ESG Funds have been the topic of much discussion over the last year as major AMCs have launched flagship NFOs (New Fund Offers) under this ‘theme’.

ESG stands for Environmental, Social, and Governance and as a theme, such funds invest in companies with unblemished standards for all these parameters. While clean investing is something that should definitely grow in creed, it leaves certain questions unanswered. These questions relate to the extent to which these parameters should interfere with investment decisions of fund managers and whether they necessarily qualify to be a theme as such. If you come to think of it, factors like good governance standards, pollution mitigation or effluent discharge processing, adequate representation of women on the board and employee strength should, in any case, be an integral part of the functioning of any organisation.

Further, by creating a separate category in itself, are we trying to crowd out this domain as the fiefdom of only a handful of corporates, that supposedly qualify or adhere to these standards? What happens to firms, for instance, in developing nations that are generating mass employment and raising wage standards as a consequence of greater profitability but fall short on the compliance scale in some of the ESG parameters? How are these funds accounting for positive externalities that get passed on to the ecosystem in and around which they operate? Are they also factoring in certain amounts of dead-weight loss that occurs to these firms, not on a strict accounting basis?

Let us also look at some of the landmark corporate events in the past that have been in some way or the other, associated with these parameters. A relatively recent and relevant example that occurs to me is the Coal block revocation of 2016 by the Government Of India. A whole host of metal, mining, cement, infra, and power companies lost complete access to raw materials as a consequence. Stocks of the related companies tumbled with amplified gravity and to make matters worse, this happened when the entire sector was recovering from a cyclical trough. Further, to add to the woes of these corporates, there was a re-auction that took place. Thus raising costs and to make matters worse some of the bids also went into a long winding spiral of litigation, leaving those manufacturing plants utterly paralysed.

Risk Facing India

The costs that such penal procedures impose on businesses and lead to an impairment of cost structures and raw material sourcing profiles almost permanently need to be considered. In governance, minority shareholder’s fortunes in events like the delisting of Cairn India or the more recent failed delisting bid of Vedanta,( which incidentally led to a rally in the stock price and resulted in massive gains for some opportunistic shareholders) also needs to be evaluated.

This also leads us to more fundamental questions of comparing the millions of tobacco consumers of tobacco companies and weighing it against the benefits of almost industrial-scale CSR undertaken by the behemoth and the livelihoods of tobacco cultivators that it supports. The cycle of sugarcane, molasses, ethanol, alcoholic beverage production, and consumption or industrial felling of trees for pulp and paper manufacturing. Both these activities support farmers and also lead to a great deal of re-afforestation as well. How are we measuring the costs and the benefits? Or are we purely sticking with completely detached or more unrelated sectors like emdia, IT, microfinance, and the like?

ESG Indices Versus Equity Indices

Source: Quantum Mutual Fund

We need to be answering more detailed questions as to what separates a pure large cap fund or a good quality multi-cap or focused fund from an ‘ESG fund’. Is it old wine in a new bottle? How is the developing universe more efficient at it compared to the US and Europe? Are we still behind the curve and are really jumping the gun just because the ‘theme’ seems exciting? Or, are there fundamentally tenable factors associated with the idea?

Thus, while ESG is still in its embryonic stage and is very exciting, there is still a lot that needs to be considered before investing. We hope this space evolves in response to the nuances that are inherent to the Indian subcontinent.

The author is Head of Investment Advisers, at HDFC Securities

DISCLAIMER: Views expressed are the author's own. Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.