While Environment, Social and Governance (ESG) as an investing guideline has existed for  several years, it has been predominantly driven by large development financial institutions and institutional investors as a part of their larger developmental goals rather than being a  focussed investment strategy. The coronavirus pandemic has really changed the paradigm  around ESG, wherein on one side, there is now a deeper emphasis on sustainability, while on  the other side, the perception around ESG investing being equated with muted returns has  also been shattered. 

A study conducted by Morningstar found that 73% of its ESG indices had overperformed their  non-ESG counterparts since inception.1Fidelity International’s research found that listed  stocks with higher ESG ratings performed better than those with lower ESG ratings in the first  nine months of 20202, an indication that ESG compliant entities may be more resilient during  periods of economic downturn than ESG non-compliant entities. A similar trend is observed  in India as well, with the MSCI India ESG Leader Index and the Nifty 100 ESG Sector Leaders  Index consistently outperforming their non-ESG counterparts over the last 5-10 years. The record capital inflows into ESG focussed funds during the coronavirus pandemic despite net outflows in the overall global funds universe is a great indicator of the positive change in  investor sentiment towards ESG investing.  

While Europe and USA have been the pioneers of embracing ESG principles into their  investment processes even in the pre-covid era, the emphasis on ESG has gradually increased in the rest of the world and perhaps accelerated due to the pandemic. The alternative assets  space has seen more than 4,000 ESG committed private fund closings globally since 2011  which have raised more than USD 3 trillion.3India has also recently witnessed increased  investments in ESG funds along with the launch of multiple ESG funds by fund managers  including Aditya Birla, SBI, Kotak, etc., in the mutual fund space. Private equity players like  Avendus, Everstone, etc., have also launched ESG funds that have raised significant amounts  of capital. In financial year (FY) 2020-21, ESG funds in India saw an inflow of INR 3,686 crore,  an increase of 76% from the preceding financial year.4 The cumulative assets under  management (AUM) of ESG funds in India has also increased by four times since 2019 and  stood at INR 11,800 crore in June 2021.5 

Role of institutional investors 

Institutional investors have been the driving force behind the accelerated growth of ESG investing recently with many prominent institutional investors committing to invest in ESG  compliant entities and integrating ESG considerations in their investment processes. While it  is well known that incidents such as corporate frauds, environmental damage, etc., have a  negative impact on a company’s reputation, revenues (especially considering the huge  penalties imposed on companies in such cases) and valuation, leading to a loss of investor  confidence in the company, institutional investors are increasingly acknowledging that ESG  compliance is likely to mitigate such risks and thereby preserve and increase the value of  companies over the long term as well as improve their ability to withstand social and  economic shocks. ESG compliance has now become a material aspect of their due diligence  

1. Dan Levkovitz, ESG Investing Performance Analyzed, Morningstar, 12 March 2019. 

2. Putting sustainability to the test: ESG outperformance amid volatility, Fidelity White Paper, November 2020.

3. Preqin Impact Report: The Rise of ESG in Alternative Assets, November 2020. 

4. Inflows of sustainable funds surge 76% to Rs 3,686 cr in FY21, The Economic Times, 22 April 2021. 5India ESG funds AUM expands 4 times to Rs 11,800 crore in two years, Livemint, 21 August 2021.

process and therefore they are seeking more comprehensive ESG related disclosures to  understand and assess the implementation of ESG policies by companies prior to making  investments.  

Institutional investors are also demanding that fund managers integrate ESG considerations  into their investment strategies and due diligence processes and offer them investment  opportunities that are ESG compliant. As a response to the increased investor demand for ESG  compliant investment opportunities, fund managers are launching specialized products in the  form of ESG focussed funds with an objective to invest only in ESG compliant entities. We are  also seeing a trend of fund managers increasingly adopting ESG policies and recalibrating  existing portfolios / constructing portfolios consisting of ESG compliant entities. A recent  survey conducted by Preqin found that investor demand is one of the primary reasons for  fund managers adopting ESG policies. Global firms like Blackstone Group, Apollo Management  Group and Carlyle Group have already imposed ESG mandates across their funds and we  expect this trend to continue, with investors increasingly demanding that fund managers  construct ESG compliant portfolios.  

Challenges for fund managers 

While the increasing demand for ESG investing is encouraging, fund managers may broadly face two challenges: 

1. At the time of raising capital: In the absence of any globally accepted standard for ESG,  fund managers are likely to face a dilemma in deciding the most appropriate ESG  standards that the funds managed by them should adhere to. Each institutional investor  would also have their own set of ESG standards that they follow and consider as the most  appropriate. While the essence of each ESG standard may be similar, it may be a  challenging process for fund managers to get everyone on the same page so far as ESG  standards applicable to the fund are concerned. Further, these standards may also need  to be modified to align them with the overall investment thesis of the fund manager. For  example, a buyout fund may have a higher flexibility of enforcing these standards as  compared to a credit or a distressed fund. Further, the nature of the acquisition (whether  it is a primary or a secondary acquisition) may also require adjustments to the extent of  how the set standards would apply. 
2. At the time of making investments: In the absence of standardized reporting and  disclosure requirements in relation to ESG compliance, fund managers are expected to  face challenges in determining whether an entity is really ESG compliant or not. An entity may represent that it is ESG compliant on account of it adopting ESG policies but in reality,  the execution of such policies may be lacking. Further, disclosures on ESG compliance may  not reflect the true extent of such compliance. Moreover, disclosures by companies, if  made, may be based on different parameters which may not be easily comparable with  their peers. We expect this to increase the burden on fund managers who will have to  remodel their investment and due diligence processes in order to successfully be able to  identify entities that are actually ESG compliant and to ensure that the ESG focussed funds  managed by them do not invest in ESG non-compliant entities.  

Role of market regulators 

While the lack of standardized metrics for determining ESG compliance is understandable due  to global ESG investing still being at a nascent stage, market regulators across the world are  constantly endeavouring to improve the quality of reporting and disclosures on ESG by 

corporates and fund managers. UK’s Financial Reporting Council has mandated UK’s asset  managers to make periodic disclosures of how they have taken ESG considerations into  account while dealing with their investee companies as well as their voting records on ESG  related issues and rationale behind their decisions, as part of their stewardship responsibilities under the UK Stewardship Code 2020. The Singapore as well as Hong Kong stock exchanges 

have recently introduced ESG focussed listing and reporting requirements. On the home front,  the Securities and Exchange Board of India (SEBI) has introduced a stewardship code requiring  institutional investors, including alternative investment funds and mutual funds, to monitor  and engage with their listed investee entities on matters like material ESG opportunities and  risks and actively intervene on concerns such as ESG risks, as a part of their stewardship  responsibilities towards their clients / beneficiaries. Further, SEBI has notified guidelines for  issuance of green debt securities in 2017 that mandate issuers to disclose details of their  decision-making process for determining eligibility of projects in their offer documents, have  systems and procedures in place for tracking the deployment of issue proceeds and have also  set out periodic disclosure and reporting requirements post issuance. SEBI has recently also  mandated the top one thousand listed companies by market capitalization in India to publish  a Business Responsibility and Sustainability Report, annually, mandatorily from FY 2022-23, that would include specific ESG related disclosures about the company. This would ensure  that investors and fund managers have access to a standardized set of ESG related disclosures, including ESG opportunities and risks of each company, in a form that is comparable with their  peers and would enable them to assess and make better investment decisions. 

Conclusion 

This trend towards ESG investing has resulted in the elevation of ESG from a secondary agenda item to an important point of discussion in board meetings of companies. With institutional  investors insisting on ESG compliance as a mandatory condition for making investments,  companies have been compelled to take ESG compliance seriously and integrate ESG policies  into their operations or risk being excluded from opportunities of receiving capital. 

Based on recent trends, it would be safe to conclude that ESG cannot be ignored any more.  We expect the volume of ESG investments to rise exponentially in the next few years and  likewise for capital allocation towards ESG funds. According to Bloomberg’s estimates, global  ESG assets will exceed USD 53 trillion by 2025 and represent one-third of the projected total  AUM of all assets. Though ESG adoption may theoretically continue to remain an “option” for  companies and fund managers, however, we expect it to practically become a “requirement” in the long term. 

The rising demand for ESG compliant investment opportunities has provided a great  opportunity for fund managers to launch more ESG focussed assets which are likely to offer  better returns. From a fund manager’s perspective, ESG is definitely the next milestone!