'ESG is a noble investment strategy that scores on performance and morals'

Investing in companies that do well on environmental, social and governance (ESG) standards is a comparatively new theme in the Indian market. We speak with Swarup Mohanty of Mirae Asset Mutual Fund to understand what it offers, how rewarding it can be, and how it has performed in overseas markets.

What is the role of ESG funds in one's portfolio?

An ESG investor tries to achieve dual objectives, with emphasis on both, i.e., generating financial return while seeking to have a positive environmental, social and governance impact.

Following are the potential benefits that one can aim to achieve by having an ESG fund in one's portfolio:

• The opportunity to align your investment with your values.
• Globally, we have seen that in the long run, ESG funds tend to have the potential to generate higher wealth along with lower volatility.
• Incentivises companies to focus not only on profit but also on planet and people.
• ESG factors can be a leading indicator that may highlight any material risk that may not be evident by financial analysis.

In fact, empirical studies have documented that having ESG funds has improved the overall risk-reward profile of an investor's portfolio. Morgan Stanley analysed more than 10,000 open-end mutual funds and found out that investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is both on an absolute and a risk-adjusted basis across asset classes and over time. In its latest study on the performance of sustainable funds domiciled in Europe, which is the largest market for sustainable investing, Morningstar found out that across all categories, at least 50 per cent of sustainable funds outperformed traditional funds.

All these indicate that an ESG-theme portfolio can form part of your core portfolio as such a portfolio has an option to create wealth with lower risk in the long run. Hence, by investing in an ESG portfolio, you are not only contributing to a better tomorrow by incentivising companies to incorporate ESG practices but you are doing so with the possibility of generating comparable, if not higher, wealth with lower risk. ESG is hence a noble investment strategy that scores on performance and morals.

In India, the concept of ESG is still in its nascent stage. How do you see the theme evolving in the near to long term? Also, since ESG factors are subjective in nature and there is no standardisation in India as of now, how can an investor pick the appropriate fund?

India has consistently been one of the largest emitters of greenhouse gases and it was ranked fifth most-vulnerable country susceptible to climate change among 181 countries in the Climate Risk Index 2020 as per a report published by a German watch. In the last few years, we have seen a rise in the occurrence of floods, a rise in sea levels, increase in heatwave, water contamination, etc., which are detrimental to population and the economy. As per a study conducted by International Labour Organisation, India would be the most impacted country due to heatwave as more than 50 per cent of the India's population is employed in the agricultural sector.

In recent years, we have witnessed a surge in corporate-governance issues, labour protests halting production and protest against companies' projects which are detrimental to the environment. In the context of India, we have seen time and again how big corporates have failed and their investors have lost substantial wealth due to poor governance issues, product issues such as adulteration in drugs, environmental damages leading to the closure of plants, failure of banks' internal mechanism to detect frauds, etc. And more importantly, investors or providers of the capital have penalised such companies. As a result of this, Indian companies have started taking cognizance of material ESG issues. They are aware that all the stakeholders will be closely monitoring any development related to ESG.

Also, the capital market regulator SEBI has pushed it from its end that all top 1,000 listed companies are required to prepare a Business Responsibility Report (BRR). Thus, partly driven by regulators and partly driven by the desire to see action from the stakeholders, India Inc has incorporated ESG practices. Various Indian corporates have integrated United Nations Sustainable Development Goals (SDGs) as part of their core corporate philosophy. Going forward, companies need to align their business and operational strategy, which creates social value and economic value. Albeit at a nascent stage, ESG investing in India is something that will grow exponentially in the coming times.

There is no predefined set or all-exhaustive definition of what constitutes ESG. A company may be claimed as ESG-compliant by some fund houses and not by other asset managers. In such cases, what is important is that an investor should understand the process and framework adopted for the ESG portfolio. It helps the investor to make an informed decision when he/she has understood the process and framework of the ESG analysis. This is one of the reasons why ETFs are one of the preferred investment vehicles for ESG investment across the globe since they are transparent and ESG-screening and integration process is well-defined.

Is it possible for all companies to incorporate good ESG practices in the way they do business? What are the challenges that they face? How can ESG compliance be boosted?

At its core, ESG is a risk-management philosophy and all companies operating across sectors can imbibe it into their own risk-management framework. The degree to which one company is exposed to the ESG risk may differ depending upon its business model. However, even companies operating in industries which are exposed to a higher ESG risk, like energy, can develop a framework around it. Generally, there are two approaches to managing the ESG risk. The first one should measure a company's exposure to industry-specific material ESG risks. Secondly, how well a company is managing or responding to those risks? Not all ESG risk can be completely mitigated and thus for some companies, a portion of risk may be considered unmanageable. For example, an oil company is not able to fully eliminate all its risks related to carbon emissions. For the portion of risks that are manageable, a company's performance should be reflected by its policies, programmes, practices and quantitative performance measures. The biggest challenge which many organisations could face would be in terms of having an ESG-governance framework, because ESG has a broad scope and considers numerous risk types and business lines. Because of this, the leadership needs to take the initiative to set exhaustive ESG-governance standards.

For boosting ESG compliance, I believe measures have already been initiated. In May 2021, SEBI mandated new disclosure norms on sustainability-related reporting for the top 1,000 listed companies by market cap by FY23. The new report mandated by SEBI is a significant departure from the existing framework. Now companies will need to provide an overview of their material environmental, social, governance risks and opportunities and approach to mitigate or adapt to the risks, along with financial implications. That said, still the scope of improvement continues to exist and most important of it being a standardisation of the ESG disclosure, setting up of a framework for ESG standards, etc. This will help in ESG being understood by masses in a simple manner, which in turn will favour the overall development of the ESG market in India.

Please comment on the degree of overlap between the Indian ESG and plain-vanilla diversified funds. In terms of returns, how has been the investor experience with ESG funds, albeit the history would be quite limited.

Since the pool of the universe is the same, there will be inadvertently some overlap between an ESG and a plain-vanilla fund. But what is important is to understand the investment framework behind both these categories of funds. One explicitly uses various ESG-filtering criteria while selecting underlying constituents, while the other may not give much consideration to it, though some traditional funds have been focusing on corporate governance, which is one of the pillars of ESG investing.

In terms of return comparison, we can look at the performance of an index such as Nifty 100 ESG Sector Leader Index, along with performance of active large-cap funds. On a three-year basis, as on August 31, 2021, 88 per cent of actively managed regular large-cap funds have underperformed the Nifty 100 ESG Sector Leader Index and on a five-year basis, 92 per cent of funds are lagging the index performance. While the past performance cannot be a guide to the future replication of it, it intuitively indicates that by shifting to ESG funds or adding ESG funds to complement their existing mutual fund portfolio, investors can enhance the portfolio's risk-return profile.

Globally, how successful do you think ESG companies have been in generating value for their investors/stakeholders? Can you quote any numbers that might help build the case for ESG-compliant companies?

A major postulate hovering among the investment community with regard to sustainable investing is that by excluding companies based on ESG, the investable universe is limited or restricted, which could result in earning lower returns vis-à-vis a portfolio with no ESG restrictions. This is not the case.

The most comprehensive study was conducted and published in 2015 by Gunnar Friede, Timo Busch & Alexander Bassen (2015), 'ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies'. The study essentially evaluated more than 2,000 empirical studies written on the linkage between ESG criteria and corporate financial performance (CFP). Ninety per cent of the studies found out that there is no performance penalty associated with ESG investing. In fact, 63 per cent of the studies found out that there is positive impact of ESG on CFP.

Further, a study conducted by Oxford Business School in a report titled 'From Stockholder to Stakeholder' found out that in 90 per cent of the studies, a company implementing a strong sustainability practice can see a reduction in its cost of capital. Eighty-eight per cent of the studies pointed out that strong ESG practices lead to an improvement in the operational performance of a company. Most importantly, 80 per cent of the studies found evidence that there is a positive influence of a strong ESG framework on companies' stock performance. As per the report, lower cost of capital, combined with an improvement in operational performance, generally leads to high valuation, which in turn may translate into higher and sustainable returns for the investor.

In its 2020 study covering the period from December 31, 2015, through November 29, 2019, MSCI found out that companies with high ESG scores, on average, experienced lower costs of capital compared to companies with poor ESG scores in both developed and emerging markets during a four-year study period. The cost of equity and debt followed the same relationship. In the MSCI World Index, the average cost of capital of the highest-ESG-scored quintile was 6.16 per cent, compared to 6.55 per cent for the lowest-ESG-scored quintile; the differential was even higher for MSCI Emerging Market (EM).

All these studies continue to indicate that incorporating ESG into their management framework has helped companies to generate or enhance the efficiency and value of the organisation, with reduced downside risk.

This interview was conducted in December 2021

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