Social and Impact
Demystifying investing through ESG: financial returns in tandem with social good
09 Aug 2021
ESG is increasingly getting intertwined in the investment strategy of public market foreign portfolio investors (FPI) or foreign institutional investors (FIIS) as well as private equity funds, who are consciously rebalancing their investment philosophy to identify firms that will deliver robust financial performance as well as a sustainable long-term social good. The ESG lens for evaluating investments calls for a clear set of criteria to identify companies that stand out in terms of their business strategy and financial performance and excel in their contributions on environmental, social, and governance aspects. 
A company’s future could face challenges due to financial and non-financial risks. The ESG investment philosophy considers mitigating the types of risks that are important in the long term. The firms that evaluate the long-term impact on their ecosystem are better equipped to survive and remain equipped for any uncertainty that will arise in the future. Companies that acknowledge the importance of ESG factors and manage them well eventually prove to be rewarding for investors. 
As ESG is fast becoming mainstream and the following trends are becoming prevalent: 
  • Around US$ 30 trillion of assets under management (AUM) are ESG funds
  • More than 50 percent of the growth in consumer goods can be attributed to their ESG related propositions
  • Three-fourth of today’s workforce comprises millennials who expect strong ESG practices
  • 90 percent of the impact of a company’s ESG initiatives is felt on its supply chain
The following factors play a pivotal role in evaluating the ESG compliance of companies:
  • Clearly defined corporate objectives and interlinked outcomes
  • Improved quality of data collected on measuring performance parameters and translating into corporate financial performances
  • Improved governance, regulations, and disclosures
  • A transparent process on reporting and assessment
  • Sustainable operations while meeting buyers, clients, or customers' newer demands of better products and services
ESG investing is no longer a niche market; it is fast becoming mainstream

As the world grapples with environmental and social challenges in its quest for growth and value creation, companies with good ESG practices are favorably placed for inclusion in investment portfolios. 

To allocate capital to companies with sustainable business practices, institutional investors and stakeholders are increasingly investing in stocks with high ESG scores, often via private equity investments or public markets. 

ESG-focused funds across mutual funds and private equity investments are evaluating investee companies in terms of their: 

  • Environmental-friendly business practices
  • Positive impact in social areas by the company products or practices
  • Regulation in corporate governance and company ethics
Technology, financial services, and consumer sectors are gaining attention due to their inherent nature of business, while energy, mining, and utility sectors need to demonstrate their track record in terms of their carbon footprint, emission norms, resource utilization, and governance standards. Investors are constantly reviewing how firms report performance on ESG parameters and how they take steps to mitigate ESG-related performance gaps. Eventually, these result in a lower cost of capital and power sustainable, compliant, and purposeful business models.
Investors’ views on ESG investments
We observe that investors who actively embed ESG in their investment thesis, look at evidence-based ESG reporting, self-certifications as well as clarity and transparency on the ESG goals of companies very closely. In addition to the goals, a clear plan and glide path and key metrics go a long way in convincing investors of the focus of the management on ESG.  
While performance on these targets can often be impacted by multiple factors outside the company’s control, at least a positive and purposeful intent and evidence of effort and investments across the organization, customers, and larger ecosystem is appreciated by investors. 

How do Investors identify companies that meet ESG standards? What are the conditions?

With growing interest in ESG, investors feel a need for frameworks and toolkits to compare the ESG performance of investee companies. Several reputed institutions have developed their proprietary frameworks and toolkits: MSCI, FTSE ESG, WHO, World Bank - IFC, etc. to help assess companies on their ESG performance. In our view, large investors will need to design something that is in sync with their investment philosophy and processes – they may build on pre-existing frameworks, but will eventually need to mold these to fit into their scheme of things. 

Coming back to India, some fund houses that offer ESG-focused mutual fund schemes are thinking of their own way of incorporating ESG considerations into their investment analysis. For instance, Quantum India ESG Equity Fund and Kotak ESG Opportunity Fund have defined their own ESG frameworks which describe the criteria for the companies they want to invest in. 

FPI inflows in India

The FPI also has a clear mandate from their investors to incorporate ESG into their investment decision-making criteria. FPI investors from across the world and especially from Europe and the Americas, are demanding that Indian companies accelerate their pace of adoption of ESG norms into their businesses. Responsible Investing (RI), which entails making ESG integral to the investment process, has become a key criterion governing the process of investment decision-making across investment managers. 

There is a flow of liquidity in the global financial markets after the US announced a USD 1.9 trillion pandemic relief package, which ensured a regular flow of assets into emerging markets like India. FPIs invested a record INR 1.50 trillion in Indian markets in Q3 FY 2021 with INR 0.68 trillion being invested in December 2020 alone. Increasingly, these funds will find their way into companies that score well on ESG criteria.

Private Impact Investors 

While ESG investing is taking root in public markets, impact investors have been directing investments in businesses that do social good along with economic good for quite some time now. Some of the prominent sectors where impact investors have funded startups are: 

  • Agriculture 
  • Healthcare 
  • Financial services 
  • Education 
  • Technology for development 
Close to US$ 90 million has been invested by impact investors in India in FY21, most of the flows have been to companies in education, healthcare, and financial inclusion spaces. 
Some of the startups funded by marquee impact investors are shown below:  

Impact investors 

Target portfolio 

Aavishkar 

Milk Mantra, ULink Organics, Zameen Organic, MeraDoctor, Raya Dairy, Vaatsalya Healthcare, Waterlife, Mela Artisans 

Accion 

ArtooAye Finance 

Acumen 

LabourNet, Asian Health Alliance, Avani Bio Energy, EduBridge  

Aspada Advisors

Eye-Q, Xamcheck, Be Well Hospitals, K-12 Technologies, Capital Float, NeoGrowth

Khosla Impact Funds

DripTech, EyeNetra, Embrace Innovations

Lok Capital

Utkarsh Micro Finance, RuralShores

Michael & Susan Dell Foundation (MSDF)

Edutel, Gray Matters India, MasteryConnect, Intellegrow, LabourNet

Omidyar Network

Vistaar Finance, Dasra, Akshara Foundation

Unitus Impact

Ruma, MYA, Kinara, MicroBenefits, Mobivi

Villgro

VectorDocSkymetUniphoreMicroGraam

Source: Praxis analysis 
Shortcomings in measuring and disclosing ESG data  

According to Climate Disclosure Standards Board (CDSB) reports, only three in 10 companies fully disclose environmental and climate-related aspects in their business model. Companies report on some types of outcomes, however, the variations in disclosure formats limit their comparability inter-player and inter-temporal comparisons. For instance, nine in 10 companies only define environmental and climate risks, one in five companies only define operational risks, and less than one in three companies reported on how environmental issues impacted financial performance. Clarity and consistency in reporting the materiality of the impact of environmental and climate change issues in financial or ESG reporting need to be improved to enable investors to truly incorporate ESG considerations in their investment philosophy. The United Nations Environment Programme Finance Initiative (UNEP FI) approach is a great start in this direction.  

There is little room for doubt that ESG is very much mainstream in the investing community, especially in developed markets. Even though the ESG theme is relatively new in India, it is expected to gain traction in the coming years with a growing appreciation for environmental, social, and governance issues, especially among millennials. With capital flows increasingly getting redirected to companies that are thoughtful about ESG considerations, it seems inevitable that companies which adopt ESG-centric business practices are likely to emerge as the future winners. 

Authored by: 

Shishir Mankad, Managing Partner, and Practice Leader, Social and Impact Advisory

Lokesh Bohra, Senior Vice President, Social and Impact Advisory

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