Why SEBI Wants to Tighten Investment and Disclosure Norms for ESG Mutual Funds?

November 2, 2021 Mutual Fund

With the spotlight on climate change and governance growing brighter, the ESG (Environment, Social and Governance) theme has picked up momentum globally. According to a Bloomberg note, ESG assets were in excess of USD 35 trillion globally in 2020. And by the end of 2025, the global AUM (Asset Under Management) of sustainable investing is expected to surpass the USD 50 trillion mark, thereby representing over 1/3rd of global AUM.

In India, the ESG investment theme is gradually drawing the attention of investors and has an immense potential to grow. According to SEBI, the total AUM of ESG funds in India including 8 actively managed funds, one Exchange Traded Fund (ETF) and a Fund of Fund (FoF) was Rs 12,403 crore as of September 30, 2021-barely a per cent of the AUM of equity-oriented schemes.

At present, in the absence of all-encompassing regulatory guidelines on definitions, functioning, and disclosures related to ESG investing, mutual fund houses are using their discretion in deciding what qualifies to be a constituent of an ESG scheme and what does not. Thus, SEBI felt the need to create an operating framework for ESG schemes and released a consultation paper last week.

The capital market regulator wants to ensure that the ESG schemes are consistent or true to their label as regards their stated objectives, documented investment policy and strategy. The framework for ESG schemes is expected to help the regulator to set, monitor, and measure the performance of ‘sustainability objectives’.

As per the existing regulations, ESG funds are classified as thematic and are required to invest at least 80% of their total assets in securities that are consistent with the ESG theme. Hence, these guidelines would apply only to the portion of investment towards the ESG theme. However, it is now proposed that the residual portion (20%) of the portfolio should not be starkly in contrast to the essential philosophy of the scheme from the ESG theme.

So, for instance, if a fund house decides to exclude ‘sin goods’ companies, i.e. goods that are harmful to society such as, alcohol, tobacco, etc.; then philosophically, the same scheme should refrain from investing in any FMCG company that, say, has a tobacco business under one of its vertical.

Similarly, if an ESG scheme decides to refrain from investing in any company that pollutes the environment, then ideally, while allocating funds beyond 80% of the total assets, it should refrain from investing in companies whose operations pollute the environment, like petrochemicals, and pesticides for example.

For ESG schemes to be true to label, the capital market regulator has proposed various disclosures which are as follows:

Disclosures in Scheme Information Documents (SIDs)

1. Name of the scheme: The name of a scheme shall exactly convey the nature and extent of the scheme's ESG focus taking into account the investment objective and type of investment strategy followed. For this purpose, all AMCs are required to have a Responsible Investment Policy incorporating aspects of ESG investing.

2. Investment objectives: An ESG scheme shall lay down in detail its objectives and mention how it will aim to achieve the stated objectives through its investment policy and strategy including the approach used for screening companies. Besides, the financial objectives, the scheme should state the real-world ESG objectives.

3. Investment policy: The investment policy of an ESG scheme should identify a broader universe of companies it will consider for investing. The investment framework is designed to generate a beneficial ESG/sustainability impact alongside a financial return. Plus, the Asset Management Company (AMC) should clearly state the intended 'real world' outcome in qualitative terms, especially for strategies related to Integration, Impact, Investing, and Sustainable Objectives.

4. Investment strategy: As per the consultation paper, AMCs will be required to disclose the type of strategy to be followed in line with ESG characteristics and the term ESG fund. The strategy could include but is not limited to the following:

   • Integration, which explicitly considers the ESG-related factors.

   • Exclusion of securities when ESG-related factors are not met.

   • Investment in best-in-class companies and positive screening.

   • Impact investing, wherein it would seek to generate a positive, measurable social or environmental impact alongside a financial return.

   • Sustainable objectives, where the aim shall be to invest in sectors, industries, or companies that are expected to benefit from the long-term macro or structural ESG-related trends.

   • The Decision-making process for investing includes the due diligence on any data, research, and analytical resources it relies on when using proprietary methodology.

   • Disclosures on the material risk that arises from a scheme's focus on sustainability.

   • The asset allocation.

   • Benchmarking, whereby the benchmark should be continuously aligned with each of the environmental, governance and social characteristics followed by the scheme.

   • Provide suitable disclaimers.

Additionally, the mutual fund schemes need to monitor and evaluate the sustainability performance of companies they are investing in. Also, schemes would be required to exercise their voting rights in accordance with the stated scheme objectives.

The capital market regulator has proposed that ESG schemes should periodically disclose positive environmental changes that investors might expect. It shall provide links to Business Responsibility and Sustainability Report (BRSR) disclosures for every company held in the portfolio or its equivalents.

ESG schemes as per the proposed guidelines of the regulator will be required to enlist ESG engagement and stewardship activities they carried out during a financial year. Besides, when periodic monitoring of targeted versus actual sustainability objectives of ESG schemes is done, necessary disclosures are expected to be made.

According to the capital market regulator, the following information covering various aspects of ESG investing should be disclosed on websites of AMCs offering ESG schemes:

• Source of ESG information of underlying investments
• Investment process and philosophy
• Key ESG factors to be considered in decision making
• Due Diligence methodology and its limitations
• Engagement policies including stewardship
• Monitoring of investments and evaluation

Compliance Obligations on AMCs

A quarterly declaration by the trustees of the mutual fund stating that the ESG scheme is following the disclosed strategy and is in compliance with the Responsible Investment Policies would be required.

Moreover, the AMC will need to ensure that its marketing material and website disclosures are fair, balanced, and consistent with regulatory filings. Also, they will be required to increase resources and processes to take into account the ESG philosophy as a theme for the launch and management of schemes in this space.

Proposed duties for AMFI for ESG compliances

The capital market regulator has observed divergences in the terms and definitions of ESG. Therefore, the capital market regulator wants the Association of Mutual Funds in India (AMFI) to encourage industry players to develop common, sustainable, and finance-related terms and definitions, consistent with global standards.

AMFI is expected to promote financial and investor education initiatives relating to the sustainability of the ESG theme.

The impact of these proposed guidelines on mutual funds

If the proposed guidelines become norms, ESG schemes will have to invest only in companies that have BRSR disclosures from October 1, 2022. In case if the existing schemes have made investments in securities that do not have BRSR disclosures, SEBI is willing to grandfather such investments until September 30, 2023. Also, the ESG scheme investing in overseas securities would be required to choose any global equivalent of the BRSR which will be specified by AMFI.

How will investors benefit from it?

Monitoring the real-world impact of ESG investing will become possible. Better disclosures will make ESG investing more transparent. That said, it remains to be seen if ESG schemes increase expense ratios in the wake of higher compliance.

ESG investing is likely to become a popular and conscious choice in a post-COVID world. The COVID-19 pandemic has taught us a lesson on being sensitive to the environment (E), choosing our leaders thoughtfully (G), and the role all stakeholders of the society (S) need to play. It also reminds all of us — the citizens, governments and corporates — to be cognizant of our ecosystem and be socially responsible.

Good health, an effective policy framework, and profit growth in an ethical way cannot be taken for granted. All stakeholders need to be more conscious of their responsibilities towards society, planet earth, and good governance matters! You see, when you invest, a business has a good chance of sustaining in the future often when it…

• ✓ Conserves the environment;

• ✓ Honours its commitments towards the society; and

• ✓ Follows transparent, fair, and good governance practices

That’s why the Environment, Social, and Governance (ESG) factors are the three pillars that encompass a lot of material issues impacting the overall performance of the company and its growth

Remember, ESG investing is not purely a ‘top-down approach’ (as in the case of other thematic funds), but also encompasses a bottom-up approach to investing. When a mutual fund scheme follows this theme, it sets the performance matrix accordingly; whereby it can measure the sustainability or the future preparedness of the companies under consideration, recognising their role in the larger community, the risk involved, the competitive advantage, while ultimately aiming to accomplish the stated investment objective of long-term capital appreciation.

Who should invest in ESG funds?

If you are hoping to make some positive difference to the world by investing in a socially, environmentally responsible and ethical way, consider investing in ESG Funds. But ensure you have the stomach for high risk and an investment time horizon of at least 5 years. Note that by investing in companies having a sustainable future won’t automatically safeguard you from the risks associated with markets and stock selection.

Investing in ESG schemes has a dual objective-financial as well as sustainability-and thus financial performance the scheme should not sole criterion for selection. You must have a balanced approach towards financial and sustainability aspects while investing in an ESG scheme.

Investing in the ESG Funds is worthwhile because of the following reasons:

1. Offers you a solution for socially responsible investing (by aligning with your personal philosophy — moral, beliefs, and social values).
2. Provides fair diversification with, of course, Environment, Social, and Governance aspects being the focal points.
3. Gives an avenue for better investment allocation.
4. Ensures liquidity and the risk is mitigated with robust investment processes in place.
5. Holds the potential to deliver decent long term risk-adjusted returns compared to its benchmark

This article first appeared on PersonalFN here