Why investors should graduate risk-return expectations from widely assumed ESG

However, India has set itself aggressive targets at the latest COP26 (Conference of the Parties) summit in Glasgow in 2021. These enhanced COP26 commitments and New Energy efforts are significant: net carbon zero by 2070, renewable energy target raised to 500 GW by 2030 from 450 GW, PLI – pump-priming – for solar modules, advanced battery storage and green hydrogen generation.

Several developments are already unfolding in India since 2008, when S&P launched its ESG India index. In 2021 a welcome standardization of ESG reporting was brought forth by SEBI. It launched the BRSR (business responsibility and sustainability reporting) framework, mandatory for Top 1000 listed companies from FY23 onwards.

BRSR will be the one-stop shop for all sustainability-linked or non-financial information for Indian companies replacing the existing BRR (Business Responsibility Report). BRR required companies to respond to a list of standardized questions that do not accurately measure the progress taken towards sustainability goals.

Apart from more transparent reporting, ESG Integration is another overarching trend in this space. Notably, it affects how an investor approaches ESG investing. Typically, the most predominant style of investing is based on negative screening. Another kind involves “best-in-class” or a “norms-based investing”.

Instead of plain bottom-up negative screening, companies are compared to their sectoral peers regarding their business practices stacked against international norms like those set by the UN (SDGs) etc. An investor could also allocate her wealth to a relevant ESG fund though currently, in India, this market is small and is only ~0.3-0.5% of the MF industry AUM (2021).

ESG integration is an indirect yet holistic approach that ingrains ESG parameters across all investment analyses and decisions and not only at the research stage of picking companies. The approach focuses on value creation via investment selection (fundamentals and valuations), portfolio management, risk management and shareholder advocacy.

For instance, within portfolio management, in Tactical Asset Allocation decisions, ESG objectives are factored in and analyzed to mitigate short-term ESG risks. In addition, in the valuation stage of company selection, adjustments are made for discount rates, perpetuity growth rate, terminal value etc., for the expected impact of ESG factors.

Investors could adopt a method for this fastly evolving ESG based investing style. Initially, to identify ESG-leaders using a suitable framework and to capture ESG-favourable regulatory trends. Ongoing tracking of FII ownership in companies would help align allocations to rating changes. Last but not least, investors should graduate risk-return expectations from widely assumed ESG to be a return-compromiser to a return-enhancer.