India is getting to grips with ESG investment, says Ranjan Pant – and find that it is good for the balance sheet, as well as the world
Environmental, social and governance (ESG) investing is no longer confined to presentations on emerging trends and future challenges: it has entered the mainstream. Broadly, it means investing in companies that place importance on non-financial outcomes relating to the environment, social wellbeing and good governance. In addition to financial returns, ESG investing carries the additional incentive of generating favourable externalities for society.
Greater awareness of ESG (especially since the COVID-19 pandemic) and regulatory moves towards sustainable business practices are likely to have contributed to the recent expansion in the number of ESG funds and the increased global investment into such funds; at the end of 2020, approximately 36% of total global assets under management were allocated to sustainable investments.
While research on green finance is ongoing, there is already evidence to suggest that ESG criteria are effective in generating higher investment returns. The MSCI World ESG Leaders Index, for example, has stayed very close to its benchmark MSCI World Index since 2008; for some periods, it has even outperformed the benchmark with similar or lower standard deviation. Performances of other MSCI ESG indices are similar in comparison to their respective benchmarks.
The Indian ESG landscape
ESG funds in India account for only 0.6% of total equity assets under management, of which the country contributes only around 0.05% of the global assets in sustainable funds. However, ESG investing in India has been gaining momentum due to increased awareness of and interest in sustainable investing. The assets under management for ESG funds in India rose from US$275m to US$650m between 2020 and 2021.
The legal and regulatory framework around ESG in India dates back to the Corporate Social Responsibility Voluntary Guidelines 2009, issued by the Ministry of Corporate Affairs as a first step towards incorporating business responsibilities into mainstream business management. Over time, the framework evolved around the themes of responsible business conduct, business responsibility reporting, responsible finance, green bond guidelines and so on. In March 2021, the Securities and Exchange Board of India (SEBI), the nation’s regulator for the securities and commodity market, issued a circular on business responsibility and sustainability reporting by listed entities, with the objective of bringing sustainability reporting on a par with financial reporting. In addition to this regulatory push, India has taken steps such as joining global initiatives on sustainability and launching the Sustainable Development Goals (SDG) India Index to evaluate the progress on social, economic and environmental criteria. The country’s corporate sector is also working to strengthen its sustainability infrastructure by defining its sustainability strategy against the UN SDGs and by incorporating ESG-related disclosures into public disclosures.
Performance of ESG indices compared to benchmark indices
The evidence from India is consistent with the global inference of ESG funds outperforming benchmarks in terms of return and volatility. The MSCI India ESG Leaders Index has outperformed its benchmark, the MSCI India Index, in terms of both annual performance and volatility. Comparing the NIFTY100 ESG Select Leaders Index with its benchmark, the NIFTY100, yields similar results. The NIFTY100 ESG Sector Leaders Index (SL Index) tracks the performance of NIFTY100 Index stocks that have scored well on ESG risk management. It excludes companies based on three main criteria: if 25% of their revenue is generated from cigarettes, gambling, breweries or weapons; if they have been involved in any major ESG controversy; or if their ESG risk score is lower than the industry average. The SL Index is then created by selecting the highest ESG-rated stocks in the NIFTY100 universe.
Figure 1: The movement of the NIFTY100 Index (red) and SL Index (grey) for calendar years 2020 and 2021 (different scales).
The trajectories of the two indices show that the SL Index has largely tracked or outperformed the NIFTY100 parent benchmark during the periods of pre-pandemic growth, pandemic shock and subsequent recovery. This is perhaps a validation of the notion that companies with high ESG scores are likely to be better managed and better positioned to respond to a crisis. Figure 2’s comparison of returns over a longer and less volatile period reaffirms the above inference. On the risk side, the volatility parameter for the SL Index is less than its benchmark for several durations, while the correlation between the two indices remains high.
Figure 2: Return percentages for NIFTY100 (grey) and SL Index (red)
In addition to better stock selection driven by ESG criteria, one of the reasons underlying the better performance of ESG is its fund composition. By excluding stocks of controversial sectors such as tobacco and alcohol, the SL Index was able to insulate itself from the underperformance of these stocks from 2018 to 2020. Additionally, the SL Index has higher exposure to IT stocks, and IT companies have high ESG scores due to their low consumption of natural resources, in line with the nature of their business. The better performance of IT stocks during the past two or three years is thus likely to have contributed positively to the SL Index’s performance.
The OECD report ESG Investing: Practices, Progress and Challenges outlines challenges related to ESG investment, such as divergence in the rating methodology and results, lack of standardised reporting guidelines, and different views on financial materiality. Additionally, there are inconsistencies in the positive correlations between ESG scores and market performance – high ESG scores do not necessarily translates into better market performance.
Focusing specifically on India, SEBI’s Consultation Paper on ESG Rating Providers for Securities Markets brings up challenges such as lack of standardisation in ESG-related products, inconsistent disclosure of the methodology and rating process and, most importantly, lack of an India-specific ESG rating focus. The combination of these factors might increase the risk of greenwashing and lower-than-expected fund allocation in green funds. While the comparison of ESG indices with their benchmarks do indicate a positive correlation between ESG scores and risk-adjusted returns, we still need to be mindful of these issues when drawing inferences from a statistical comparison of return between indices.
Ranjan Pant works for the India branch of Swiss Re