- Ethical Investing. (Say no to alcohol, no to tobacco, no to vices)
- SRI (Socially Responsible Investing)
- Islamic Funds Investing in companies or instruments that are in strict compliance with the shariah laws)
As global wealth keeps rising, these are some themes that keep cropping up. To me, every industry fulfils someone’s needs and hence there is no question of morals in business. Is Coca Cola a moral thing? Is Horlicks a moral thing? Are fire-crackers environment friendly? Are plastics good for the earth? Are automobiles good for us? Do they contribute to health issues? Is coal mining socially responsible? If you ask all these questions, soon you will be left with nothing but organic farming that is truly socially responsible.
I used to know of a leading broking house that used to disallow employee reimbursements on non-vegetarian food and alcohol. In proprietary trading, they would not invest in companies that used or sold anything that was non-vegetarian. However, they did not mind executing client orders on such shares. In the capital markets, wining and dining are an accepted way of doing business. This firm would not allow any reimbursement of bills that pertained to liquor or tobacco or non-vegetarian food. The way out? A no-question asked ‘business promotion’ allowance to their staff who had to indulge in this expenditure in the line of duty!
From exclusion to ESG
Till recently, the principles of ethics in investing were applied by exclusion. In other words, you avoided investing in certain kinds of stocks because you said no to ‘Sin’, even if Sin is recession proof and makes more money. But the exclusion concept did not become very popular, so we now are seeing the emergence and spread of “ESG” investing. In addition to financial criteria, ESG considers factors that communicate whether our investments are socially responsible or not. Environment, Social responsibility and Governance are the three pillars of ESG.
It is interesting that the creators of this concept have cleverly appropriated ‘Governance’, which I think any good investor considers in the normal course of his investment selection. The argument advanced in favour of “E” and “S” is that they impact longevity of businesses. With rising concern for the environment and human health, there is indeed increasing focus on these factors, but there are also equal attempts by companies to hide their guilt. Coca Cola is venturing into other businesses and publicizing everything except its core product. ITC never talks about its bread winner. Petrochemical companies, chemical companies and so many other industries all have issues. If we go by an ‘exclusion’ principle, I doubt if any company we know would meet the highest standards of ESG.
To me, a key sign of the arrival of the ESG concept is its entry into the MSCI indices, which are in use as a benchmark by global investors. This is how MSCI has approached the concept:
This is cleverly done. No institutional money manager would like to say that he does not care for these factors. So far, we had accountants, lawyers, credit rating agencies and international standard organizations who thrived off industry as consultants. Now, there’s a new line of business for them in ESG scoring, very much like Governance institutes.
How it’s done
Let us now look at how the typical ESG assessment is done. I have taken the liberty of reproducing a small portion from a detailed exposition by “SES Governance” (a firm that examines corporate governance and is known for its proxy advisory services) that offers consultancy services in ESG assessments. Here are the broad factors that they look at:
Personally, I would not give much weight to the first part- “Business Responsibility Report”. No company is going to admit that they are anything but snow-white. The factors on ‘Environment’ are interesting. Some have a direct bearing on the costs and to that extent, an improving score on that should also mean improving profitability. These factors are present in the annual report and it is a question of compiling them and assigning scores.
The third box ‘Social’ is something that we do not normally focus on as investors. With ESG investing, a poor score on this can deprive a company of some institutional flows. We are unlikely to find these Social negatives from company-published information. The last factor – Governance – is something that seasoned investors and professional fund managers anyway look seriously at. I see that the factors carefully ignore political risks. Nor do they look at the tax paying records.
Does it help returns?
Whether it is objective or subjective, ESG appears to be here to stay. So as an investor, we should be evaluating if ESG-based stock selection indeed means a higher return.
I do not think there are straight answers. If I were to use ESG, I would give ‘Governance’ the highest weightage. If that is done, then I can clearly say that a higher ESG score would mean a superior return. If weights are equal to E, S and G, I am not so sure and would rather stick to conventional investment analysis.
For one, managers launching new funds have many innovative ways to prove that ESG gives higher returns. FMCG companies can be easily given higher scores (no matter if they sell sugar water or detergents) and mining companies will be given the lowest scores. But today, I do not need an ESG score to help me make this choice. I would be keener to see if the ESG scores mean that I can get a better return from Marico as compared to HUL or Nestle.
Two, ESG investing will also lead to industry biases. Some will score consistently higher on E and S factors and some will lose out. Can this lead to skewed portfolios and missed opportunity?
Three, companies engage consultants to prepare the annual reports and BRRs, that are the inputs to ESG scoring. These folks clearly know the art of public relations and compliances and know how to make a company look good on ESG. So I do not expect miracles on this.
Domestic ESG funds
As an investor in direct equities, I would prefer to ignore ESG and look at my potential return. I am not managing “Other Peoples’ Money” and not in the public glare. I am not embarrassed about why I invest money. But a fund manager has the need to be seen to be in line with the global trends. Already, a few domestic funds have launched some products. Here is the portfolio of one of the funds:Here is the portfolio of another ESG fund, that also has some international stocks:
This raises some questions. I do not see why finance companies or banks should figure in an ESG portfolio. How will they be assessed? They lend to different sectors and the money they lend has different social and environmental impacts. The funds seem to have stayed away from mining, metals, tobacco. That’s predictable. But I also see a name called “Taiwan Semiconductors”. A medium sized semiconductor fab unit consumes more clean water than a tier two city’s drinking water needs! I would also question the inclusion of petrochem, chemicals and auto. So, I’m forced to conclude that it’s all about labelling. Clearly, someone is banking on PSU refineries getting re-rated and following the beaten path for the rest. The ESG scores based on which the selections are made, are not mentioned at first glance.
I am reminded of an old episode from “Yes Prime Minister”. The PM wishes to bat for a huge hike in taxes on cigarettes. Our friend, Humphrey Appleby tells the PM that the tobacco industry is actually good for the nation. He throws up statistics to show that the taxes collected from tobacco companies exceed the total spend by the National Health Service! We will surely see a lot more such stories as consultants build tales to spin around ESG.
I would say, for now, stick to the conventional funds if you are a mutual fund investor. It is too early to say if there is enough data availability and transparency in India in order for ESG to be a success factor. ESG is an evolving concept globally. Over time, some companies will tend to get ignored by the institutional investors and even get excluded from global and domestic stock indexes. If Coal India is scored poorly on ESG, it will go out of the index. If automobiles are also scored poorly, then you can imagine. So index investing should in itself serve the purpose for lay investors.
However, we should remember that big business has a way of protecting its interests. We will definitely have cases of sinners showcasing their prayer sessions to demonstrate that they deserve better consideration under ESG. I just saw a presentation at an ESG conference by ITC Ltd, where they talk about everything except the social impacts of the cigarette business. Stay focused on the age-old investment principles. ESG is already factored in if you are a 360-degree investor.
That’s about domestic funds, so what’s the global scenario?
Globally, even vanilla institutional investors are increasingly focusing on socially relevant themes that have one or more of following characteristics:
- Exclusion of some company or sectors
- Focus on companies or industries with highest ESG compliance
- Limit investment to minimum threshold of ESG score
- Social impact investing
All of these are themed under ‘sustainable’ investing. This will extend to lending and investment in fixed income papers also. Which would imply that companies with excellent ESG compliance would get money at lower rates and from a wider range of investors.
In light of this, I would like to think that stock valuations do factor in ESG to some degree. Environment and governance are factors that investors already consider. However, formal labelling and scoring means that money flow will be directed more towards those considered ‘fit and proper’ under the ESG measures which are very subjective. The ‘weights’ to different ESG factors can skew scores and whether a company fits the bill. If there are serious issues in governance, that could be a veto for an ordinary investor, but an ESG fund could still own it because it makes the cut on E and S.
Given these imponderables, I would wait and watch for the evolution of ESG investing in India. In the meanwhile, I will not bet my money into ESG themes in India, till these ranks become as popular as credit ratings.