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Explained: What to look at before investing in ESG funds

🔴 With policy frameworks changing, experts say socially responsible investing will bring good returns. But there are some areas of concern to address.

Written by Pranav Mukul , Sandeep Singh |
Updated: December 24, 2021 7:58:32 am
ESG funds, ESG investing, Investment news, Investors news, Explained, Indian Express, National Stock Exchange NSE, NSE Prime, Indian Express Explained, Current affairs, business newsMarket experts say investors in funds and companies would do well to keep the factors of environmental sustainability, social responsibility, and corporate governance in mind for long-term sustainability of investment returns.

Environment, social responsibility, and corporate governance have of late emerged as key themes for investors in India. The asset size of ESG funds has ballooned nearly five times to Rs 12,300 crore over the last couple of years. Earlier this week, the National Stock Exchange (NSE) launched NSE Prime, a framework that allows companies to submit to standards of corporate governance that are higher than those required by existing regulations.

Market experts say investors in funds and companies would do well to keep the factors of environmental sustainability, social responsibility, and corporate governance in mind for long-term sustainability of investment returns. However, some are sceptical of the possibility of “greenwashing”, and of fund managers over-weighing certain stocks once other options are deemed non-compliant with ESG investment parameters.

ESG investing

The expression is used synonymously with sustainable and socially responsible investing. While selecting a stock for investment, an ESG fund shortlists companies that score high on environment, social responsibility, and corporate governance, and then looks at financial factors. With the overall increase in awareness, and with regulations moving in this direction, investors are re-evaluating traditional approaches and considering the impact of their decisions on the planet.

As ESG funds gain momentum in India, companies will be forced to improve governance and ethical practices, and act with greater social and environmental responsibility, fund managers say. As the policy framework changes, companies that do not alter business models or become more environmentally sustainable, could have their revenue and profits impacted in the long term, they say. Globally, many pension funds and sovereign wealth funds do not invest in companies that are seen as polluting or socially not responsible.

NSE Prime

While sign-up is voluntary, NSE is looking to create a bouquet of companies across market capitalisations that will follow a higher standard of corporate governance (as prescribed for NSE Prime) which is a notch above the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations.

Some key requirements for companies to qualify for NSE Prime are: a minimum 40 per cent public shareholding; mandatory segregation of the posts of chairman and CEO; independent directors as chairpersons of the risk management, stakeholder relationship, nomination remuneration, and audit committees.

The idea is to nudge companies to raise levels of corporate governance practice on their own. The creation of such a group of companies will result in better decision-making and protection of shareholder interest, it is hoped.

“It will send a message that these companies truly believe in higher standards of corporate governance and that they are ready to raise the bar on holding themselves accountable,” NSE CEO Vikram Limaye said.

ESG MF offerings

Most top fund houses, including SBI Magnum Equity, Aditya Birla Sun Life, ICICI Prudential, Quantum India, Kotak Mutual Fund, and Axis Mutual Fund offer ESG investment opportunities. Because this is a niche area, the fund houses have set the expense ratio of their ESG funds in the higher range.

ESG funds use parameters such as greenhouse gas and carbon emissions, and employment generated to assess the ESG impact of the companies. Thus, companies with higher carbon outputs such as tobacco manufacturers, coal miners, oil and gas companies, and fossil fuel-based power generators typically do not feature in ESG fund portfolios. On the other hand, companies in the technology, renewable energy, healthcare, and FMCG space feature heavily in these portfolios.

Behind ESG growth

Fund managers have pointed out that greater policy focus on aspects such as cleanliness, skill development, expanded healthcare coverage, and education indicates potential public investment in these social development and environmentally sensitive sectors of the economy. There is increasing awareness and understanding among younger investors about the impact of business on social development and environment.

The 2021 Millennial and Gen Z Survey by Deloitte found: “During the pandemic, health care and unemployment topped millennials’ list of concerns. But environment remained a priority (#3 for millennials and #1 for Gen Zs ). ~40% believe that more people will commit to take action on environmental issues after the pandemic…”

Experts say that companies that are part of the ESG or NSE Prime will not only be on the right side of regulations and benefit from it in the long term, but will also have a better reputation and potentially command a premium on valuation in the long run. They may also attract a better quality of retail and institutional investors, these experts argue.

An area of concern

Alongside the greater attention on issues such as climate risk, emissions, supply chains, labour rights, anti-corruption, etc., certain concerns have been flagged as well.

One of these is the possibility of “greenwashing”, understood as an act of conveying a “false impression or providing misleading information about how a company’s products are more environmentally sound”.

In an agenda note published on December 21 on ‘How to address sustainable investment backlash and improve ESG reporting’, the World Economic Forum noted that greenwashing is a top concern among global institutional investors, “cited by six in 10 respondents as an issue when selecting sustainable investments, according to a Schroders Institutional Investor study. It’s also been known to be a problem for retail investors, who especially struggle to decipher complex ESG investments”.

Investment experts have also pointed to the tendency of fund managers to over-weigh certain stocks and companies in a situation where most large investment-friendly companies have fallen short of the qualitative and quantitative parameters used for ESG investing.

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