Introduction

In financial markets, corporate commitment to sustainability has grown in importance in recent years. As a result, many businesses use sustainability strategies that incorporate the assessment and implementation of Environmental, Social, and Governance (ESG) factors. Investment portfolios that have been selected and built with a strong focus on ESG, have been shown to improve long-term returns as well as benefits to society. Social injustice and climate change have compelled regulators and legislators to focus their efforts in recent decades on more sustainable practices based on ESG pillars. These initiatives seek to accelerate the switch to renewable energy sources and shift the focus to more aggressive climate and sustainability-related policies. When buying a company’s shares, investors typically consider returns, balance sheets, and earnings. However, when the world turns its attention to issues like deforestation, carbon emissions, and climate change, investors are now reinforcing  the need for ESG to be front and centre in how a company behaves and contributes to society in general.  As a result, Governments are adopting aggressive environmental targets of their own and leaning heavily on businesses to drive the agenda.

Before diving more deeply into the current topic, readers wanting to learn more about ESG can refer to my previous blog at https://quantlegaltech.com/blog/nurturing-a-culture-of-compliance-sebis-role-in-esg-implementation-and-the-transformative-power-of-legaltech/.

Although India’s ESG regime is not the focus of this note, the following is a brief explanation of the rules that are in place. The initiatives include mandating listed companies to disclose their ESG-related initiatives and performance in annual reports. In 2012, SEBI issued a guidance note recommending that companies listed on Indian stock exchanges disclose their ESG performance in their annual reports. Additionally, SEBI has integrated ESG-related disclosures into the Listing Obligations and Disclosure Requirements (LODR) for listed entities through Regulation 34(2).

In 2021, SEBI introduced guidance on Business Responsibility and Sustainability Reporting, delineating a framework for companies to report on their ESG performance. This framework assists companies in aligning their business strategies with ESG principles, thereby promoting a culture of responsible and sustainable business practices.

How can ESG affect the stock market?

Understanding the relationship between ESG and the stock market is a crucial consideration for investors as they make investment decisions. The main reason why companies work diligently on maintaining a strong ESG focus is to inform their investors that they are cognizant of their responsibilities as good corporate citizens and show that they have taken proactive steps to implement reforms consistent with this agenda. Based on ESG performance metrics, the investor can assess the reliance and stability of the company, thus influencing their investment decision. If an investor is aware that the company recognizes and acts positively in response to ESG considerations and has adopted strategies to further this agenda, he can invest in the company with more confidence.  Although performance is a result of many different factors, companies with a strong ESG-focus are more likely to get the attention of investors and this in turn encourages them to look more closely into the company’s performance. Conversely, a poor ESG record is often a red-flag that the company may have other compliance failings as well. While there is no guaranteed correlation, many investors take the view that a company with a strong reputation for corporate governance and ESG is more resilient to negative events.

According to the 2020 Global Sustainable Investment Review, sustainable investment assets under management are continuing to increase worldwide except for Europe, which is experiencing a decline due to significant changes in the way sustainable investment is defined under EU legislation. The figure given below is the global sustainable investing assets for the years 2016-2018-2020 (USD billions)

Looking at the figure shown above, more than 80% of global sustainable investing assets during 2018 to 2020 are represented by the two most important global financial hubs (United States and Europe), followed by Japan (8%), Canada (7%) and Australasia (3%).

Having shown the relevance of ESG investment considerations in quantitative terms, it is useful to look at the data on how  sustainable assets under management are divided among the different investment strategies.

The most widely adopted sustainable investment strategy globally is ESG integration, as shown above, with USD 25.2 trillion in assets under management employing an ESG integration approach. This sustainable investment strategy is followed by negative/exclusionary screening (USD 15.9 trillion) and by corporate engagement/shareholder action (USD 10.5 trillion).

This data shows a clear change in preferred investment strategy, starting from 2018, shifting from negative/exclusionary screening to ESG integration. Furthermore, an increasing number of reports shows that many investment organizations are adopting a combination of strategies, rather than solely relying on just one.

Impact on stock market

The integration of ESG criteria into investment decisions is reshaping the dynamics of the stock market in several ways:

• Capital Allocation: ESG considerations influence capital allocation decisions, directing investment flows towards companies with robust ESG profiles. As investors prioritize sustainability and ethical practices, companies that fail to meet ESG standards may face challenges accessing capital or experiencing valuation discounts.

• Corporate Behavior: The growing emphasis on ESG incentivizes companies to improve their environmental, social, and governance practices. Faced with investor pressure and stakeholder expectations, companies are increasingly incorporating sustainability into their business strategies, leading to positive changes in corporate behavior and performance.

• Market Valuation: Companies with strong ESG credentials may command premium valuations due to their perceived resilience, innovation, and long-term growth prospects. Conversely, companies with poor ESG performance may face valuation discounts or reputational damage, affecting their stock prices and market competitiveness.

• Risk Management: ESG integration enhances risk management by enabling investors to identify and mitigate potential ESG-related risks. By considering environmental and social factors, investors can better assess a company’s exposure to regulatory, legal, operational, and reputational risks, thereby safeguarding their investment portfolios against adverse developments.

The picture compares “Nifty 100” and “Nifty 100ESG”. It underscores that in August 2023, the latter index began gaining significant momentum.

How are ESG scores calculated?

A variety of data points pertaining to a company’s social responsibility, environmental and corporate governance practices are examined to produce ESG scores. Numerous sources, such as corporate reports, third-party databases, and regulatory filings, are used to gather the data. The process employed to determine an ESG score may differ according to the rating organization or research company.

Following data collection and analysis, an ESG score is given to each organization. Higher ratings indicate a better commitment to environmental, social, and governance issues. These scores can vary from 0 to 100. ESG scores are determined by several organizations and rating agencies, each with its own methodology and data sources.

Conclusion

ESG investing is no longer a niche trend but a fundamental shift reshaping the investment landscape. As investors recognize the interconnectedness between sustainability, corporate performance, and financial returns, ESG considerations are becoming integral to investment decisions. By aligning capital with companies that prioritize environmental stewardship, social responsibility, and ethical governance, investors have the opportunity to drive positive change while seeking attractive risk-adjusted returns. As the momentum behind ESG investing continues to grow, its impact on the stock market can only deepen, ushering in a new era of responsible capitalism.