There is rising recognition of Environment Social and Governance (ESG) investing in developing economies, especially in times of increasing global uncertainties owing to the COVID-19 pandemic. Companies with strong ESG credentials are seen to be performing well financially with a marked increase in the share prices vis-à-vis their competitors. This indicates increased integration of ESG into asset pricing. Interestingly, the risk and return trade-off for investors have also changed after the onset of the pandemic.
Looking at global trends, the United Nations Principles for Responsible Investment (UNPRI) has reported an increase of 26 percent in ESG assets in 2021, as against 22 percent in 2019. By March 2021, 601 signatories (asset owners) of the UNPRI group managed more than $121 trillion.
Global inflows in sustainable funds have increased by 88 percent, in which Europe has accounted for almost 80 percent, followed by the United States, Asia (excluding Japan), Australia/New Zealand, Japan, and Canada.
According to the Emerging Portfolio Fund Research (EPFR), a wealth management advisory firm, equity funds with a focus on ESG mandates have seen a record inflow of $168.74 billion in 2020 vis-a-vis $63.34 billion in 2019, manifesting an increase of 166 percent in 2019-20. Similarly, the number of ESG Exchange Traded Funds (ETFs) has jumped from 39 in December 2009 to 221 in June 2019 with an increase in the Assets under Management (AUM) at a CAGR of 15.8 percent since 2009.
ESG investing in India has been steadily gaining momentum in the last five years, but efforts are still in the nascent stage. It has been estimated that inflows in ESG mutual fund schemes in India have increased by 76 percent in 2021, increasing from Rs 2,094 crore to Rs 3,686 crore in the time period 2019-20. In addition to this, in 2020, India’s large asset management companies (AMCs) have launched schemes that have a clear focus on ESG aspects. In the stock indices too, the sustainability themed index NIFTY ESG 100 has outperformed the NIFTY 100 across between 2020 and 2021. Further, anticipating stable, long-term risk-adjusted returns, pension funds too have started integrating ESG factors.
So, what contributes to better performance of ESG portfolios vis-a-vis conventional ones?
Positive performance is attributed to accounting for ESG risks, thereby emphasising on risk-adjusted returns. In case of funds, value creation is obtained through cost reductions from effective resource utilisation, increase in social credibility and reputation, developing stronger community relations, increased governance, and undertaking long-term investment decisions to minimise the risk of stranded assets. For companies, long-term value creation is achieved through investing in sustainability strategies, and communicated to investors through effective disclosures. This increases accountability to both its internal and external stakeholders.
While trends in ESG investing are positive, several challenges remain. The main among them is that there are definitional discrepancies. There is a significant overlapping of assets under sustainable investing in which the terms ‘sustainable’, ‘ESG’, ‘green’, ‘climate’ and ‘responsible’ investing are used synonymously. There are four challenges which need to be highlighted.
First, while all these fall under the broad category of sustainable investing, ESG investing refers to integration of ‘environment’, ‘social’, and ‘governance’ factors in investing, and is essentially an investing technique applied by institutional investors.
Second, traditional models such as the Capital Asset Pricing Model, and multi-factor models such as Arbitrage Pricing Theory cannot be used to factor in risk emanating from ESG into asset pricing. However, ESG risk modelling has been attempted by a handful of asset managers using Fama-French multifactor models.
Third, not all ESG indicators can be converted into quantitative variables. Quantification of the qualitative variables is tricky. Fourth, there is a lack of responsiveness towards ESG factors, especially in the fixed income space. This might also be due to information asymmetry, and time lags in capital markets.
These hurdles do not have a one-stop solution, especially when investors are trading off alpha returns and beta risk factors.
Institutionally, Indian companies need to come up with materiality or ESG reporting in which disclosures on financial value addition attributed to ESG factors can be provided. These disclosures assist investors in taking informed decisions.
Moreover, ESG accounting practices also need improvement. The Sustainability Accounting Standards Board and the Taskforce on Climate Related Financial Disclosures provide guidance on this. A significant development in this space is the Business Sustainability Reporting guidelines proposed by the market regulator Securities and Exchange Board of India to increase transparency in the ESG reporting space. The guidelines indicate a notable departure from the previously implemented Business Responsibility Reporting guidelines. The disclosures will help investors assess ESG risks and take informed decisions. Similarly, it will also enable companies to demonstrate their sustainability strategies, and long-term value creation potential.
Simultaneously, the role of the AMCs is extremely significant as they are the potential stewards for developing ESG frameworks in line with the international best practices and principles.
The changing paradigm of institutional investments is evident through increased ESG integration in India. Addressing the barriers will enable to expand ESG integration in fixed income and structured finance spaces. Nevertheless, an overarching regulatory framework needs to be established to fully reap market benefits.
Ria Sinha is Fellow of Resource Efficiency & Governance Division, TERI.
Views are personal and do not represent the stand of this publication.