during the evening peak hours. Replacing a power source that can run 24x7 with renewables that generate power intermittently, is not a good idea at all!
The events that unfolded in Europe during the summer of 2021 bear testimony to this – high dependence on wind power (20 per cent of total consumption) meant that low wind output, amid issues in the supply of natural gas, led to a spike in wholesale electricity prices. Tariffs rose by 36 per cent and 48 per cent in Germany and France respectively, in just a couple of weeks in September 2021. Increasing electricity prices is surely a hit to the finances of regular households and is not very socially responsible.
Moreover, renewable power projects have their own inherent complications – both environmental as well as social. Utility scale solar projects are highly space intensive – requiring up to three to five times the land required for a coal-based plant.
“This land intensity has resulted in social conflicts in many parts of India, as marginal communities protest about land occupation. Wind power has been objected to in many countries for reasons ranging from harm to birds from the rotating blades, to increase in noise pollution and clearing of woodlands. How does a fund manager then be sure he is funding the right ESG compliant projects,” says Desai.
“It is clearly unfair for such financial institutions to deny capital/funding to projects in the developing/lesser developed world that would raise domestic standards of living. ESG investing, in a way has the potential to lead to exactly this,” says Vijay, adding that the challenges do not dilute the relevance of ESG investing. Carbon emissions, whether in developing, or in developed nations, or whether in urban or rural India, harms the planet everywhere.
“In fact, the emerging ESG mandate in corporate governance presents a new challenge for companies in India. There cannot be a one-size-fits-all approach. Though there are influential holdouts still against the trend towards ESG-focussed corporate governance, it would seem that the ESG mandate is becoming well-accepted globally. Indian companies such as Tech Mahindra, Infosys and Wipro are a part of the Dow Jones Sustainability Index (DJSI) which assesses the ESG performance of companies globally,” observes Eshvar Girish, Supratim Guha and Harshita Srivastava of Nishith Desai and Co, in their paper. Historically, the companies which have been a part of the DJSI and follow healthy ESG practices have fared well on the Indian bourses.
Well accepted, globally
Blue-chips stock such as TCS and Reliance Industries recently announced roadmaps towards reduction in greenhouse gas emissions towards zero. “Investors too seem to have an appetite for innovative instruments to finance environmental and social initiatives. The Ghaziabad Municipal Corporation (GMC) raised R150 crore through the issue of green bonds and they are currently listed on the Bombay Stock Exchange. GMC is using the funds for the construction of a tertiary treatment sewage plant. JSW Hydro Energy Limited has raised $707 million overseas through the issuance of dollar-denominated green bonds which are currently listed on the Singapore Stock Exchange.
“Increasingly, ESG-conscious customers are also evaluating their banking partners based on their sustainability focus and the sustainable financing solutions that they can offer. Sustainable financing is the key part of our strategy and helping DBS attract and retain such businesses that want to do good. Ultimately, we want to be able to demonstrate that sustainable companies tend to be more credit worthy companies and are more successful in future-proofing their businesses to remain relevant,” says Yulanda Chung, Head of Sustainability, Institutional Banking, DBS Bank.
“The physical and transition risks associated with climate change will get deeply embedded into a risk analysis of investment and lending decisions at banks over the next few years. Additionally, financial institutions will also continue to actively track and improve upon intensity of their own greenhouse gas consumption. These efforts of lenders will be further pushed by their own stakeholders like ESG focused investment funds and regulators. For e.g. in India from FY23 it will be mandatory for top listed companies to publish an annual business responsibility and sustainability report (BRSR),” says Chetan Savla, President – ESG and Financial Inclusion, Kotak Mahindra Bank.
“So illustratively, if a manufacturing company has made efforts to reduce greenhouse gases, then that company’s lender should not claim the same benefit again. Lenders’ climate risk management frameworks will give due to weightages to a sectoral mix of the lending portfolio, geographical locations and tenures of lending. Financial institutions will also complement this climate risk management effort, with proactive support to climate-positive sectors like renewable energy, electricity grids and mobility and green energy such as hydrogen,” adds Savla.
Among the evolving trends, companies with strong ESG credentials are given preference over their competitors.
“This denotes better integration of ESG into asset pricing and the altered risk and return trade-off for investors. The paradigm shift in institutional investments is observed as there is a marked increase in ESG investing in India, though it still has a long way to go,” observes Pradip Seth of ExchangeConnect. “With the advancement of reporting standards, it is now evident that reporting is no longer a backward-looking and performance measurement tool. It needs to expand – adding forward-looking benchmarks and business strategy formulation that denotes the company’s proactive approach to ESG. A company’s actual value creation can be established only through both financial and non-financial impact assessment,” adds Seth talking about the major development in this arena is the business sustainability reporting (BSR) guidelines proposed by SEBI to increase transparency in ESG reporting. “This will enable investors to make well-informed investments and aid companies to provide more effective disclosures”.
Paradigm shift
Recently, SEBI has come out with a circular on business responsibility and sustainability reporting (BRSR) by listed entities. However, it is applicable only to the top 1,000 listed companies by market capitalisation. This is a paradigm shift from the erstwhile business responsibility reporting (BRR) regime to BRSR reporting regime.
Says Jal Irani, ED, IE, Edelweiss Securities: “The top 1,000 Indian companies use SEBI’s BRR. From FY23 they mandatorily have to move to BRSR. Multiple reporting standards are available across geographies namely GRI, ISO 26000, CDP (prevalent in UK) and SASB. To the best of my knowledge, of the few Indian companies which use global reporting norms, GRI seems to be the most popular.”
When it comes to sustainability linked bonds (SLB). This market is more nascent when it comes to Indian issuers. UltraTech Cement’s $400 million issuance was the first of its kind from India. Cement companies in general are significant emitters, and under this specific bond, UltraTech has committed to achieving a 22 per cent reduction in its emissions by 2030 versus 2017 levels. In return it was able to secure an attractive cost of debt.
More recently Adani Electricity Mumbai Limited (AEML) issued $300 in sustainability linked bonds – and the KPIs chosen for this issuance contribute to UN Sustainable Development Goals (SDG). “More generally speaking and not linked specifically to any capital raise are the new disclosure norms released earlier this year by SEBI on “Sustainability Related Reporting”. They will be applicable to the top 1,000 companies by market capitalisation and come into effect in FY23. Let us see how many companies go beyond the minimum ‘essential’ disclosure requirements and actually go for the enhanced ‘leadership’ disclosure option. "This will tell us how the market participants view the subject and how important they feel such credentials are in raising capital as well as operating their businesses,” says Gagan Sidhu, Director - CEEW Centre for Energy Finance.
“ESG themed funds, from a fund manager’s perspective, give an opportunity to bring in to fold and harvest the ESG aware and compliant corporations. It is also a novel change to be able to focus on non-financial metrics and to explicitly reward the stocks that try their level best to improve their governance and their environmental and social surroundings,” says Ankit Pande, manager at quant Money Managers. However, he cautions that one has to be a bit critical, “I would add that the ESG theme is well intended but perhaps not very well conceptualised. The boundaries separating ‘ESG good’ from ‘ESG bad’ are fuzzy to say the least. The reporting is very non-standardised and hard to evaluate and score.”
In any case, the world cannot transition seamlessly from hydrocarbons to clean renewables in a short span of time. For instance, it takes 20 years to plan and build a nuclear power station. Wind energy is fickle, unreliable, less efficient and difficult to maintain. Is the theme of ESG investing overrated? It is very difficult to answer this clearly and far easier to raise questions and doubts at this stage.
Lastly, ESG assets under management in India have increased by four times in the last two years to touch Rs11,800 crore. Bloomberg has forecasted global ESG assets to hit $53 trillion by 2025.