Environmental, social and governance (ESG) factors are becoming increasingly relevant to corporate entities, investors and regulators alike. ESG-forward businesses – i.e. businesses that have demonstrated ESG consciousness and, or, have high ESG ratings – are generally viewed more favorably by consumers. ESG-forward companies also attract greater interest from strategic and retail investors alike and regulators in India and abroad have begun mandating ESG requirements and, or, ESG-related disclosures.
Socially and environmentally conscious retail investors in India looking to invest in ESG forward companies may, in theory, undertake their own analysis by evaluating public disclosures, ESG ratings and generally tracking the National Stock Exchange’s (NSE) dedicated ESG indices. However, as this could be complex, ESG-conscious retail investors can instead invest in ESG-themed mutual fund schemes.
What Are ESG-Themed Mutual Fund Schemes?
In India, ESG-themed mutual fund schemes are mutual fund schemes that invest 80% or more of their assets under management in equity or equity-related instruments of ESG-forward companies. Currently, from a regulatory perspective, ESG-themed mutual fund schemes fall under the larger umbrella of “thematic funds”, and are not regulated as a separate category. As a result, these schemes are not subject to any ESG-specific standards or disclosure requirements.
There are currently several domestic ESG-themed mutual fund schemes in India, one exchange trade ESG-themed mutual fund scheme, and one climate focused fund-of-fund (FoF) scheme. However, due to the absence of specific regulation, the approach adopted by each scheme varies. Illustratively:
- Each fund house has its own internal policies and criteria for the assessment of performance against ESG metrics.
- The weightage applied to each of the three aspects of ESG may vary – a particular fund may attach a weightage of 40% to governance factors and 60% to environmental and social factors, while another fund house may assign different weightage.
- While each fund house evaluates and scores companies and securities as part of their screen process, the scoring mechanisms may vary – example, some rate securities on a scale of 1 to 3 and others on a scale of 1 to 5.
- While most funds do not invest in sectors such as alcohol, tobacco and controversial weapons (such as nuclear and biological weapons), some funds go a step further and exclude companies engaged in highly polluting industries such as thermal power generation, Arctic drilling and the like.
The disparity in methodology, evaluation and exclusion criteria makes it difficult for investors to compare ESG-themed mutual fund schemes and their performance.
There do, however, appear to be a couple of constants that investors can rely on:
- The ESG-themed mutual fund schemes (other than ETFs and FoFs) are all benchmarked against the NSE’s Nifty100 ESG TRI Index. However, this is only a benchmark and the mutual fund schemes do not restrict their investments to companies on that index.
- Most ESG-themed mutual fund schemes do not invest in companies in the alcohol, tobacco, gambling and controversial weapons (nuclear and biological) sectors.
- There are a couple of common companies in which most of the India specific funds appear to invest – example, HDFC Bank Limited, Tata Consultancy Services Limited, and Infosys Limited – and, to that extent, there is some consistency in the fund houses’ approach.
In the absence of uniform guidelines and disclosure norms for ESG-themed mutual fund schemes, it is difficult for investors to compare schemes and to measure the performance of the underlying investee companies on ESG factors.
Investors must, therefore, analyze the scheme information documents carefully and monitor the relevant scheme’s investments from time to time to ensure that the schemes continue to meet the investors’ ESG-related expectations.
How To Invest In An ESG Themed Mutual Fund Scheme
Like any investment in a mutual fund scheme in India, investment in an ESG-themed mutual fund scheme can be made directly through the relevant fund house’s website or through an intermediary.
The investments may be in dematerialized (demat) or non-demat form. To invest in demat form, an investor must first have a demat account through which they can hold their investments.
Opening A Demat Account
A demat account must be opened with a depository account registered with the Securities and Exchange Board of India (SEBI), India’s securities market regulator. Most large Indian banks are SEBI-registered depository participants. A person who holds an account with such a bank, may open a demat account linked to their bank account. Alternatively, an investor may open with a non-bank depository participant such as the Stock Holding Corporation of India Limited.
To open a demat account, an investor must:
- Identify the depository participant
- Submit a duly filled out application form
- Complete know your customer (KYC) formalities by providing proof of identity (PAN card, voter ID, driving license, etc.) and proof of address (registered lease deed, passport, electricity bill, etc.)
- Provide details of their bank account with a copy of account statements or passbook. The supporting documentation should have been obtained within the three months preceding the submission to the depository participant.
Once the demat account has been opened, the account will be linked to the investor’s bank account, and all demat investments made by the investor, including mutual fund investments, will be reflected in that demat account.
ESG Disclosure Requirements Under the Indian Law
The reporting of performance against ESG factors was first introduced in India in 2009 via the Ministry of Corporate Affairs’ (MCA) voluntary guidelines on corporate social responsibility. The 2009 guidelines encouraged Indian companies to disclose initiatives taken for ethical functioning, respecting the environment, caring for stakeholders and social and inclusive development in their annual reports and on their websites.
Key point to note is that while the MCA’s guidelines were updated in 2011 and 2019, compliance with the guidelines remains voluntary.
The MCA guidelines set out nine overarching principles against which disclosures should be made. Based on them, businesses should do the following:
- Conduct and govern themselves with integrity, and in a manner that is ethical, transparent, and accountable.
- Provide goods and services in a manner that is sustainable and safe.
- Businesses should respect and promote the wellbeing of all employees, including those in their value chains.
- Respect the interests of and be responsive to all its stakeholders.
- Respect and promote human rights.
- Respect and make efforts to protect and restore the environment.
- When engaging in influencing public and regulatory policy, should do so in a manner that is responsible and transparent.
- Promote exclusive growth and equitable development.
- Engage with and provide value to their consumers in a responsible manner.
Under the MCA guidelines, disclosures against the principles are to be made at two levels – essential and leadership.
SEBI has mandated the disclosure of performance against ESG metrics since 2012. In May 2021, it issued a new disclosure regime under a circular on “business responsibility and sustainability reporting by listed entities” (BRSR). From FY2022-2023, the top 1,000 listed companies are required to make disclosures in accordance with the BRSR. Other companies should also elect to make disclosures in accordance with the BRSR.
Disclosures under the BRSR are divided into three categories:
- General disclosures: Details on matters such as business activities, employees and workers, employee turnover, grievance redressal mechanisms, the company’s material responsible business conduct and sustainability issues;
- Management and process disclosures: These include specific commitments, goals and targets set by the company, a statement from the director responsible for the report highlighting ESG issues, etc.
- Disclosures against the nine principles set out in the MCA guidelines.
Neither the MCA guidelines, nor the BRSR set out objective metrics to measure compliance with the nine principles. This is, to some extent, positive as a “one size fits all” approach would be inappropriate for companies of all sizes and from all sectors. However, the lack of objectivity can lead to a fair amount of subjectivity both in the manner in which companies make disclosures, and the manner in which these disclosures are analyzed.
ESG Rating Providers
Measuring companies’ performance against disclosures made against the MCA guidelines and the BRSR may, in theory, be made easier by ESG rating providers (ERPs) who analyze these disclosures and score these companies and their competitors. However, ERPs do not appear to use uniform assessment criteria and ranking systems, and they do not publish their methodology. This lack of transparency, again, gives rise to concerns of “greenwashing”.
“Greenwashing” implies giving a false impression of a company’s products and business being environmentally sound in the absence of objective criteria and metrics to measure performance.
SEBI’s Efforts To Reduce Ambiguity
SEBI appears to have recognised that the extant regulatory framework may not adequately address issues of transparency and greenwashing and is evaluating further measures to resolve these issues:
Consultation Paper on Disclosure Norms for ESG Mutual Fund Schemes
On October 26, 2021, SEBI issued a consultation paper suggesting disclosure norms for ESG-themed mutual fund schemes (MF Consultation Paper).
The MF Consultation Paper proposed that each mutual fund with an ESG scheme should:
- Ensure that the name of their ESG scheme accurately reflects the nature and extent of the scheme’s ESG focus based on the account investment objective and strategy.
- Ensure that the investment objectives of the scheme provided transparency as to the nature and extent of the scheme’s ESG-related objectives. The detailed objectives need to be laid out along with a statement on how it aims to achieve the stated objectives through the investment policy, strategy and screening approach.
- Provide for the review of investments during certain periods and state the strategy for doing so, including the broad category of companies in which they intend to invest. The asset management companies (AMCs) should clearly state the real-world outcome that their investments would have in qualitative terms.
- Set out their investment strategy including their exclusion strategy, best-in-class inclusion and positive screening strategy, and the methodology to assess the impact of their investments.
- Disclose the material, unique risks that arise from the scheme’s focus on sustainability and measures to mitigate risks relating to greenwashing and reliance on third party scoring (ratings from ERPs).
- Align their benchmarks relating to ESG. The fund should also provide a link to the index methodology.
Currently, thematic mutual funds, including ESG mutual fund schemes, must allocate 80% of their assets towards equity and equity-related investments consistent with the scheme’s theme. The remaining 20% of the assets may be deployed in such a manner as the fund manager sees fit. However, as per the MF Consultation Paper proposed that the remaining 20% of assets should not be deployed in a manner that starkly contrasts with the theme of the ESG scheme and that AMCs should endeavor to have a higher portion of the assets of the scheme under the ESG theme and make disclosures accordingly.
The MF Consultation Paper also proposes additional steps such as the monitoring and evaluation of key performance indicators, real-world outcomes, etc., the implementation of a stewardship policy for the exercise of voting rights in accordance with the scheme’s objectives, and as definitions vary across fund houses, the creation and adoption of common sustainable finance terms and definitions in accordance with global standards.
Through the MF Consultation Paper, SEBI has sought comments on various matters including the proposed disclosure requirements, whether AMCs should only be permitted to invest assets of ESG themed schemes in companies making BRSR disclosures, and the grandfathering of investments in companies that do not make BRSR disclosures.
SEBI has yet to formulate regulations based on the proposals in the MF Consultation Paper.
Regulation of ERPs
In January 2022, SEBI issued a discussion paper on ERPs for securities markets (ERP Consultation Paper). Given the increased reliance on ratings from ERPs and the opacity in how such ratings are calculated, SEBI proposes to regulate ERPs going forward. The ERP Consultation Paper proposes, amongst others, that:
- ERPs assign ratings to listed entities and listed securities to be accredited by SEBI.
- Listed entities, SEBI-registered entities engaged in fund-based investment, and index-providers may only use the services of SEBI-accredited ERPs.
- Only credit rating agencies, and research analysts with a minimum net worth of INR 10 crores will be eligible for SEBI accreditation;
- The type of rating products should be rationalized, and ERPs must provide at least one of the following products:
- ESG Risk Ratings which assess a company’s resilience to ESG related risks but do not factor in the company’s impact on the environment or society;
- ESG Impact Ratings which assess the positive and negative impact of a company on the environment and society, and the company’s corporate governance profiles; and
- Other full-fledged ratings or benchmarking products such as carbon risk ratings and ESG disclosure ratings;
- ERPs should adopt subscriber-pay models as opposed to issuer-pay models so that their revenue is not primarily dependent on the companies that they evaluate.
The ERP Consultation has not resulted yet in regulations for the accreditation of ERPs.
Establishment of Advisory Committee
In May 2022, SEBI constituted an advisory committee to advise on:
(i) enhancements to the BRSR.
(ii) ESG ratings and devising the approach for ratings and disclosure requirements for ERPs
(iii) ESG investing, including the enhancement of disclosures for ESG themed mutual fund schemes “…with particular focus on mitigation of risks of mis-selling and greenwashing…”.
Presumably, SEBI will not implement regulations in respect of ERPs and, or, disclosure requirements for ESG-themed mutual fund schemes until the advisory committee has made its recommendations.
Until SEBI institutes specific norms and disclosure requirements for ESG-themed mutual fund schemes and ERPs, ESG conscious investors should exercise caution and discretion before investing in ESG-themed mutual fund schemes to ensure that the objectives of the scheme match their own.
Additionally, as some funds invest in high pollutant industries such as thermal power generation, steel, etc., investors should also ensure that the list of excluded industries for the relevant ESG-themed mutual fund scheme meet their expectations.
Once SEBI announces legislation for ESG-themed mutual funds and ERPs, ESG-conscious investors will be able to rely on the fact that the ESG-themed mutual fund schemes are, in fact, ESG-conscious and meet investor expectations, and need only undertake an analysis of the financial performance of these schemes when deciding where to invest.