ESG Investing: Understanding the need of it
Created on 16 Oct 2020
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Updated on 17 Oct 2020
"CAUTION" is perhaps the most commonly used, required, and important word in 2020. Caution before touching the knob, the tap, the handle, the food, basically, everything around; but isn't it a necessity in these trying times of the global pandemic, which is spreading like wildfire? It is said, "Fear is good; it keeps you alive."
For a certain reason, we know it. It doesn't matter how many times an entrepreneur reads their affirmations; the fear always arises. How to attract investors? Not knowing where to start? No demand, stagnant stocks, investors are losing interest, etc. Currently, in the time of COVID-19, the fears are pretty prominent.
The businesses have started to realize that being cautious in the metrics of treating their employees, taking care of the surrounding,s and keeping the organization's governance in control are the only ways to attract investors to infuse.
What is ESG, and what does it measure?
ESG stands for the environment, society, and governance. It is a framework for analyzing companies and assessing how well they compare to their peers in terms of performance against these metrics.
These factors are a subset of non-financial performance indicators and help socially responsible investors in deciding whether to invest in a company or not. They include ethical, sustainable, and corporate governance issues. The number of investment funds that incorporate the ESG factors has been growing rapidly since the beginning of this century.
The Rise of ESG Investing
On 25th May 2020, a protest broke out across the US following George Floyd's death, after a police officer knelt on his neck. As the Black Lives Matter movement brought thousands of people out on the streets, companies also tried to show their support on social media. They started changing their Instagram profile pictures to black pictures and condemned police brutality and racial injustice.
Consumers and activists soon called the companies out with their campaigns with hashtags #openyoupurse and #pullupandshutup. Some companies complied with these campaigns.
Bank of America announced a one billion dollar plan to assist communities of colour impacted by the pandemic. Cisco donated 5mn dollars to several racisms fighting organizations. Nike committed 40mn dollars to the Black community over the next 40 years, although it faced criticism for lack of diversity among executive ranks.
Before the death of George Floyd and the pandemic, companies were singled out based on corporate responsibility. It's a trend that began to accelerate well before the current demonstrations and pandemics; however, now it is mainstream.
It's gone haywire from something that is looking at policies and procedures to something that is looking at real-time behaviour as it plays out in front of us. This all falls under what is known as ESG investing, which stands for environmental, social, and governance. It's a catch-all term for socially responsible investing.
How can ESG change the Business World?
ESG investing means taking into consideration how a company's environmental, social and governance performance will affect its financial performance and in turn, use that to determine investing in the company.
According to a Morningstar Direct Report, a record $45.6 Bn went into the global sustainable fund universe in Q1 FY2020. Interest in sustainable investing jumped 85% in 2019 up from 71% in 2015.
The origin of ESG investing lies in the 2004 letter from former United Nations Secretary-General Kofi Annan. He wrote to 55 CEOs of the world's leading financial institutions, inviting them to participate in an initiative that would bridge the gap between investors and important environmental, social, and governance issues.
The group formed into what is known today as the Principles for Responsible Investments. Members are supposed to report their responsible activities every year. More than 2,000 money managers like Morgan and Stanley, BlackRock, JPMorgan have signed on.
The Current Situation
Coming back to 2020, the CEO of BlackRock released a letter to its investors. Fink wrote, "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."
Now, every CEO wanted to discuss how they were making profits and doing good at the same time.
Investors used to think that socially responsible investing would eat into profits and competitive advantage. Now investors see it as an opportunity to identify potential risks or even disasters before they happen.
Companies make huge promises w.r.t. CSR which opens them to ESG money and improves goodwill, but some do not comply with promises. For example; Volkswagen's emissions scandal. Volkswagen's Emissions scandal keeps shares in the red. People were duped into believing they were buying a green vehicle that was not green. Fines and settlements that Volkswagen had paid up to 20Bn dollars made it one of the costliest corporate scandals in history.
Research firms, investors, and other stakeholders take the self-reporting data and other public information to rate the company, based on a range of ESG data. Criteria can range from how they treat their employees to how sustainable their corporate culture is or how diverse their board is.
Even if a company receives a high ESG ranking, it doesn't guarantee that the company will be profitable in the long term. We can know from research the companies that genuinely understand and integrate these issues; not more box-ticking, not greenwashing but those who are actually integrating.
In the long run, they are better-performing companies, especially those that identify and improve on the financial material issues of their industry. One of the things that we have found is that depending on the model that you're using; you might be getting very different estimates.
India and ESG
ESG has gradually gained popularity in India since it was the first launched in 2018. Since then, three more ESG funds have entered the field, with the category now making up 0.6% of total equity AUM, as per Bloomberg.
The Nifty 100 ESG Index is down 2.8% versus an 8% drop in NSE Nifty 50 Index. Most of India's new sustainable funds use in-house and third-party research to assign scores to companies for various ESG metrics to short-list stocks eligible for investment.
Factors that impact the growth of ESG investments in India are as follows:
- Evolution of an approach to greener economy: India submitted its Nationally Determined Contributions in 2015. The commitments require $2.5 Trillion of investments between 2015-2030. Also, India is committed to achieving the SDGs to drive its agenda of development without destruction.
- Action by global peers: Global ESG funds have invested in India, and as per Global Sustainable Investment Alliance (GSIA), 41 Global E&S seeking funds have invested on an average 25% of their funds in India equities.
- 95 socially responsible funds have been allocated on an average of 18.5% to Indian companies.
- The emergence of sustainability-oriented indices in India:
- S&P BSE Greenex- Tracks the top 25 companies w.r.t. greenhouse emission, Market Capitalization, and liquidity.
- S&P BSE Carbonex- Tracks 100 companies based on commitments to fight climate changes.
- NIFTY 100 ESG Index – Reflects the performance of companies in the NIFTY 100Index based on ESG score.
Why is COVID-19 a turning point for ESG Investing?
The COVID-19 pandemic of 2020 has not only brought a great recession, but investors are also calling it the 21st century's first "sustainability crisis". It is a wake-up call for decision-makers to prioritize a more sustainable investment approach.
J.P. Morgan polled investors from 50 global institutions, representing $12.9 trillion in AUM on how they expected COVID-19 to impact the future ESG investing. Around 71% of the participants responded that it was likely that the occurrence of low probability /high impact risk would increase global awareness to tackle high-impact risks related to climate change and biodiversity losses.
ESG can cater to multiple needs of an investor. It is not only helpful in uncovering attractive long-term investment opportunities but can also be instrumental in eliminating investment risk.
Companies that incorporate ESG risk management prove to be better long-term custodians of investor capital, provide downside protection, and generate better long-term risk-adjusted returns.
ESG investing has become quite the buzz globally and is gradually gaining traction in India. Investors are beginning to recognize the importance of weighing both financial and non-financial metrics while making investment decisions.
The key is to understand the factors that contribute to the value of ESG investing and making investment decisions that are well-aligned with the overall asset allocation strategy.
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