All you need to know about ESG investing and how it differs from ethical investing

To arrive at a universe of stocks for investing, many different types of filters or criteria can be used. Among the many criteria, ESG (environmental, social and governance) parameters have gained wide prominence in many advanced economies and are gaining traction even in India.

Companies are chosen based on how responsible they are with environmental factors, how they treat the society they operate in, as also employees, and finally how they deal with the governance and legal frameworks while working with shareholders, governments and the like.

In other words, ESG is in part about sustainable investing and more importantly, being highly responsible to multiple stakeholders.

Worldwide, ESG assets are over $35 trillion currently and are expected to increase to more than $50 trillion by 2025, according to Bloomberg data. An increasing number of pension funds and institutional investors insist on choosing only companies that score high on ESG parameters.

Here, we look at each of E, S and G in detail, what are the indices available in India, the investment avenues on offer and finally, discuss the difference between ESG and ethical investing.

 Critical factors determining stock selection

 As mentioned earlier, environmental, social and governance are the three pillars for stock selection in this mode of investing. Here are some key points considered under each of the three heads before zeroing in on suitable investments.

Environmental: Some of the factors considered include energy consumption, checking on greenhouse gas emissions, water usage, waste disposal, rainwater harvesting, renewable energy usage, paper consumption, environmental fines, cutting of forests for expansion and so on.

Social: Such points as gender parity, workforce diversity, employee safety, fair treatment of labour, remuneration, workplace safety, supply chain, community and customers are taken into consideration.

Governance: Under this head, factors such as treatment of minority shareholders, board structure, board independence, functioning of audit, compensation and nomination committees, transparency in voting during annual general meetings are monitored closely.

Fund managers following the ESG style, apply these filters to get a universe of companies that have better revenue quality, lower cost of production, easier loan financing terms, enjoy more government support and subsidies, committed employees and superior return on capital.

Getting scored on ESG

Many agencies rate companies on each of the ESG parameters and give an individual and overall score based on their assessments. Dun & Bradstreet, Sustainalytics from Morningstar, and ESG data from the likes of MSCI, S&P and MSCI are sources of scores on companies based on their ESG metrics.

In India, a company called SES (Stakeholders Empowerment Services) rates the top 100 companies based usually on publicly available data on ESG parameters. It gives the rating on each of ESG parameters and ranks them based on the overall scores.

Standard setting bodies such as the IOSCO and FSB are still working on exact frameworks and disclosures on the ESG front.

Closer home, SEBI (securities and exchange board of India) has mandated the top 1000 listed companies by market capitalisation to come out with a business responsibility and sustainability (BRSR) report every year, which includes ESG reporting as well. It has floated a consultation paper as well on evolving a rigorous ESG reporting framework for companies.

However, despite many agencies and regulators insisting on ESG scoring, there are no universally or even locally agreed common parameters followed by all companies. Definitions on environmental, social and governance parameters vary quite widely across rating agencies, countries and even within industries.

Indices tracking ESG companies in India

In India, both the leading exchanges have an index each made of constituents rated on ESG scores.

We have the S&P BSE 100 ESG Index and the Nifty 100 ESG Index which are constructed based on scores of ESG companies. Of course, both these indices have been around only for a few years.

The list above is that of the top constituents of the ESG index from the BSE and their weightages.

As seen from the performance record, it pays to invest in the index with ESG constituents. Over three and five-year timeframes, the ESG index has outperformed the BSE 100 TRI by 1.5-2 percentage points.

Further, back-tested data from BSE shows that in the 8 calendar years from 2015-22, the ESG index has outperformed the regular index in seven of those years.

The following is the list of top companies in the Nifty 100 ESG Index. As is clearly seen, the top constituents of the BSE and NSE indices are a bit different, and the weightages too vary significantly.

Even in the case of the Nifty ESG Index, there has been outperformance over the broader index when a three-year period is considered.

These indices are dominated by financials, information technology companies and consumer discretionary firms. The firms in these sectors are generally the least polluting, high on all financial and other disclosures, generally treat employees well, apart from having sound governance structures. Energy and petroleum product companies are also in favour.

Options for ESG investing in India

The concept of ESG investing is relatively recent in India. Fund houses such as Aditya Birla Sun Life, Axis, DSP, HDFC, ICICI Prudential, Quant, Quantum, Kotak Mahindra, Invesco, Mirae Asset and SBI have ESG scheme offerings for investors. Most have a track record of less than three years and hence it may be too early to judge their performance record.

There are a few PMS (portfolio management services) players, too, that offer HNI (high net worth investors) the option to invest in portfolios with ESG mandates.

As mentioned earlier, SES grades the top 100 listed companies in India and gives them an ESG score each. The following is the top 10 in the list.

This rating is based on policy disclosures of companies, environmental, social and governance factors disclosures based on publicly available data.

The score distribution factor-wise is as follows.

Ethical investing and ESG

Another style of investing is using the ethical angle. But ethical investing is not the same as ESG style. Ethical investing is more moralistic, and principles based. It means certain ‘sin’ industries are altogether excluded from the investment universe. Therefore, those swearing by ethical style would completely exclude tobacco manufacturers, alcohol companies, gambling firms, weapon makers, makers of products that do animal testing and the like from their investment portfolios. In their opinion, such companies spoil the morals and ethics of families are harmful to the society at large.

ESG investment would at best penalize on scoring such industries or would stringently evaluate the environmental, social and governance parameters. They would reduce or keep exposures to such companies at the minimal levels to the extent that these are productive investments. Fund managers would impose strict criteria on how much portion of a company’s revenues comes from sin businesses and so on.  

Green washing

Many companies strive hard to get a good rating on ESG parameters so that more and more global investors consider them for their portfolios.

But some firms do not actually put in as much efforts to improve on the ESG parameters but still market themselves as entirely being focused on those lines to attract investor attention. It spends more on advertisement and marketing efforts projecting themselves as deeply involved in ESG, while actually doing precious little on the ground.

This is called green washing. It may also involve companies exaggerating the sustainability angle of their products or services, while in reality they could be environmentally quite damaging.

ESG Investing is nascent in India. There needs to be more formal push on standardizing parameters and giving a strong regulatory push to get more companies to become compliant.

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