Mutual funds get ESG push, but greater finesse required

On July 20, Sebi (the Securities Exchange Board of India) released guidelines creating new mutual fund categories for investing in the theme of Environmental, Social, and Governance (ESG). ESG has become a major theme for the world’s financial markets. Whether it is banks or capital markets, there is a sustained focus on making the balance sheet compliant with ESG norms. The financial regulators are also playing a key role by enacting regulations to nudge financial entities to make investments in the ESG space. Sebi has done the same in the mutual fund space.

There are two ways in which the financial sector can become ESG compliant.

First, to bring ESG-related changes within the firms themselves and report these changes in terms of data. In terms of ‘E’, the firms use less environmental resources and do not contribute towards Climate Change. In terms of ‘S’, it would mean focusing on employee safety and health, encouraging social diversity and equity, among others. In terms of ‘G’, it would mean improving corporate governance, prohibiting bribes, preventing corruption, etc.

Read | Checklist for selecting the right mutual fund for you

Second, to provide funds to sectors which are more ESG compliant. While the first way is being increasingly adopted by both financial and non-financial firms, the second way can be done only by the financial firms. Both banks and capital market firms can channelise a larger share of funds to ESG compliant businesses.

Sebi’s guidelines on ESG investments are an attempt to channelise higher mutual fund investments towards ESG-complaint companies. Before the guidelines, mutual funds were permitted to launch just one scheme with ESG as the central theme of investments. Sebi has now permitted mutual funds to launch multiple ESG schemes under six themes: exclusion, integration, best-in-class & positive screening, impact investing, sustainable objectives and transition or transition-related investments.

The ESG funds will now be named as ‘ESG Exclusionary Strategy Fund’, ‘ESG Best-in-class Strategy Fund’, etc. This is like other mutual funds which have generic categorisations like ‘Equity Large Cap Fund’, ‘Equity Small Cap Fund’, and so on. The idea behind these six categories is to create a vibrant ESG mutual fund market. In turn, a vibrant ESG mutual fund market is a key ingredient to creating a wider ecosystem of ESG financial markets.

Read | Importance of cash in your financial portfolio

These mutual funds are an intermediary which can only invest the proceeds in ESG-compliant listed firms. So, unless listed companies are ESG compliant, only then will mutual funds be able to offer ESG funds. Sebi has been working on creating this very ecosystem. Before releasing these guidelines, Sebi had earlier issued regulations that stated that from 2023-24 onwards, the top 1,000 companies would release an annual Business Responsibility and Sustainability Report (BRSR). BRSR is a set of key performance indicators (KPIs)/metrics under nine ESG attributes such as greenhouse gas footprint, water footprint, employee well-being, fairness in engaging with customers and suppliers, etc. Sebi has also issued a circular on ESG ratings providers which will verify the claims made by companies towards their ESG goals.

The fund manager of the ESG mutual fund will be required to issue an annual commentary which details the ESG strategy, among other details they already provide.

RBI and environment

How do we assess these regulatory changes on India’s mutual fund system, and broadly on the financial system?

First, six categories are a bit too much and are likely to create confusion. Sebi could have started with two or three categories, and then expanded the list. In the past, Sebi has initiated regulations to simplify mutual funds and their categories. It should have followed a similar approach in this case too.

Second, the traditional mutual fund industry may not have the expertise to deal with ESG-related matters. This is a specialised field which requires specialists for the job. If the industry is serious about creating ESG categories, it will have to start recruiting officers who have training in ESG-related matters. The lack of skills in ESG is not just limited to mutual funds but also for those who are going to rate/rank ESG funds.

Third, Sebi and mutual funds join hands with RBI and banks/financial institutions to make the Indian financial system the driver for action against Climate Change. The RBI has not really adopted a universal ESG strategy for its regulated entities but has instead followed these parameters separately.

The central bank issued a discussion paper on climate risk and finance followed by a survey of banks readiness for Climate Change. Its officials regularly give speeches on economics and finance of Climate Change, and how banks can help in the transition. The theme for the RBI’s annual currency and finance report 2022-23 was Climate Change.

Following the 2010 banking crisis the central bank has been very cautious about governance. It has made multiple changes to restore governance in the regulated entities. Overall, with Sebi joining hands with the RBI, the Indian financial system will hopefully usher in more responsible finance in the future. The way things are panning out, going forward ESG financing will be the main way of financing.

ESG criticism

The ESG bandwagon is surging ahead despite criticism. Aswath Damodaran, Professor at New York University and a global voice of financial valuation, has been a long-standing critic of ESG investments. In this research, Damodaran says that evidence shows that socially responsible firms do not deliver high growth and value. In fact, it adds to extra costs. The bad firms are anyways punished by markets in forms of lower returns. He adds that though ESG is marketed as being good for companies and society at large, the reality is that it just makes more money for consultants, bankers, and investment managers.

We must wait and see whether Damodaran is right or this change in the Indian financial system proves him wrong.

Amol Agrawal is an economist teaching at Ahmedabad University.

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.