Environmental Social Governance is a type of sustainable investing that gauges a corporation’s moral contribution to all its pertinent stakeholders. In fact, this strategy of investing in Companies’ whose social and environmental goals meet with investors’ individual goals and beliefs is seen fastest growth. First World Countries are progressively incorporating ESG requirements, thereby imposing tight corporate ESG compliances by amending or establishing legislations. Many Companies are now under high alert to provide information about the adverse effects of their actions on the environment and society as investors have become well aware of their obligations to the Environment as well as society.
In todays’ times, ESG Compliance reports of respective companies play a significant role in determining the profitability of an investment in the respective companies by investors.
ESG Investing and Performance
ESG investment is a tactic, one can employ to invest money in organisations that work to improve the world. Investors prioritizing environment to be a significant factor for investing in sectors where one can have an impact and eliminating companies that do not comply with ESG goals. There’s always a confusion as to whether investors prioritize ESG for creating an impact or is it a strategy to screen out organizations with strong financial and investment performance as ESG is associated with profitability.
ESG investing continues to gain momentum today, as a growing number of institutional investors (and their clients, in particular) look to align financial returns with ethical and other non-financial considerations[i]. ESG investment relies on third-party evaluations, like ESG Scores, to examine a company’s practises and stances on matters of governance, social impact, and environmental performance.
Globally, ESG criteria used to evaluate companies for ESG investing:
- What kind of environmental impact does a corporation have? This may involve the carbon footprint of a business or the use of hazardous materials in manufacturing.
- How can the business strengthen its social influence both inside and externally?
- How does the board and management of the organisation promote positive change?
ESG activities should be closely related to the PDM guidelines issued by the International Monetary Fund (IMF) and the World Bank (WB)
Example: Trillium Asset Management-Boston Based Investment Firm. The investment by this firm is made by evaluating the following characteristics of a company, which may include:
- Environmental-Business model aligned with a low carbon economy, limits harmful pollutants and chemicals and carries responsible raw material management.
- Social- LGBTQ friendly social setup, fair wage payment, encourages diversity and inclusion and operates an ethical supply chain.
- Governance-Pays executives reasonable wages, dedicated to corporate transparency[ii]
Example: The World Bank Treasury managing the bank finances to ensure financial sustainability also acts as a trusted advisor to its member countries to maximize finance by applying innovative sustainable financing solutions to channel funding to climate, pandemic, refugee crisis and infrastructure development among other priorities[iii].
The World Bank communicates outcomes and environmental and social impacts across 11 sectors in which it provides financing. Investors in World Bank bonds can get a clear understanding of what the entire balance sheet supports, not just green bonds. All World Bank project documentation includes environmental risk assessments and reporting on social risk and mitigation efforts[iv]. Its largest global bond issuer focusing on sustainability development.
ESG Investors sell their stocks if the portfolio companies involve in unethical practices. Like in Norway, the Government Pension Fund Global’s divestment of its stake valued at 15.16 USD million in then, FTSE-listed Indian Company and PGGM’s divestment of 14.55 USD million across the same company and its subsidiaries in response to the environmental and human rights violations by a certain industry in their mines in Orissa[v]. According to World Bank ESG Guide 2020[vi], Investors are increasingly considering environmental and social risks when making investment decisions rather than traditionally focusing on governance. In this paradigm, corporations will be encouraged to incorporate sustainability into their behaviour.
SRD II -EU Directive Principle mandated the asset managers to make disclosures of their policies in relation to the companies they invest in[vii].
The Alternative Investment Fund Managers Directive and Undertaking for Collective Investment in Transferable Securities regimes were subject to revisions proposed by the European Securities Management Authority (ESMA), under which managers would be required to consider sustainability risks in addition to general due diligence obligations.
As non-financial variables increasingly influence the values of securities, ESMA also suggested new rules on ESG disclosure requirements for Credit Rating Agencies (“CRAs”). This indicates that credit rating agencies must fight for ESG integration[viii].
EU Commission Reforms introduced an assessment to gauge investor’s ESG preferences and how likely are they willing to affect fund performance.
In India, Kotak Committee on Corporate Governance was the first to recommend SEBI to publish a Circular, thereby, setting up Stewardship Code for Asset Management Companies (AMC), Mutual Funds, and Alternative Investment Funds similar to EU. ESG Funds introduced in India are way less when compared to global economy. ESG Mutual Funds actually give scope for less risk as in less volatility and offer greater exposure to financially healthy companies as ESG funds have higher sustainability score according to ESG ratings agency in global economy. SEBI mandate for mutual funds in India to vote on corporate responsibility issues is great regulatory shift for responsible investing.
Green Bond Finance catering for renewables, bio energy and low carbon transports (Ex-GMC & JSW Hydro Energy).
In 2021, India participated in UN Climate Change Conference-(“COP26”). To incorporate these COP26 mandates, SEBI has released consultation papers for ESG framework which mandatory for 1000 listed companies to include a Business Responsibility and Sustainability Reporting (“BRSR”) section in their annual reports s for the financial year 2022-23. Currently, this ESG framework is not applicable for Start-ups. Additionally, the MCA has released voluntary ESG disclosures through ‘Report of the Committee on BRR’.
BRSR is not yet recognized by international investors but, the details might be used for interpretation. Indian companies in global markets are already reporting on (Climate Disclosure Project (“CDP”), that has more focus on climate risk or say GRESB (Global ESG Benchmark for Real Assets) that is for real estate investors or other similar frameworks. But BRSR is a good start for all companies that haven’t started on the ESG disclosure journey.
ESG: Lending Practices
Investors focus on organizations who prioritize and develop their businesses through sustainable ways. The banking system is also given an opportunity to contribute to businesses fulfilling the commitment by US and India under Paris Agreement. ESG activities should be closely related to the Public Debt Management (PDM) guidelines issued by the International Monetary Fund (IMF) and the World Bank (WB). The World Bank has developed a National Green taxonomy as a guide for companies in countries. ESG investors are mostly focused on the sovereign bond market, while earlier was focussed on asset classes such as equities and corporate bonds.
Sustainability Linked Loans (“SLL”) and Sustainability Bond Agreements (“SLB”) has risen to prominence in the loan world. Sustainable finance involves aspects of climate risk assessment and the ESG Factors into investment strategies.
Green loans/bonds principles emphasise the following four key components:
(a) use of proceeds, requiring the financed projects to fall within the non-exhaustive examples of green projects
(b) process for project evaluation on sustainable objectives,
(c) management of proceeds, and
(d) reporting to lenders
Example: GMC (Ghaziabad Municipal Corporation) is currently listed in Bombay Stock Exchange due to the amount the corporation raised through the issue of green bond[ix]. The first two green bonds were introduced by European Investment Bank in 2007 and IBRD in 2008.
Blue Bonds: Blue Bonds as the term, all by itself means for the protection and development marine environment. These bonds also operate on the green bond principles stated above. A National Policy on Blue Economy is being finalized by Ministry of Earth Sciences in alignment with SEBI’s framework with ICMA’s Green Bond Principles[x].
The ‘S’ in the ESG for Investment:
Often when Sustainability or Environmental governance is still dominated by conservation of energy and natural resources but never drive thoughts towards the protection of labour force from exploitative industries. Even today, FDI views “Sustainability” and “Labourer’s rights” as two very distinct topics but when viewed through ESG lens, its one and the same. Corporate and governmental scrutiny on working conditions in industries is very important for investment.
Tech Companies have invested in electric vehicles and declared that the motive of their company is to support their employees to build their ESG credentials. Investors may also research on company’s responsibility to its independent contractors or gig workers. Few states in USA have proposed legislations where gig workers would be guaranteed a minimum wage and protection such as dispute resolution.
EU new ethical supply chain rules, compel businesses to disclose any infractions of international laws including child labour, labour rights, or environmental damage.
Investors are willing to support a resolution where the executive pay is tied to ESG goals as they believe that during times like COVID19 if employees have faced pay cut, layoffs then the top executive must bear the pain too and people will put their actual effort in resolving the problems in the system. A Shareholder Platform called on a Multinational EV Car company to link its executive pay to ESG metrics. In India Nomination and Remuneration Committee (NRC) mandated by the Companies Act, 2013 seeks to maintain balance between fixed, incentive based and long-term performances of top executives and their remuneration. Every listed company must disclose the ratio of remuneration of differed grade starting from director and their percentage increase of remuneration every year[xi].
Advantages of ESG Investing:
The real question as to whether the investment in companies that integrate ESG factors remains profitable till the expiry of the investment period depends on two factors- Identifying risk and time frame issue.
- Inclusion of ESG factors while making investments has the capacity to mitigate systemic risks like inflation, natural disasters, climate change, wars etc.
- Usually, ESG integrated companies use the pretext of full length of the investment period desirable to certain investors expecting long term value as opposed to investors who seek for good returns in less span of time.
There are many challenges that ESG investments currently face in India. Some of them are as listed below:
- Lack of high-quality data: Analysts or fund managers are frequently used to obtain specific information regarding a company’s social, environmental, or governance performance. The sustainability report of an organisation may also provide specifics on such information. Various other documents, such as annual reports, news articles, media releases, etc., contain more information about ESG. Finding specific information about an organization’s ESG can be time-consuming and frequently wrong for investors. As a result, the trustworthiness of the information remains a barrier to the expansion of ESG investments in India.
- Lack of measurement standards: ESG investing is not currently standardised in the Indian market. The terms “impact investment,” “sustainable investing,” “socially responsible investing,” and “responsible investing” are frequently used by investors. Standardization of data collection, measuring standards, and reporting methods is required for this type of investing to continue growing.
- Traditional perspective: Many investors and fund managers view ESG as an unnecessary extra expense. This factor also hinders the expansion of ESG investing in India.
- ESG funds have a shaky track record: In India, ESG funds have only recently begun to take off. Due to this and the ESG funds’ lack of track record, many investors may be discouraged from considering this investment choice.
- Lack of knowledge: Although ESG investing is becoming more and more popular among investors, many people are still unaware of this fact. To expand the market for ESG investment, more and more investors must be made aware of its advantages.
- Greenwashing; Misrepresentation of investment strategies by fund managers without solid reasoning.
ESG is the solution for mitigating systemic risks. There are no concrete laws mandating companies to implement integration with ESG factors other than Stewardship Codes. From 2008 recession to Pandemic and now there are predictions for recession in USA indicating a dire need for change of investment landscape.
State involvement, followed by economic regularisation, and then shared accountability between the state and private bodies, have all been causal factors throughout generations and continents. In India, Sector-specific BRSR formats can be considered with specific additions to the primary material and not replacement because the BRSR formats can be generic and there may be a lot of scepticism from some sectors. This can create confusion and zero uniformity in ESG in relation to International Forums.
To conclude, it seems befitting to quote CJI Chandrachud:
“The burden of establishing environmental compliance rests on one who intends to bring about a change in the existing state of the environment. There can be no gamble with the environment: a ‘heads I win, tails you lose’ approach is simply unacceptable; unacceptable if we are to preserve environmental governance under the rule of law”[xii]
[i] Abhishek Gupta, ESG: Regulatory Framework in India, Samisti Legal LLP, (Aug 2022), https://samistilegal.in/esg-regulatory-framework-in-india/.
[ii] Trillium ESG Criteria, https://www.trilliuminvest.com/documents/positive-negative-screens.
[iii] World Bank ESG 2020 Final, https://thedocs.worldbank.org/en/doc/375981604591250621-0340022020/original/WorldBankESGGuide2020FINAL.11.5.2020.pdf.
[v] R. Mandal, CSR in the post pandemic era: the dual promise of ESG investment and investor stewardship, T&F Online (Jan 2021), https://www.tandfonline.com/doi/full/10.1080/24730580.2021.1899627.
[vi] Id at 2.
[vii] Jaydeep & Anomitra, Making the Legal Case for ESG Investing (2021) 4.1 JCLG 122
[viii] ESMA 33-9320, ESMA , Final Report Guidelines for Credit Ratings and its Disclosure requirements.
[ix] R.Rahul, Meyappan, ESG Prevalence and Relevance, NDA (Nov2021), https://www.nishithdesai.com/fileadmin/user_upload/pdfs/Research_Papers/ESG_Prevalence_and_Relevance.pdf
[x] A.Shah, H. Wadia, S.Agarwal, Sustainability Loans in India: Green, Blue and Others, AZB & Partners (Nov 2022).
[xi] V. Shyam, Say What on Pay? – A Comparative Evaluation of the Impacts of the Regulatory Reforms and Covid 19 on Executive Compensation in the UK, US and India, 1 NMIMS L Rev (2021) 12
[xii] Hanuman Laxman Aroskar v. UOI 2019 SCC Online SC 441
Author: Abhishek Gupta, Senior Associate (assisted by Sahithi Guda)
Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at firstname.lastname@example.org