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ESG For Dummies!

October 2020

In early 2004, the then UN Secretary General, Kofi Annan laid the foundation of ESG (Environment, Social and Governance) Principles. He approached over 50 CEOs of major financial institutions to collectively deliberate the cause of sustainable businesses. The objective of this joint initiative was to find ways to integrate ESG into mainstream capital markets. These industry captains participated in a joint initiative under the auspices of the UN Global Compact with the support of the International Finance Corporation (IFC) and the Swiss Government. The term ESG was first coined in 2005 in a landmark study conducted by the IFC entitled “Who Cares Wins” to examine the role of environmental, social and governance value drivers in asset management and financial research.

The tenets of ESG Investing are:

Environmental issues such as lower energy consumption, reliance on renewable resources and reducing carbon footprint

Social aspects such as employee welfare and relationship with all stakeholders 

Governance stands for a company’s accounting and financial practices

The essence of ESG Investing is to investing sustainably. It broadly covers issues that traditionally are not part of financial analysis, yet are pretty relevant. ESG investing is a step towards complete risk analysis and aims to design a systematic approach for an all rounded and well-informed investment decision. Among many other things, it includes how corporations:

  • Respond to climate change
  • Treat their employees
  • Build trust and foster innovation
  • Manage the relationships with various stakeholders

Even as cynics argue that responsible investing is just a fad, a closer look at the trajectory of ESG considerations and adoption over the past 15 years suggests otherwise. The steady growth of ESG investing started around 2013/14 when studies showed that sustainability is associated with positive financial results. In fact, ESG Funds have attracted a higher percentage of investors’ money in every year since 2013, while their non-ESG counterparts have experienced yearly outflows since 2015 (as reported by EPFR Global and Barclays) despite robust stock markets during this period. As can be seen below, ESG focused investors currently hold an estimated $40 trillion in AUM or around 40% of all professionally managed assets around the world. 

India, too, has witnessed a surge of ESG funds, with SBI and Axis recently launching their ESG Public mandates. Even the Private Equity ecosystem has shown an ESG preference, driven by the Limited Partner (LP) mandates. 

The journey from Kofi Annan’s office to ESG being integrated into every corporation’s life has not come without its stumbling blocks and challenges. Traditional financial and management accounting tools are evidently inadequate for measuring ESG impact because they focus, primarily, on monetary aspects. Intangibles such as ethics, brand value, market reputation and sustainability efforts are usually sidelined in pure financial analysis since they are subjective inputs. Additionally, non-standardized targets and terminology have made ESG studies difficult. Investors and regulators are not fully aligned with ESG factors due to fragmented and inconsistent data collection and presentation. These frameworks have been evolving and will continue to change with the changing dynamics of socio-economic environment. All is not lost as rating agencies across the globe have created their own ESG indices to cater to demand for ESG data and reporting. Most notably the S&P 500 ESG Index, MSCI ESG Universal Index and MSCI Climate Change Index. Focused and consistent reporting is the key to building an ecosystem conducive to ESG investing and generating higher returns through the same. 

Despite these impediments, softer and intangible aspects of ESG investing are gaining favour with a new generation of investors who seem to be the driving force behind ESG investing going mainstream from being a niche till recently. Sustainability-minded millennial investors seem to be influencing the slow and steady gain in ESG investing popularity. Research suggests that millennials want their investments to reflect their personal values and belief systems in addition to generating returns on their investments. They are inclined towards socially responsible investing and are attracted towards the ESG philosophy. According to a recent global survey conducted by the deVere Group, a remarkable 77 percent of millennial investors said that ESG concerns are their top priority when evaluating investment opportunities. 

The ongoing COVID-19 pandemic has brought home the point that in years to come any investment strategy will need to include some moat against black swan events. Even as the pandemic continues to test the healthcare system, it is also stress testing many institutions and cultural norms, from economic inequality to racial injustice and climate change. It has brought to the forefront the cost of modernisation and nudges us to evaluate the impact of our actions and choices on society and our planet. As the pandemic effects unravel across the globe, investors have been increasingly attracted towards strong ESG performers. 

ESG investing entails responsible and active management, and like any other investment thesis it comes with its share of positives and negatives. Questions such as who will be held accountable for shortfalls in returns to the beneficiaries if there is no long term payoff from moral superiority continue to linger in the minds of investor community. One thing that cannot be ignored is that ESG factors are just as important as financial factors. More importantly they have an impact on a company’s financial condition and its ability to generate returns over the long term. ESG implementation is a journey. It is a long sighted strategy and builds on our responsibility to ensure a future that is better than today. As Greta Thunberg famously said, “Change is coming, whether you like it or not.”