Vikku Agarwal, Faculty-Finance
To address the global ecological issues and in line with the Sustainable Goals of the United Nations, Environmental, Social and Governance (ESG) has been increasingly gaining traction. ESG is the underlying criteria of measuring financial operations and investments by the companies worldwide. ESG measures the social and ethical impact of an investment by a company. This article underscores the radically changing priorities of global investments over time to more sustainable, socially responsible investments for long term financial success of an organisation. ESG funds are getting increasingly popular amongst investors who wish to contribute towards cutting global warming and human development, without compromising on the financial returns.
Briefly, ESG factors can be perceived as :
Ideally, an ESG Fund should be a combination of only those securities which have scored high on their sustainability and should exclude companies which have a dismal or unsatisfactory approach towards sustainable factors e.g. causing environmental pollution, improper employee management or unsound management practices.
ESG factors are highly considered in the longevity or sustainability of a company. In other words, companies that follow high quality environmental, social and governance standards are more likely to outperform their peers in the long-run.
A study by MSCI reveals that companies with higher ESG ratings are associated with
Higher profitability: Better rated companies generate abnormally high returns leading to higher profitability
Lower idiosyncratic tail risk: Such companies are better at managing their
company specific operational and business risks
Lower systematic risk: High ESG rated companies are less exposed to systematic,
macro-economic factors leading to lesser risks hence more stability.
“ESG momentum” is a term indicating a relationship between a change in company’s ESG
characteristics and changes in the company’s idiosyncratic and systematic risk. As per
MSCI, the there is a time lag of three years between change in ESG characteristics and a
resultant change in the above three transmission channels and the valuation variables of
a company. The graph below exhibits a direct relationship between ESG momentum and
cumulative returns of securities.
The above parameters, of late, have become very critical for investors to choose their
investments. Research has shown that selection of ESG securities leads to betterinformed
investment decisions, and that sustainability funds can perform better than
non-sustainable ones, to an extent because of better risk management over contentious
issues. For example, companies with a lower carbon footprint would face lower
regulatory or societal risk than a polluter, and so its shares should be less volatile over
ESG factors can significantly impact the company’s financial performance. For example,
Volkswagen’s emission’s scandal in 2015 cost the company $7 billion to cover the costs
and more than $4 billion in penalties. Besides, the company’s stock experienced dramatic
declines throughout the scandal.
Journey so far
In 2007, European Investment Bank issued its first Green Bond worth EUR 600 million.
The proceeds of this issue were used for funding renewable energy and energy efficient
projects. By 2017, over $155 billion worth of public and corporate green bonds had been
issued (https://hbr.org/2019/01/the-state-of-socially-responsible-investing). The world
has since been flooding with a gamut of similar investment instruments making the size
of sustainable investing- which includes environmental, social and governance (ESG) and
impact investing – to grow by 34% since 2016 to $30 trillion in the year 2018, as per the
report from Global Sustainable Investment Alliance.
Amongst all the developed and emerging nations, the traction on ESG investing has been
found to be the highest in the regions of Europe, US, Japan, Canada, Australia and New
Zealand; Europe having the maximum share of global sustainable assets and
Australia/New Zealand the least. Japan has shown the maximum leap of 360% in its
investments since 2016.
As per the Forum for Sustainable and Responsible Investment in US, in the beginning of
2018, 25% of the professionally managed assets of US i.e. $11.8 trillion were under ESG
investment strategies, a stark rise from 2010, when the amount was close to just $3
ESG investing, while it has the generous objective of financial returns coupled with social
responsibility, poses a challenge of not being driven by any global standards hence there
is no set framework of ESG investing. Companies have the discretion of choosing their
own ESG components which sometimes become expansive enough to get diluted and
may lead to Greenwashing.
ESG investing in India
Appetite for ESG investing has been on an upward trend in India. Fund houses are actively
introducing new ESG funds or changing the constitution of existing funds to make them
more socially responsible. As per some eminent fund managers, investors here are more
concerned about the ‘G’ (governance) than about ‘E’nvironment and ‘S’ocial. That, in my
opinion, is because any slip on the governance aspect has a direct impact on the returns
of a company. Environmental and Social are relatively distant since a lot of emphasis is
expected on these fronts at the political and regulatory level e.g. solar energy covers the
Environment aspect of ESG but these companies are reeling under huge losses clearly
because there is comparably lesser emphasis on moving our preferences to this source of
ESG investing is still a niche market here though the regulatory bodies realise the
importance of socially responsible investing. The Ministry of Corporate Affairs came out
with the ‘National Voluntary Guidelines on Social, Environmental and Economic
Responsibilities of Business’ in 2011. Since 2012, the top 100 listed companies as per
market capitalization disclose their Business Responsibility Report as a part of their
A sample look at the MSCI ESG Leaders Index exhibits better returns from ESG funds in
India against the non- sustainable funds, well in tandem with the global trends.
A deeper look into the constituent companies of these indices illustrates primarily those
companies which have been historically categorised for sound financial performance and
public trust. Secondly, by virtue of their market status, the companies have had a track
record of being the leaders in socially responsible initiatives in addition to their consistent
financial performance and financial returns.
The propensity of investors towards ESG is extremely critical for bigger participation into
such investments by the companies. The success of these instruments represents the fact
that investors investment decisions are largely based on the commitment of funds
towards sustainability. Retail investors seem to be inclined towards ESG investing
primarily because of the impetus at the institutional level.
A continued propulsion of ESG may help address the global issues of sustainability to a
great extent in the coming years. A deeper research and analysis into the effective
weightage of various components of ESG in the overall growth and success of the
economy may encourage more informed ESG investing.
Environmental, social, and governance criteria are very subjective and accurate
assessment of the factors can be extremely challenging. Development of a suitable
framework or model for ESG investments is vital for bringing greater legitimacy to this
new investment model.
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