Doing ESG investments the right way

It would be an understatement to say that ESG investing is becoming mainstream. Sustainable investing assets (or investments incorporating Environmental, Social and Governance factors) globally are upwards of $30 trillion and have grown at a healthy clip over the last five years reflecting the rising awareness among all stakeholders (investors, companies, and fund managers) as well as the evolving regulatory environment which has sparked new interest.

In India, as well, investing using ESG principles has generated significant interest over the last couple of years, mirroring the global trend, buoyed by a significant policy push which is creating newer investment opportunities, for example, as observed in renewable energy which has been a focus area with a target capacity of 450GW by 2030.

Over the last few years, the government has put in place many policies and practices focused on sustainable development. There is also both a push and pull approach toward ensuring better ESG standards, including incentives/subsidies for establishing renewable power plants, introducing stringent emission norms for auto companies, Sulphur Oxide and Nitrogen Oxide (SOx/NOx) limits for running of thermal power plants and carbon tax on coal among others.

Sebi has also implemented several regulations to improve governance and financial reporting standards to bring them on par with developed economies. A few notable policy changes over the past decade include (1) introduction of the Companies Act 2013, (2) adoption of Indian Accounting Standards (Ind AS), (3) SEBI Listing Obligations and Disclosure Requirements (LODR) regulation changes, and (4) Insolvency and Bankruptcy Code. More recently, the regulator has also made sustainable reporting for top-1,000 companies in India more comprehensive by introducing new Business Responsibility & Sustainability Reporting (BRSR) mandatory effective FY2023.

But what value does ESG drive, for either investors or corporates? In our analysis, a value of a company is the present value of its future cash flows. In one of the valuation models, more than 90% of the value is derived from the terminal value. Poor ESG practices pose a risk to business longevity and hence reduce the terminal value of the company. Thus, ESG considerations are critical in assessing business longevity and terminal value risk. There are numerous examples in India and elsewhere where poor ESG practices have led to the closure of plants, hefty fines, and other regulatory actions which in turn destroyed shareholder wealth. That is why ESG adoption in India has moved beyond a “soft” issue to a strategic priority. Corporates are increasingly integrating core business drivers with ESG factors, and it is no longer a question of balancing trade-offs between ESG impact and financial returns - it is now well understood that a strong ESG proposition built on sustainable growth drivers is a win-win for all stakeholders.

Obviously, different sectors will have differing sensitivities to ESG factors. For example, companies in utilities and resources will have to tackle very different ESG risks as compared to an IT or a financial services company. In general, we see clear evidence of companies across the spectrum taking firm actions to address some of the ESG-related risks. The utility sector is subject to higher scrutiny not only because it deals with emissions and waste disposal but also because the regulations pertaining to the sector have often been perceived to be non-transparent, especially in other emerging economies like China. But Indian chemical companies have successfully navigated this challenge by integrating ESG into their core business strategy and adopting world-class technologies to cut down emissions. Sector leaders have also optimised processes to ensure better use of raw materials (bringing down costs as well), incorporating more efficient waste management as well as building capabilities in green chemistry.

Recent geopolitical events though have raised concerns of some investors on the viability of ESG as an investment theme. True, there are still certain inconsistencies especially when managers have to deal with factors like lack of standardised reporting & limitations of ESG data providers. Investors have also become warier of ‘greenwashing’, which is the practice of making the fund appear ESG compliant by misleading claims and data representation to attract ESG capital flows. There have also been issues with managers classifying their existing funds as ESG compliant. However, we believe that a higher degree of scrutiny on ESG investment products is welcome as it will force managers to build a robust methodology that incorporates real-world social and environmental trends.

It is important for managers who build a holistic assessment of the business to understand the materiality of ESG factors. A deep emphasis should also be laid on how quickly companies can transform their operations in relation to ESG risks. A relevant example is a sector like cement, which is a large greenhouse gas emitting one. Sectors like cement wherein Indian companies have done well by having one of the lowest carbon intensity among all their peers across the globe. In sum, ESG investing may be in flux right now but companies who build moats around sustainability and good governance will provide more alpha-generating opportunities as well.

(The writer is Investment Director at White Oak Capital Partners)