Prospects of ESG Investing in India, explained by Ruchit Mehta of SBI Mutual Fund

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#ESG, #ESG fund, #SBI AMC, #SBI Magnum

ESG (Environmental, Social, and Governance) based investing, which focuses extensively on evaluating a company’s social consciousness rather than simply considering the bottom line for making investment decisions, has been catching up fast, especially with young investors, who want to move beyond quantitative aspects to assess the prospects of a business.

Per data, inflows in ESG funds to Rs 3,686 crores, a 76 percent rise in 2021, as against a base of Rs 2,094 crores in 2020. We catch up with Ruchit Mehta, Fund Manager, SBI Mutual Fund, as he elaborates on the potential and scope of this branch of investing in India.

How do you view the prospect and potential of ESG investing in India? What are some of the trends you’ve noticed in recent times and in the next five-10 years to come?

While ESG investing is currently viewed as simply a thematic way of investing by most investors, it is essentially an extension of the research process needed to determine good investments and a very important way to understand rising risk factors to business sustainability from various global issues such as climate change and income inequality, challenges, and risks, among others. ESG will soon become mainstream and a popular investing approach rather than simply remaining thematic over the next five-10 years.

Each country will have to approach ESG in its own manner, best suited to the need of that country. For example, the western world is seeing a shunning of investments in fossil fuels. But for a country like India where there is still inequality of energy availability, shunning fossil fuels outright may not make sense. It is better to engage with companies in that space and work with them so that they develop a transition path to a more sustainable and equitable future.

Having said that, there are a few trends that are specific to India. For instance, responsible investing and ESG integration has been adopted more proactively and quickly by the asset managers here rather than the asset owners as has been the convention in most developed countries.

Do you think the environmental aspect of the ESG is highlighted and more emphasized than the Social and Governance aspect of the three when it comes to evaluating investments on these parameters? How do we ensure that all these parameters are holistically included in scoring?

Generally, environmental aspects tend to get highlighted more as they are global in nature and affect every human being. This is good as it is a pressing matter and affects all regardless of where you live, or the business operates. There is a downside to this as it leads to ESG being termed simply as reen investing. Most investors have a false notion of ESG investing is about investing in renewable energy firms, recycling firms, etc.

But, nothing can be further from the truth. ESG investing is about looking at all three aspects equally and holistically. There will be nuances in each sector, like environmental matters are crucial in the mining sector and labor issues most important for the textile sector.

Investors will do well to look comprehensively at the business a company is in and evaluate the operating parameters and consequently, judge which aspect of ESG deserves greater scrutiny or analysis. Also, we believe that Governance factors have an extremely important interplay here.

A well-governed business, run by a competent, ethical, and responsible management team will certainly incorporate environmental and social factors in their decision-making processes. This is why, while environmental and social factors may differ or have a higher/lower relevance based on the industry sector, governance factors stay constant and highly relevant.

Valuation giant Aswath Damodaran termed ESG investing as a mistake, as he said, “If being good makes companies less risky, investors in good companies will earn lower returns than investors in bad companies, before adjusting for risk, and equivalent returns after adjusting for risk”. There is an increasing list of experts who are growing skeptical of ESG investing? Why? What are the potential downfalls and risks associated with this kind of investment?

Professor Damodaran is right in the way he has framed the problem. If doing good leads to lower risk-taking, it will mean lower returns for investors. Many like him are skeptical about ESG investing, and that has got more to do with the way the investing community has approached ESG than the fundamentals of ESG.

The investing industry has jumped onto the bandwagon of ESG as it is a new rising trend, something which is attracting a lot of assets. This has led to many instances of greenwashing, green labeling, and a host of uncharitable practices which do more harm to the furtherance of ESG than any purported good.

However, this does not mean the concept of ESG is immaterial. Following good ESG practices does not necessarily lead to lower risk-taking or lower returns for companies. Companies adopting more sustainable business practices tend to see material benefits as well. This can range from the lower cost of capital (which can encourage risk-taking), better employee retention, and better consumer demand (theoretically with an ability to charge more).

Look no further than a metals and mining firm from India’s largest conglomerate. They have had some of the best labor relations over a century, all because they have had one of the best employment practices. In a business fraught with labor disputes, they have had very minimal disruptions. And whilst the benefit of this is not quantified, it does accrue.

Also, this is a perception because the most common way of creating ESG Funds is via exclusion/negative screening of companies by sectors. It may lead to exclusion of sectors like coal or oil which may be major revenue earners for governments, or not investing in sectors like tobacco, alcohol, etc which may be more profitable than some other sectors. However, increasingly, funds are adopting an ESG integration approach rather than an exclusionary approach.

From that perspective, it is just logical to keep very risky companies out of the portfolio, just like you would anyway keep bad companies out of your portfolio. The sustainability of long-term rewards is also material to investors, which is what ESG funds focus on.

Data on ESG funds has shown that these funds have performed equivalent to other funds and have at times outperformed the benchmarks. More conclusive data would emerge when the funds will be older enough to assess the data in a meaningful way in the Indian context.

The ESG momentum is being driven by the millennials who are distilling their social consciousness in their investments. But since the parameters are so abstract and evolving, concrete, conclusive data is hard to find and understand for an individual investor. How do you think investors can truly assess the impact and performance of these funds accurately?

ESG investing is still an evolving area. There are issues of quality data, and not all of it is objective. This has led to a disparity in the views held by investors and service providers. It is well documented that two rating agencies looking at the same company can have very different ESG Ratings.

It is therefore natural for investors to be confused or feel unable to assess the performance of ESG funds. The key here lies in assessing the ESG process followed by the asset manager. The robustness of the ESG evaluation process, the level to which ESG is integrated into investment research and the commitment of the firm (such as are they a UNPRI signatory? Do they have a dedicated ESG team?) are important factors to evaluate.

Also, with the regulators like SEBI laying stress on increased transparency in the form of BRSR, we expect the data unavailability, standardization, and assessment issues will get mitigated over time as companies will be expected to provide quantitative data in the public domain. This will make them more accountable to the millennials, and easier for fund managers to access data and integrate it into their decision-making process. However, even with data availability, the concepts around ESG assessment themselves are dynamic.

For instance, today, we may want to see the historical performance of a company to assess whether it has demonstrated responsible behavior. However, in a few years, we might want to look at future strategies and changes brought in the company’s process in recent years – a concept known as the ESG improvers. So, it largely depends on how fund managers decide to integrate the assessment in their decision-making process and how they evolve their understanding and frameworks over time.

What are the parameters and selection criteria that the SBI Magnum Equity ESG fund follows for selecting companies? What factors are predominantly important?

Let me talk about the selection procedure we follow here at SBI. The Magnum Equity ESG fund has a two-step process to determine security selection. First, we narrow down the universe of stocks covered by the research team using a set of filters that focus on ESG factors. The negative screening is focused on three areas.

First, it is revenue exposure for companies (greater than 5 percent) to Tobacco, Alcohol, Adult Entertainment, Gambling, and Controversial weapons (anti-personnel mines, cluster munitions). Second, is high unresolved controversies pertaining to material ESG factors. Third, are companies that score poorly on their ESG rating, where we have a minimum cut-off. The second process is security selection based on our fundamental view of the business, the attractiveness of the growth opportunity, valuations, and ESG performance (leaders or scope for material improvement).

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