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Environmental, Social, and Governance: The megatrend in investing

We published our first report on ESG (Sustainability- Expanding Horizons) in June 2017.What we saw as a significant emerging trend back then has gained remarkable acceptance amongst investors in the past 5 years and is now evolving as a megatrend in investing.

* While the roots of Environmental, Social, and Governance (ESG) date far back to 1970’s, it has gained significant ground in the last decade – especially since the launch of the 17 Sustainable Development Goals (SDGs) by the United Nations Organization (UNO) in 2015. The size of sustainable assets grew multifold at a CAGR of ~11% between 2016 and 2020 and stood at USD35.3t in 2020. The sustainable investment share in global AUM rose to 36% in 2020 (from 28% in 2016).

* The emerging markets (EMs) currently have a negligible share in the sustainable asset pool, mainly due to the emerging state of the capital markets and economy. Going forward, the rising adoption of stewardship codes in these markets, along with a focus on governance reforms and improved ESG disclosure, may help boost the share of such assets allocated to them. India is also likely to see a higher allocation of funds in the form of sustainable investments in the coming years.

Why has investing in ESG become so critical?

* Global warming and climate change have emerged as the world's greatest risks today. Countries across the globe have set targets to achieve carbon neutrality and are working towards achieving these targets and walking the path to a more sustainable future.

* Companies are already experiencing the financial consequences of failing to act on sustainability as many countries have implemented regulations such as carbon taxes and penalties. Moreover, the Financial and Banking sectors have integrated ESG rules into their funding criteria. The only way stakeholders can avoid poor lending conditions and exclusion from the capital markets is to show evidence of having developed robust sustainability and ESG strategies.

* Investors, especially foreign institutions (FIs), have included sustainability and ESG criteria into their portfolio strategies. Investors have realized that investing in companies with a robust and convincing ESG strategy positively affects returns and reduces the investment risk, generating sustainable and better long-term financial returns.

India's ESG journey in the nascent stage

* India is trailing with regard to sustainability performance and ranks 120th out of 165 countries in terms of total progress towards achieving all SDGs, as per the UN Sustainable Development Report 2021. Recently with India committing to a 2070 deadline to achieve net-zero emissions, the progress towards sustainability should gather pace in the coming years.

* The regulatory push has, over the years, shaped the governance landscape in India. Sustainability has also been introduced to Corporate India through regulations. Regulatory steps such as the introduction of stewardship codes for institutional investors and the Business Responsibility and Sustainability Reporting (BRSR) framework - which would be applicable for the Top 1,000 listed companies, by market capitalization, from FY23 (voluntarily in FY22) - are certain key steps in the direction of improving governance standards and ESG disclosures for companies.

ESG investing in India to grow multifold

* The size of ESG investments in India from a global sustainability AUM perspective is currently negligible, but it has been growing significantly. Even domestically, the aggregate AUM in ESG funds as of 30th November 2021 was just ~0.3% of the MF industry AUM.

* However, COVID-19 has further accelerated demand for sustainable investing. 7 of 10 ESG funds in India have been launched since January 2020. ESG funds witnessed strong inflows, with aggregate AUM jumping to INR123.2b in November 2021, from INR26.3b in November 2019, reflecting a ~4.7x jump over a two-year period.

* Since most of the ESG funds have started recently, it would be premature to evaluate their performance with benchmark indices. In developing regions, given the nascent stage of the capital markets, the outperformance of ESG funds should be sharper as the gap in practices between the ESG leaders and laggards is larger - and the same should apply to India. This is evident from the sharp outperformance of the MSCI India ESG Leaders index v/s the MSCI India index since its launch in 2007.

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