Governing ESG

The Securities and Exchange Board of India (SEBI) is right in seeking to tighten the disclosure, strategies and practices of funds based on the Environment, Social and Governance (ESG) theme. With the increased emphasis on adopting sustainable growth, there has been a surge in ESG investing globally with these assets surpassing $35 trillion by the end of 2020, according to Bloomberg Intelligence. The momentum is expected to continue with ESG funds accounting for a third of global assets under management in five years. Investing based on the ESG theme is beginning to attract higher interest in India too, with assets under management of ₹12,085 crore invested across thematic equity schemes, exchange traded funds and Fund of Funds. However, the regulation of this segment is at a nascent stage with global regulators such as IOSCO and FSB just beginning to discuss the manner of streamlining ESG ratings, indices, products and so on. SEBI’s discussion paper draws from these global discussions and rightly tries to nudge mutual fund AMCs to define the intent of the ESG schemes and to communicate it clearly to investors.

Improving the disclosures in ESG funds is imperative since there isn’t enough clarity on the manner in which ESG funds select stocks. SEBI’s proposal to ask AMCs to disclose the nature and extent of the scheme’s ESG-related objectives and the approach used for screening companies is good as it will help investors judge if the fund meets their requirements. Asking fund houses to disclose the strategy employed by the ESG schemes to select stocks is also a good idea as it will clearly define the scheme’s mandate and provide more clarity to investors. Disclosure of risks arising from investing with the ESG mandate is also much-needed to moderate investor expectations from these schemes. But asking funds to ensure a beneficial ESG/sustainability impact alongside a financial return is going to be a tough ask. For unlike social impact funds, mutual funds typically hold only a small stake in companies and mostly cannot influence the functioning of the company. Defining the intended ‘real world’ outcome of ESG funds could therefore be quite difficult. Especially, with only handful of listed companies involved in creating a social impact.

The proposal suggesting that ESG funds should only invest in companies which have filed Business Responsibility and Sustainability Report (BRSR) from October 1, 2022, is a good one and should be strictly enforced. In May this year, SEBI mandated that the BRSR will be mandatory for the top 1,000 companies by market capitalisation from 2022-23. But there is no reason why other companies should not file this report too. Restricting fund houses to investing in the companies filing this report could make more companies toe the line. However, the existing investments in the schemes for which there are no BRSR disclosures can be grandfathered for a little longer, at least two years, to give companies time to comply.