The mainstreaming of environmental, social and governance (ESG) principles by corporates acknowledges the fact that their integration furthers the sustainability of a business by safeguarding the environment, the society, and the interests of various stakeholders.
Investors, on their part, are increasingly considering sustainable, responsible, and ethical practices when they assess corporate performance and risk. Asset managers also play an important role as active investors in companies and in influencing them as part of their larger stewardship role.
For banks as well as non-banking financial sector, too, it is increasingly becoming important to factor in ESG risk as part of their credit appraisal process to appropriately value and mitigate the risk, price it in and suitably adjust loan covenants and tenures.
To be sure, ESG has a positive relationship with a company’s financial performance. Adoption of these principles enhances corporate growth and resilience by boosting the topline through efficient resource use and helping raise capital at lower costs.
ESG also works beyond financial parameters: it enhances the organisation’s public image, making it an attractive investment destination and increasing access to ESG-focused capital. Negative ESG-related news tends to drag down stock returns.
Small wonder, companies across the world are increasingly reporting ESG metrics, driven by regulatory push and investor needs. They are now including this information in their annual disclosures to showcase the health and sustainability of their operations.
In India, with Business Responsibility and Sustainability Reporting becoming mandatory for the top 1,000 corporates, ensuring the incorporation of ESG in evaluation would be easier for investors.
A growing number of central banks and supervisors have also committed to support climate-related financial disclosure reporting, with a consensus that climate change forms an essential part of financial risk and should be addressed by central banks globally. establishment of the Central Banks and Financial Supervisors Network for Greening the Financial System (NGFS) and Sustainable Banking Network (SBN) has further supported the push towards sustainable financial practices.
The Reserve Bank of India (RBI) joined the NGFS in April 2021, aiming to learn about and contribute to global efforts on green finance. This step is likely to support India in its efforts towards policy formation and building climate risk-resilience in the financial sector.
The RBI has also come up with a discussion paper to address climate risk focused on risk evaluation and stress testing, strategy building, internal capacity building, governance, and the risk management structure.
Among the strategies being adopted is negative/exclusionary screening for environmentally and socially sensitive companies. This is a relatively simplistic approach that focuses on avoiding investment in companies that score poorly on ESG parameters.
Relatively evolved investors adopt ESG investment approaches, which incorporate best-in-class and positive screening to capitalise on opportunities.
Several investors are also resorting to complete integration of individual ESG parameters, along with the overall financial evaluation. This approach requires detailed cross-sectoral understanding of ESG parameters and frameworks.
ESG integration as an investment strategy tends to protect from downside risks, especially during an economic crisis, and also performs better than negative screening approaches.
However, asset managers are facing challenges as they need industry-specific technical and financial knowledge to evaluate the achievable net-zero commitments of companies.The active investment approach also requires sustained efforts and specialist resources. Further, at times, data is not quantitative, clear or comprehensive.
The availability of reliable data from companies plays a critical role in ESG assessment and peer benchmarking. Data reliability also determines the degree of integration adopted by investors.Investors also rely on third-party ESG ratings/scoring providers and proxy voting agencies.
To conclude, internal capacity building, evaluation and integration frameworks, access to data and independent third-party opinions have ..
Although many investor classes are still at an early stage of their ESG evaluation journey, most large global institutional investors have well-defined ESG policies as part of the investment due-diligence and monitoring process.Many of the funds have also embedded ESG as part of the incentive structure of fund management and investment teams.
Moreover, funds with specific mandates in these domains have emerged to capitalise on opportunities for impact investing and clean energy investments. ESG evaluation is deeply ingrained in the overall investment process for such funds.
Evaluation and integration frameworks
Many other investors are still grappling with creating an evolved ESG framework.
Among the strategies being adopted is negative/exclusionary screening for environmentally and socially sensitive companies. This is a relatively simplistic approach that focuses on avoiding investment in companies that score poorly on ESG parameters.
Relatively evolved investors adopt ESG investment approaches, which incorporate best-in-class and positive screening to capitalise on opportunities.
Several investors are also resorting to complete integration of individual ESG parameters, along with the overall financial evaluation. This approach requires detailed cross-sectoral understanding of ESG parameters and frameworks.
ESG integration as an investment strategy tends to protect from downside risks, especially during an economic crisis, and also performs better than negative screening approaches.
However, asset managers are facing challenges as they need industry-specific technical and financial knowledge to evaluate the achievable net-zero commitments of companies.The active investment approach also requires sustained efforts and specialist resources. Further, at times, data is not quantitative, clear or comprehensive.
The availability of reliable data from companies plays a critical role in ESG assessment and peer benchmarking. Data reliability also determines the degree of integration adopted by investors.Investors also rely on third-party ESG ratings/scoring providers and proxy voting agencies.
To conclude, internal capacity building, evaluation and integration frameworks, access to data and independent third-party opinions have become all too crucial for companies, given that most are at an early stage of their ESG journey. These are also important from the perspective of investors and lenders as they help gauge the sustainability quotient of a company.