Ever heard the term ‘ESG’? If you are someone who closely follows the Fortune 500 companies or Nifty50 companies in India or even a mutual fund investor, you might already be familiar with this term.

ESG stands for Environmental, Social & Governance with a set of criteria prescribed for companies. Environmental criteria include how the company is responding to climate change and the steps being taken to address the issue. Social criteria include the way the company treats its employees, suppliers, customers and the community in which it operates. Governance criteria are all about legal compliances, audits, executive pay, internal controls and shareholder’s rights.

Now, how does ESG help?

For example, a minerals mining company clocking humungous profits might be damaging the environment around it or doesn’t care about the welfare of its workers or doesn’t report its financials/undertakings adequately. There are quite a few companies that do all these together. So, how do we hold such companies responsible? That is where ESG scores help.

Most often, in the financial world, an idea gets pursued only when it is wrapped with financial incentives. So, a gentleman named Kofi Annan, who was a UN Secretary-General, wrote to over 50 CEOs of major financial institutions in January 2004, inviting them to participate in an initiative. The goal of this initiative was to find ways to integrate ESG into the capital markets. Within a few months, several established studies were published showing the relevance of ESG in markets and the New York Stock Exchange (NYSE) launched the Sustainable Stock Exchange Initiative (SSEI).

With the launch of this concept in the markets, ESG became an instrument for socially responsible investors to gauge the company based on the score and invest accordingly. And there were many funds that popped up whose objective was to invest in companies which make products relevant to ESG. As per a report by Moneycontrol, there has been a surge in sustainable assets globally, especially in the US, where nearly 33 per cent, or USD 17.1 trillion of the total USD 51.4 trillion assets under management (AUM) as of 2020, was in this segment. In India too, there has been a recent rise, with the combined AUM of 10 ESG funds amounting to INR 11,818 cr as on March 31, 2022, increasing five-fold over the past 3 yrs. NASDAQ in a report says that investments in ESG strategies grew by 42% from 2018 to 2020. So far so good, isn’t it?

Under Scrutiny

There are a few themes on which the ESG funds are designed like single theme, exclusionary and best-in-class.

In the exclusionary theme, the fund manager doesn’t invest in a specific type of companies that are involved in per se, coal mining, tobacco, weapons manufacturing or alcohol based on their mandate.

In single theme, as the name suggests, is based on one main criterion. For example, the index tracker SHE tracks the companies which have at least one woman in their leadership team promoting gender diversity. There are also funds which focus on solar-based or water management companies which make use of natural resources in a sustainable manner.

Everything seems fine until now, isn’t it? But most of the funds have been heavily invested in the big-tech companies or top 500 companies in India (for Indian ESG funds). These companies usually lack the E factor or the S factor in ESG. For Meta, previously known as Facebook, the S factor is tough to evaluate. It is the same with some of the companies in India including a few IT conglomerates. And the E factor isn’t yet seriously considered in most top Indian companies in the way they operate their buildings, energy and water. So, how are the ESG funds getting deployed in such companies?

Here comes Best-in-class, where the fund manager has the flexibility to use looser criteria to evaluate the ESG score of a given company and evaluate it among the company’s competition rather than the whole market. This puts many of the companies in the basket, even if it looks counterintuitive to the intended ESG approach. There are a few big ESG funds, which invest in Oil & gas, mining, tobacco, banks and automobiles.

And the critics out there argue about this situation in two ways. One that says stricter ESG criteria are required. The other says that the stock market is going the right way about ESG. So, which side are you on?

This also tells us that we have to study every detail of any fund before we proceed to invest.