ESG – is it the future of “sustainable” investment

Contributed by: Samvad Partners






The COVID-19 pandemic has impacted the world in unprecedented ways and has accelerated and forced the recognition of environmental, social, and governance (ESG) considerations and responsible investment philosophies and practices. The crisis, which forced multiple countries into recession, has brought the focus back on issues such as climate change and has pushed the policymakers and investors towards considering more sustainable investing methods. The future of sustainable investing is in the balance. It involves balancing financial and extra-financial considerations, balancing the short term and long term to ensure that short-term goals do not compromise long-term goals, and balancing stakeholder interests and seeking fair outcomes for all. Sustainable investment develops deeper insights about how value will be created going forward using ESG considerations.


In the attempt to rebuild businesses, many companies have started adopting and have a very focused approach towards ESG principles to attract more cross-border investments. In India too, ESG investing has been gaining momentum, which is corroborated by the fact that several funds have been set up with the view to invest exclusively in companies that promote ESG values. In 2019, Avendus Capital launched a $1 billion fund, the “Avendus India ESG Fund”, with ESG investments as its primary focus. This fund is stated to invest on the basis of predetermined ESG factors, along with in-depth financial analysis, with the aim of generating long-term risk adjusted returns. Former Tata Group executives floated a $1-billion private equity fund along with Quantum Advisors mutual fund, designed to invest solely in publicly listed companies that promote environment, social and governance (ESG) value. On the similar lines, investment funds such as 3one4 Capital Advisors LLP, SBI Funds Management Private Limited, Omnivore Partners and Equicap Asia Management Private Limited have all signed the United Nations Principles of Responsible Investment (“UNPRI”). UNPRI consists of six principles which are commitments made by the investors on possible actions that they would take for incorporating ESG values into investment practice. According to data released by the Association of Mutual Funds in India (AMFI), combined assets under management (AUM) of existing ESG funds in India was Rs 9,516 crore in December 2020.


ESG investing considers environmental, social and corporate governance criteria to generate risk-adjusted long-term returns with positive societal impact. ESG aims to achieve the triple bottom line—good for people, planet and profits. It is a structured approach for measuring sustainability by identifying potential opportunities and unearthing risks hidden beneath a company's business activities. This indeed imparts a material impact on a firm's valuation.


Although India does not yet have a formal policy framework or legislation dealing with ESG, certain principles of ESG are well entrenched in various Indian laws. India is one of the few countries to legislate on principles of corporate social responsibility (CSR), mandating its compliance for certain companies under the ambit of the Companies Act of 2013 (Companies Act). In 2018, the Indian Ministry of Corporate Affairs (MCA) also issued the “National Guidelines on Responsible Business Conduct” (NGRBC) which sets out nine principles of business responsibility that are akin to ESG principles. Briefly, NGRBC states that businesses should provide goods and services in a sustainable and safe manner, respect and promote the well-being of all employees, respect and promote human rights and make efforts to protect and restore the environment.


Enumerated below are some of the laws that indicatively regulate ESG principles in India:


Environment

One of the significant laws governing environmental issues in India is the Environment (Protection) Act, 1986 (EP Act) which deals with the legal framework for protection and improvement of the environment. The EP Act specifically addresses offences by companies and makes the company, as well as every person directly in charge of conducting the business of the company, liable for any offence under the EP Act.


The EP Act was enacted in the wake of the unfortunate incident of gas explosion in the pesticide factory of Union Carbide India Limited in Bhopal in 1994. The incident is considered to be one of the worst industrial disasters in India, which led to leakage of at least 30 tonnes of the deadly methyl isocyanate gas, that killed over 15,000 and affected nearly 600,000 people. The EP Act brought about significant changes in determining the persons in charge of a company and their responsibilities in case of occurrence of an industrial disaster.


On the investments side, India has embraced green bonds, becoming the second-largest emerging green bond market in the world, after China. Green bonds are essentially used to raise money specifically for financing new or existing projects that have a positive environmental effect, such as projects involving renewable energy, waste management or water and land use. Between 2015 and 2018, the Indian market issued green bonds worth a cumulative value of $7.1 billion. In 2018, the State Bank of India (SBI), India’s biggest public sector bank, established a $650 million green bond, as part of a larger program to raise up to $3 billion via green bonds. Moreover, aside from financial institutions, local governmental authorities in India have also undertaken the issuance of green bonds. The Pune Municipal Corporation became the first civic authority in India to issue green ‘municipal’ bonds worth INR 200 crores to fund its project of enabling 24-hour water supply under its Smart City initiative in 2017. Similarly, in 2018, the Greater Hyderabad Municipal Corporation also issued similarly sized green bonds to fund its road projects under the Smart City Initiative.


Social

CSR framework governed by the Companies Act, mandates that any company, with a net worth of INR 500 crores or more, or a business turnover of INR 1000 crores or more, or net profit of INR 5 crores or more during any financial year should have a CSR policy, under which the company should undertake initiatives towards betterment of the community. The objective of CSR regulations is to get businesses to consider social and economic issues which may not influence their profit margins but are important in bringing about a positive change in the society.


While formulating CSR policies, companies have the option of choosing on how to spend the CSR funds based on a list of approved activities provided under the Companies Act, which include activities involving eradication of poverty, promotion of education, promotion of gender equality, combating human diseases, ensuring environmental sustainability or through contribution to funds set up by the central government or the state governments for socio-economic development and relief. At least 2% of the average net profits earned by a company during the immediately preceding three financial years, needs to be spent, every financial year towards CSR activities. The Companies (Amendment) Act of 2019 further provides the fines and punishments for contravening the CSR provisions instituted in the Companies Act.


In 2020, the MCA notified that a company’s expenditure towards combating the COVID-19 pandemic will be considered valid under CSR activities. Funds may be spent on various activities related to COVID-19 such as promotion of healthcare, including preventive healthcare and sanitation and disaster management.


Although the move to make CSR mandatory among certain companies is an appreciated move by the MCA, the criteria of such net worth, turnover or net profit thresholds largely limits the number of companies who must abide by the CSR requirements. Smaller companies and start-ups do not have to undertake any such CSR activities under the Companies Act.


Governance

Governance is one of the key elements of ESG principles. India was ranked at 7th position among 12 countries with a score of 54% in the Asian Corporate Governance Association 2018 report on corporate governance in key Asian jurisdictions.


Corporate governance in India is derived from a set of mandatory requirements as established by the laws, regulations and voluntary guidelines issued by the regulators. The Companies Act also lays down the powers of the board and details the roles and responsibilities of directors in a company. Furthermore, the Companies Act makes reference to the ESG principles by stating that a director of a company is required to act in good faith to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for protection of the environment.


Aside from the Companies Act, the MCA issues rules and guidelines that provide further measures and disclosures companies need to follow in India. Listed companies in India are also regulated by the Securities and Exchange Board of India (SEBI).


In 2012, SEBI issued a circular (2012 Circular) mandating the largest 100 listed companies of India to publish an annual business responsibility report. This requirement of publishing an annual business responsibility report of the largest 100 listed companies of India was expanded to the 500 largest listed companies by SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. The business responsibility report required companies to provide details on the implementation of core nine principles as provided in the 2012 Circular. These principles are the same as the nine principles provided in the NGRBC released by the MCA and focus majorly on incorporating many ESG factors in the day-to-day operations and business of a company including ethics transparency and accountability, policies for employee well-being, promotion of human rights and steps taken by the company towards restoration/protection of the environment.


A rise in ESG investing could ultimately lead to more stringent laws governing ESG factors in India. However, steps are being taken, both globally and in India too, to boost ESG investing. Rating agencies like Moody’s have incorporated ESG risk in their ratings by taking qualitative and quantitative ESG factors into account and considering them in the overall analysis of credit drivers. In 2018, the Bombay Stock Exchange published the “Guidance Document on ESG Disclosure” which provides voluntary ESG reporting recommendations that are set to broaden organisational disclosures beyond traditional financial metrics and raise corporate transparency on environmental and social metrics. The document contains 33 ESG key performance indicators on which companies should focus, including environmental policy, health care benefits for employees, human rights policy of the company, gender parity ratio at workforce, gender pay ratio and bribery/anti-corruption code, amongst others. In 2019, the MCA also stated that it is in the process of developing India’s National Action Plan on Business & Human Rights (in consultation with various Ministries and State Governments) by 2020. A zero draft is uploaded on the MCA website, which states that the national plan seeks to provide an overview of India’s legal framework setting out the state’s duty to protect human rights, the corporate responsibility to respect human rights and access to remedy against business‐related human rights violations.


In India, contributions made by companies towards COVID-19 relief work has been categorized as a CSR activity by the MCA, this is likely to enhance the social factor of the ESG scores of companies. However, some companies may, in a desperate bid to cut operating costs, overlook certain ESG factors, but at a time like this when the investments scene is changing towards sustainable and impactful investing globally, this could be a poor move that may lead to losses for such companies in the long run.


Since there is no permanent policy on ESG either globally or in India, investors and funds are free to decide their own parameters for ESG compliances. A company's track record in handling environmental, social and governance aspects is increasingly becoming an essential consideration for investing. However, for an average investor, analyzing these aspects could be challenging, primarily due to lack of resources like time and information. This could be attained, subjectively, by evaluating parameters across the environment, social and governance domains while screening companies. Weightage could be given to companies on their ESG performance relative to their peers and national/global regulations on material ESG aspects and the remaining analysis could be done on the levels of disclosures provided by the companies in their sustainability reports/business responsibility reports/annual reports.


Companies should also be more inclined to inculcate ESG principles while undertaking their businesses as it works well for the long-term sustainability of the company. Ranking high on ESG parameters would not only attract more ESG investing, but failing to abide by certain ESG factors such as environmental violation or poor governance could lead to the company facing major backlash from the media and stock market plus incurring huge losses. For example, the Volkswagen emission scandal of 2015 cost the company $7 billion to cover the costs, another $4 billion in penalties and huge dip in the company’s stock prices and global reputation.


The world faces enormous challenges in securing a sustainable future and the adoption of ESG policies by companies at large and insistence by investors on implementation of the same, would represent an essential early step in the right direction. Better ESG corporate practices (such as supply chain management and corporate governance) have made companies more resilient to shocks and made them outperform. Thus, within sustainable investing lie the fundamental elements of the sustainability of investing. Investors and the investment industry have a considerable role to play in determining the pathway and shaping a future worth investing in. The fact is that COVID-19 has strengthened the case for responsible investment and global investors must now harness this momentum to help drive forwards a green, inclusive, and sustainable recovery.


Contributed by Samvad Partners


The above article has been authored by Ms. Nisha Mallik(Partner).