With the threat of climate change and depletion of natural resources, ESG or Environmental, Social, Governance analysis is being increasingly applied by investors across the world in their investment process to gain a comprehensive understanding of the companies they are investing in. The analysis is based on three non-financial factors vis-à-vis Environmental, Social and Governance. This article aims at providing an insight into ESG investing and its metrics.
What is ESG investing?
ESG investing refers to the process wherein the investors invest in the companies that rank higher in terms of environmental, social, and corporate governance scores, as ascertained by a third party, independent companies, or research groups. This strategy is now being popularly used to put the money with companies that are striving to perform better and make the world a healthier place. Through this, investors are trying to create a positive influence on society.
ESG factors
ESG comprises three non-financial factors impacting a business operation. These factors may be measured but it is difficult to assign a monetary value to them.
Environmental:
It refers to the sustainable use of natural resources, waste management, and the conservation of flora and fauna. A company may be measured in terms of its sustainability efforts and adoption of eco-friendly practices towards preserving the natural world by means of reducing its carbon emissions, controlling air and water pollution, methods adopted for waste management, energy efficiency, recycling, and disposal practices, etc.
Social:
It refers to business relationships or the involvement of people in operating an organization. It also includes Corporate Social Responsibility i.e., a company’s contribution towards society from its earnings and profitability. The parameters may include the customer satisfaction score, labor standards adopted, employees’ health and safety, gender equality, racial diversity, prevention of sexual harassment, employee satisfaction, etc.
Governance:
It refers to a company’s code of conduct or the policies adopted for running a business. Companies that score high on Governance are the ones that are clean and transparent and whose management is ethical in the conduct of its activities. It takes into account the Board composition, audit committee structure, whistleblower schemes (allowing employees to report any illegal work), political contributions, etc.
Why ESG investing?
Investors nowadays are becoming more aware of environmental and social problems such as climate change, gender inequality, data privacy, etc. They want to ensure that they do not invest in firms that add to these problems but rather invest in those that are leading the ESG movements. The Covid-19 pandemic which has heavily impacted the global economy has further reinforced the importance of making long-term sustainable investment decisions. Sustainable investment is possible only if an investor incorporates both financial and non-financial factors (ESG) while evaluating the companies.
Considering the ESG factors gives a fuller view of companies, which can help in mitigating risks by avoiding investing in companies that might pose a greater financial risk due to their environmental or other practices. Some surveys have shown that stocks of companies with better ESG scores are less volatile during the market movements triggered by unforeseen circumstances and also offer better returns. About 53% of institutional investors agree that companies with better ESG track records generate better investment returns. It may sometimes happen that a company is performing well in terms of its stock price but may still be considered bad for investment purposes because of its unethical conduct of business.
How are ESG scores calculated?
ESG score is nothing but a rating provided by ESG research firms by evaluating the three components i.e., E, S, and G on certain criteria as listed above (not an exhaustive list) based on publically available information and then assigning a weight to each criterion. Some of the well-known research companies include Bloomberg, JUST Capital, and MSCI. Scores may vary among the research firms as they may employ different evaluating criteria and assign different weightage. For example, scores provided by CRISIL (an Indian analytical company) are based on a scale of 1-100, with 100 denoting best-in-class ESG performance. On the other hand, Morningstar (A Chicago-based investment research firm) assigns a risk rating score which means, the lower the score, the better the company performs on ESG metrics.
CRISIL has assigned ESG scores to 225 companies in India across 18 sectors amongst which Infosys, Mindtree, TCS, Wipro and Kotak Mahindra Bank have emerged as the top five entities in terms of ESG scores. They scored 79, 77, 75, 75, and 74 respectively out of 100. The lowest scorers include India Cements (37), Vodafone India (40), Star Cements (41), Godfrey Phillips (41) and Coal India (43). It was concluded that IT and financial companies scored relatively high because of their lower natural resource intensity resulting in lower wastage and emissions. Also, the employment rate in these companies is high. At the same time, oil and gas, chemicals and cement companies scored lower ESG scores given their extractive use of natural resources and potential adverse impact on environment and community.
For a better understanding of scoring done by Morningstar, if we take the example of Nestle India Limited, it has been assigned an ESG risk rating of 27. The company also ranks 88 in the food products industry among 550 others. This indicates that Nestle is a medium risked company. For arriving at this rating, Morningstar evaluated the company on the basis of its exposure to material ESG risks (like corporate governance, resource utilization, customer health and safety, product quality, etc.) and how well it is managing those risks. Also, the risk rating was highly impacted by the controversies that Nestle has been involved in, including the Maggi noodles controversy which challenged the health and safety standards followed by the company. It nearly threatened the existence of Nestle India.
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Risks of ESG Investing
There are mainly two risks associated with ESG investing-
i) There is no approved universal standard for evaluating ESG performance which may create inconsistencies in scores.
iii) There is no mandate for companies to report on their ESG issues and so they may voluntarily stop providing such information in the public domain. [However, SEBI is considering making it mandatory for large companies to file ESG-related disclosures annually in the form of a Business Responsibility and Sustainability Report (BRSR)].
ESG in India
According to Morningstar, globally about $2.96 trillion has been invested in funds that are managed with an ESG focus. However, in India, the concept of ESG investing is still evolving. The Nifty 100 ESG Index was designed to reflect the performance of companies within the Nifty 100 index based on the ESG score. While looking at the data from the last five years, it is evident that the Nifty 100 ESG Index has performed better than the Nifty 100 Index. The Indian mutual fund industry has also rolled out new funds with an ESG focus. Currently, there are top three funds in ESG — SBI Magnum Equity ESG, Quantum India ESG Equity and Axis ESG.
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