ISSUE 47 - 05th December 2021
In this week's FinMail we understand an Investing theme that is getting popular in the west and as well as in India - ESG.
On Thursday, 2nd December 2021, IIM Ahmedabad (IIMA) launched the 'Arun Duggal ESG Centre for Research and Innovation' aimed at contributing towards the development of the Environmental, Social and Corporate Governance (ESG) ecosystem in India and helping Indian organisations to integrate ESG into their core business and investment decisions.
It is named after ICRA Chairman Arun Duggal who has contributed funds for the development of the centre. This news comes at a time when companies are looking to incorporate ESG into their core business structure as many Investors too are preferring companies with ESG values for their investments.
And the buzz around ESG has been rising for the past couple of years and has picked up the speed after the Black Lives Matter Campaign and the current pandemic. And that is just not it, ESG Investing is now a trend amongst Millenial Investors who have newly entered the market after the worldwide lockdown.
So today we are going to cover ESG Investing right from the basics and discuss its future as well. So let's not waste much of your time and start right away.
ESG Investing: The Context
We can agree that the world is moving towards Capitalism and the major part of Capitalism is the private enterprises and corporations. And whenever we talk about such enterprises, we presume that these entities work for generating profits for their owners. And that is factually true as well because such organisations often put their own interests before the interest of others even if their interest contradicts the ones at large.
And that is wrong. Such organisations work in the same society; the interests of which they put at risk sometimes. Think of a big corporation carrying out mining activities in ecologically sensitive areas to earn profits but in turn also damages the environment or ecology around the area.
And that is not fair, obviously. And when you invest in such a business you indirectly help them continue the activities that harm the overall ecology. And such wrongdoings are not limited to businesses that harm the environment. Investing in businesses that conduct any kind of harm to the society, the culture of the nation, peace, etc. is wrong. So what is the solution here?
To impose restrictions on such businesses you might say which is quite practical on paper but not in reality (we all know that). But what we as investors could do is when we invest in some of these companies, we analyze their non-financial factors such as how they do welfare of the society or contribute to the society in any kind or conduct business in the morally correct arena and then invest in such businesses. And that's where ESG comes into the picture.
ESG: The Meaning
ESG Investing, Socially Responsible Investing, or Impact Investing - all are the same. The meaning is just as same as the name suggests where the Investors not just consider the financial parameters of the enterprise but also factors how the company or organisation takes care of the society in which it exists. In other words, the investor takes up the mantle of 'Responsible citizen of the Society' and invests in businesses that match the investor's monetary (profit) interest and the society's interest.
Let's look at each of them individually
Our planet's ecology or environment is polluted and damaged more than it ever was, be it carbon emission, water pollution, or forest degradation. It is no surprise that the major contributors to these irreversible damages are nothing but the economic activities that are carried out by businesses. Chemical factories, petroleum refineries, power generating plants, dairy industry, etc. And let us tell you a surprising fact, the music that you stream, the data that you save on the cloud, the emails that are stored in Gmail also contribute towards global warming as electricity is consumed in carrying such activities.
With youngsters getting more and more concerned about the environment that they will live in in the future, they look for businesses that work in sync with the environment. And thus the businesses that conduct their business to protect the environment or just conduct business that doesn't interfere with the harmony of the environment form part of the E of ESG Investing.
Businesses exist in a society, in fact, businesses earn from it. Social responsibility is what businesses owe to society against what it draws from it including resources & manpower. So it becomes essential to provide a quality working environment for its employees, maintaining & providing human rights to people of all the communities, coming forward for the betterment of society when required in the best possible way. And who can forget the recent outrage of the death of George Floyd; the one that triggered the Black Lives Matter movement around the world. This has created the need for businesses to conduct inclusive and non-discriminatory business. Such businesses form part of the S in ESG investing
As the legend, Jamsetji Tata himself once said,
"In a free enterprise, the community is not just another stakeholder in business; but is, in fact, the very purpose of its existence."
We often come across companies where the top executives/promoters go all greedy and do something which is totally against the interest of other stakeholders of the business. In another language - a scam. The failure of business not just costs its parties associated with it but also creates an imbalance in the industry. Corporate governance is all about integrity and honesty of the management of the company, a prime requisite for long sustainable growth. We have seen the examples of both the contradictions, a company with solid corporate governance policies as well as companies with irregularities in its corporate governance. At any given point, investors would choose the former one. And such businesses form part of the G in ESG Investing. But how did this theme of investing in 'morally' correct companies came into existence?
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The Rise of ESG
The origins of ESG Investing can be traced back to 2004 when the then secretary-general of United Nations; Kofi Annan wrote a letter addressing 55 CEO's of the world's leading financial institutions inviting them to participate in an initiative to help bridge the gap between Investors and important environmental, social and governance issues. A group was formed which is now known today as Principles of Responsible Investing. These include some of the world's largest fund managers like BlackRock, Morgan Stanley, and JP Morgan. But it was not until 2020 which really helped ESG Investing really rise like a theme to look out for. BlackRock's CEO in January 2020 wrote in a letter to his investors and fellow executives that Investments surrounding Climate Change would lead to a fundamental change in the world of finance.
"As a fiduciary, our responsibility is to help clients navigate this transition. Our investment conviction is that sustainability-and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward."
This made us believe that even the largest of the fund managers are looking to invest in companies that conduct sustainable business. Then a series of events like Covid or the BLM movement only made ESG more firm and stronger as an Investment Strategy. As per a report by CNBC, the major investors who are interested in ESG themed investing are Millenials, Married Women & HNIs. Millennials because they are the ones who will invest the most wealth in coming years, married women because they are taking investment decisions on behalf of the household and well HNIs have the ability to pay hefty fees and judge where the wind is blowing.
According to a Bloomberg report, Global ESG assets are on track to exceed $53 trillion by 2025up from$37.8 trillion by the end of 2021. This amount is more than 1/3 of the $140.5 trillion projected in total assets under management.
While Europe accounts for half of the global ESG assets, U.S. has the strongest expansion this year and may dominate the category starting in 2022. The next wave of growth could come from Asia — particularly Japan, according to the report.
Data from the global fund-flow tracker, EPFR, revealed that equity funds that offered ESG investing saw record inflows of $168.74 billion in 2020, a huge jump from the $63.35 billion seen in 2019. In addition, a BlackRock survey in December 2020, conducted on 425 investors across 27 countries representing an estimated $25 trillion in assets under management (AUM), revealed that investors plan to double their ESG investments over the next five years. This would take the share of ESG in total AUM from 18% in 2020 to 37% by 2025.
ESG Investing in India
ESG assets in India have grown at 22% a year ever since the launch of Principles of Responsible Investing in 2006. The Nifty 100 ESG Index has specifically been designed to track the performance of companies on the Nifty 100 based on ESG scores. This index has outperformed its parent, Nifty 100, across multiple timeframes. The Nifty 100 ESG Index also outperformed the Nifty 50, generating higher five-year returns in 2020.
As per the Morningstar data, inflows in ESG funds jumped to ₹3,686 crores, a 76% rise in 2021, as against a base of ₹2,094 crores in 2020
The numbers & projections are all glittering (in India as well as) globally. Investors are willing to put their capital into ESG compliant companies but wait here, what about the companies? Are they really getting benefitted by following the ESG guidelines? And if companies are indeed following ESG guidelines and really weighing towards ESG compliant business in the future or are they just pretending to do so just for the sake of gaining the interest of investors?
Do companies benefit by being ESG Compliant?
The straightforward answer would be, yes, of course, but how exactly?
ESG makes companies pay attention and care about the things which are non-significant in a shorter period of time but will matter a lot in long run.
Yes, the brand image of that company would be positive among the people but there's something more to it which is quite more worthy. If you look at the ESG matrix, it binds a business owner to behave responsibly & to think more dynamically. Ultimately, that company would have less friction to carry out its business with lesser downsides such as legal conflicts, employee retention, etc. All these things would result in sustainability. And that is why ESG investing is also called 'Sustainable Investing'. So it's a win-win for both, investors as well as businesses.
Quoting Blackrock's CEO Larry Fink again, he mentioned in the same letter,
"A company's ability to manage environmental, social and governance matters demonstrate the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process."
But is it really a win-win?
No there ain't no twist here, it's not an Abbas Mustaan film. ESG funds or ESG investing definitely is gaining traction and it is there's only one way for ESG Funds' AUM, up! So one thing is for sure there would be money flowing in for companies that are ESG compliant. But there's an opportunity for companies as well or rather a chance.
There's no denying that data can be faked, you can show something while the actual picture might be totally different. So there would be companies that might take this opportunity and try to make themselves look like they are ESG compliant company but in reality, they aren't. A major problem with this is that currently there is no set number of rules that categorize companies based on ESG compliance. It is totally up to the fund manager or the investor to decide. So the lines are a little blur as of now.
We personally looked at the portfolios of some ESG funds available in India and all of them have IT, Finance & Banking, Service, FMCG, and construction sector stocks which seems pretty much in line with ESG investing. During our research, we also came to know that the biggest ESG fund in the world - Morgan Stanley Global Opportunity ESG has 6.6% of assets parked in Amazon and last we chacked Amazon's CO2 emissions have increased 19% to 60.64 million metric tons. Well, well, well. But for relief, that's not the case in India, at least not yet.
ESG was already on a buzz just before the pandemic happened and now it is a trend more than ever. Just like every other trend in financial markets, there would be some beneficiaries of this trend while some would be losers. Companies that were doing good would do better and companies that are totally in the opposite direction of ESG would suffer till they change their direction. Companies involved in the oil business, mining, chemicals might face some difficulties while tech companies would be a clear winner here as they are lesser CO2 emitters.
As we are going forward, we are seeing regulators and governments weighing more on incorporating ESG into the company's businesses and the news of IIM-A is in the same direction as well. And it is not a compulsion if you can see through it but rather an action to fix the roots of capital flow.
Nevertheless, the popularity of ESG would encourage companies to take up the road of sustainability by following the right methods. A company can't sustain without having society and people by its side and this alone would make them to adapt the ESG road rather than just doing it for the sake of some law or regulation.
That is it for this week's FinMail. Keep learning, keep investing in good companies and we'll see you in the next week.