How do ESG-focused AIF work

“The greatest threat to our planet is the belief that someone else will save it.”— Robert Swan
 

The quote perfectly sums our collective responsibility towards caring for the environment and nature. This has never been as urgent as it is today, given the visible impact of climate change, from unseasonal rains to floods to record soaring heat. While governments and corporations have stepped up their efforts, more needs to be done, especially to mobilize funds to fight the climate change crisis. Recently, the World Bank issued a new kind of bond to raise funds for Amazon reforestation. At an individual level, adopting sustainable habits in everyday life is one way to care for nature. But there is more you can do by emulating this philosophy of sustainability also into our investment strategy. How? Let’s explore the concept of ESG. 
 

You must have heard business leaders talk about ESG -- environment, social and governance. Investors are increasingly using ESG framework to scrutinize how the investee companies are performing in these three areas, beyond the revenue and profit goals. They assess whether the company’s operations have any impact on the environment and if so what measures the company is taking to rectify. ESG is a broader framework and within the three segments there are sub-segments. For instance, under the environment, investors will assess parameters such as waste management, energy conservation, pollution etc. Similarly, employee policies, diversity, inclusion, customer protection are assessed under social, while board structure, transparency, disclosure, shareholders rights are scrutinized under governance framework. 

The mix of conscious investment and policy push has given rise to funds that specifically focus on investing in companies with ESG as the theme. Globally, asset managers are launching ESG-focused funds in the form of exchange-traded-funds and bond funds. According to a PwC report, ESG-related assets under management are expected to touch nearly $34 trillion by 2026 from around $18 trillion in 2021. The shares of these assets in total global AUM is expected to reach 21.5%. Vanguard’s ESG US Stock ETF is a popular ESG fund that excludes companies from industries such as weapons, alcohol makers, fossil fuels, etc. Similarly, PIMCO ESG Income Fund invests only in social and green bonds.  

ESG investment as a concept is evolving with a framework that is global in nature. Some of the early development of the ESG framework has been on the back of initiatives like UN Principles for Responsible Investment and Sustainability Accounting Standards Board. 
 

Indian landscape 

In India, the concept of ESG investment is slowly and gradually gaining traction as the country heralds towards meeting its goal of net zero emission target by 2070 and as more and more companies seek to comply with regulations related to ESG disclosures.  India’s first ESG fund was launched by Avendus in 2019. 
 

ESG Funds are segmented as category III alternative investment funds or AIFs, which is a privately pooled investment vehicle. They invest in assets beyond stocks and bonds, such as private equity, venture capital, real estate, commodities, etc.  Investment in AIFs is suitable for high-networth individuals because the minimum ticket size is higher and most of them have a lock-in period of three years.
 

Interestingly, asset management companies have capitalized on the trend with some of the leading fund houses launching ESG thematic schemes. This theme garnered popularity in the post-COVID era. But the real boost came in July 2023 when SEBI allowed AMCs to launch multiple ESG-themed schemes with various subcategories like exclusion, integration, best-in-class & positive screening, impact investing, sustainable objectives, and, transition or transition-related investments.  At least 80% of the AUM of ESG schemes must be in equity and related instruments of that particular scheme. 
 

SEBI’s decision was with an aim to facilitate green financing with thrust on enhanced disclosures and mitigation of green washing risk. Greenwashing refers to promoting misleading and false information of a company’s product being environment friendly. 
 

However, the returns are something not very encouraging as they underperformed Nifty 100 ESG Total Return Index. But there are more nuances to this. Firstly, the ESG theme itself is new to gauge long-term performance. Secondly, most of the ESG schemes have invested in stocks of large banks and information technology companies. Both sectors have been underperforming the border market. Additionally, unlike the US, the universe of large cap stocks in India is limited to 100. By design, sticking to quality names from a small universe has implications on returns because these stocks may already be at a premium valuation. Then there are also issues pertaining to data and disclosures standards are yet to be rolled out fully. 
 

That said, the ESG investing space is expected to see more investor interest. One of the key reasons for this is as more and more companies come into the fold of SEBI’s Business Responsibility and Sustainability Reporting framework. Last year, the regulator introduced this framework’s sub-set called BRSR Core, which mandated companies to disclose additional information related to nine ESG attributes such as green-house gas footprint, water footprint, energy footprint, enabling gender diversity in business, among others. Right now, the top 150 listed companies by market cap need to disclose this information. It will gradually extend to top listed 1000 companies by FY27. 

According to experts, as more companies disclose data, it will increase the investible pool for asset managers.