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Here's How to Make Sense of ESG Investing

Here's How to Make Sense of ESG Investing

It is important to understand the investment objective -- whether one wishes to protect downside by ESG risk mitigation, or to generate alpha

Illustration: Anirban Ghosh Illustration: Anirban Ghosh

Environmental, social and governance or ESG has become ubiquitous in recent years, finding a mention in almost every discussion in the financial world. Increasingly we keep hearing questions about whether ESG compliance can help companies drive better returns. In our understanding, ESG ‘compliance’ is a misnomer, or better yet, an oxymoron. We say this because there is currently no specific set of rules that describe ESG and, importantly, it is more than just compliance. The term compliance infers a mandate to do something, whereas ESG initiatives are undertaken proactively. There is a possibility that ESG will become a market-driven or regulator-driven mandate soon. Then the question around better returns becomes moot since everyone will need to be compliant.

The more relevant question is, what purpose does ESG serve? ESG should be looked at from two aspects: as a risk mitigation tool, and as a means to monetise new opportunities. This serves the dual purpose of safeguarding returns and optimising them over the long term. When companies improve their policies, governance structures and programmes to ensure responsible behaviour towards stakeholders, they are essentially mitigating regulatory risks, ensuring a social licence to operate, and winning investor confidence. And when they are proactively investing in green technologies and social infrastructure, they are capitalising on new areas that may attract more investments. Consequently, ESG-conscious companies are in a better position to drive higher returns vis-à-vis companies that have had a history of poor governance or non-compliances with respect to environment, employees or communities, which tends to make investors wary of investing in them.

While all of this seems logical, investors may see companies focussed on ESG delivering lesser returns in the short run than those performing poorly on material ESG criteria. For instance, most ESG-themed funds would not invest in a business in alcohol or tobacco or weapons. But that doesn’t mean that these won’t do well financially—till demand for their products exists or is growing, they’ll keep doing well. In such a scenario, ESG becomes a choice that an investor consciously makes.

We need to understand the necessity of the ESG criteria beyond a sectoral bias. Any well-governed company is responsible towards its stakeholders and tries to improve, and in most cases, would be able to safeguard its investments in the long term. It is more about risk mitigation and will be relevant across sectors, say, for both a thermal power company and an electric car company. However, if an investor is looking at alpha generation from ESG investing, then looking at the thermal power company may not be prudent in the long term. That does not mean the electric car company would get a free pass to not have to align itself to the best governance and social standards just because its business is green. It is important to understand that even businesses that look green need to be ethical and responsible for them to be counted as ESG investments. Therefore, it is important to understand the investment objective—whether you wish to protect downside by ESG risk mitigation, or to generate alpha; both the approaches would differ in stock-picking with the basics of ESG being the same.

Globally, there seems to be a view that in India, ESG-based investing is not pure-play ESG. However, we believe that the view about emerging markets is mostly from the ‘E’ side of the equation. ESG investing has a huge market context that gets missed out if such investments are looked at from a single, green-tinted lens. European funds may today be able to exclude coal from their green investments but countries like India would still have decades before our emissions peak. A combination of fossil fuels along with renewables would be the only way to go forward. India has unique circumstances. We are the third-highest greenhouse gas emitter in the world and among the lowest in per capita emissions. Our 2030 goals, as per the Sustainable Development Goals, require us to address energy access for all, while our climate targets require us to reduce emissions. So, the very definition of ‘pure-play ESG’ could differ given the context. Even in Europe, the EU Taxonomy is considering gas and nuclear-based investments as ESG because of their specific context. So, a transition-oriented Indian context would also be relevant to our market.

Despite the various debates on ESG, we have to take note that the ESG investment space in India is becoming interesting. Till 2018, there were two ESG-themed funds; in 2021, there were 10. The assets under management of these mutual fund products increased to over `12,000 crore in 2021 from `3,500 crore in 2019-end. The green bond space has also been evolving fast. As per Bloomberg data, in 2020, India was the second-biggest market for green bonds in the emerging markets after China. More investors are now integrating ESG in their investment decisions. However, it is still an evolving space and needs a lot of investor education and regulatory streamlining. We anticipate positive movement in the green bonds market in the country once we have clarity on the role of sovereign green bonds as announced in the Budget in March 2022. We also anticipate more ESG integration in funds, irrespective of them being thematic.

The basic difference we have seen between India and most western markets is that in Europe, asset owners have taken an active role in responsible investments and have mandated ESG principles for asset managers, whereas in India, asset managers have taken the lead and are proactively integrating ESG. We now see asset owners becoming more active in India. Once more asset owners warm up to the idea, the ecosystem will evolve faster. The Reserve Bank of India (RBI) has also signed up to the Network of Central Banks and Supervisors for Greening the Financial System. We expect the movement from the banking side when the RBI starts putting out guidelines for banks. Increasingly conscious millennials and Gen Z investors are also expected to demand sustainable and socially responsible funds and investments. We anticipate that the investor community will have no choice but to move fast in this direction to cater to the demand and regulatory mandates. Of course, the early movers will have distinct advantages and would be able to benefit by anticipating risks and monetising the opportunities in a better way.

 

Dhingra is Investment & ESG Analyst, SBI Funds Management Limited; Srinivasan is CIO-Equity, SBI Funds Management Limited