A significant challenge for fund managers is the difficulty in demonstrating real-world impact and outcomes of the ESG product.
By Sivananth Ramachandran and Mohan Kumar Prabhu
Investors have financial objectives defined in terms of return and risk, time horizon, and liquidity. Increasingly, they also wish to express their ESG preferences, ranging from the need to incorporate ethical principles or values into investment decisions, avoid ESG risks that may impact investments, or contribute to achieving measurable environmental and social outcomes.
In response, the investment management industry has developed products that incorporate a variety of investment approaches for considering ESG issues. However, investors face several issues when selecting the right ESG products that suit their preferences. These issues range from the varying and non-standard terminologies in investment products, and a lack of clearly defined categories into which these products can be assigned.
These factors have resulted in an increase in greenwashing, wherein disclosures or advertising materials intentionally or inadvertently mislead investors about the ESG characteristics or the ESG approaches used in an investment product, or the degree of influence that an investment product has on ESG issues.
There is no single solution to address this, but good ESG disclosures are one place to start. Effective ESG disclosures helps improve investment efficiency and allows investors to ensure that ESG schemes are consistent or true to their label as regards their stated objectives, documented investment policy and strategy. Accordingly, better ESG disclosures for investment products are fast becoming a key priority for financial market participants and regulators globally. While multiple ESG disclosure frameworks are emerging through various global standard setting bodies and regulators, there are still no universally agreed standards or disclosure frameworks used by all fund managers globally.
Considering the increased activity in ESG investing in India, SEBI recently published a consultation paper on introducing disclosure norms for ESG Mutual Fund schemes in India with the aim of protecting the interest of investors and market participants and addressing issues of greenwashing of ESG funds in India.
A study done by the CFA Society India compared the recommendations of SEBI’s consultation paper with international regulations like the SFDR and voluntary initiatives like the CFA Institute’s ESG Disclosure Standards for Investment Products and found that the recommendations align well in most respects. However, international standards might provide a level of detail that is complementary to SEBI’s proposals. For example, for best-in-class screening, SEBI’s proposals require fund managers to provide “details and specifics of metrics used”. On the other hand, the CFA Institute’s ESG disclosure standards require fund managers to disclose, among other things, the characteristic of the investment that is evaluated, the thresholds used, or if any exceptions are applied. Also, there is a case for SEBI’s proposals to be better structured in terms of firm-level, product-level, and periodic disclosures. Lastly, the recommendations related to practices, policies, and procedures needs to be clearly differentiated from requirements.
Notwithstanding the quibbles, the more pertinent question is whether the fund managers in India are currently equipped enough to put in place such firm level policies and ESG related product level disclosures? In a recent roundtable convened by CFA Society India, market participants highlighted several challenges and practical considerations in the implementation of some of the proposals in SEBI’s consultation paper.
A significant challenge for fund managers is the difficulty in demonstrating real-world impact and outcomes of the ESG product. Most funds consider ESG risks and opportunities when creating investment portfolios, but not the impact of portfolio companies on environment and society. Even if the two might be interlinked, it is easier for fund managers to report on the former than the latter. Indeed, SEBI itself acknowledges this distinction in its recent consultation paper on ESG ratings, where it makes a distinction between ESG risk ratings and impact ratings. ESG risk ratings deals with the impact of social or environmental issues on the company’s enterprise value, and the impact ratings deals with impact in the other direction.
The second challenge cited by participants is the potential duplication of disclosures, particularly around stewardship reporting. The proposal for fund managers to report on stewardship and engagement on every ESG product is expansive and potentially adds to the compliance burden. This is because stewardship reporting is currently done at the fund house level, and if a fund house has multiple funds, the engagement with the issuer is not different across funds.
The proposal around making BRSR disclosures, which is mandatory for top 1000 Indian companies, a requirement for inclusion in ESG funds also raises interesting questions. In principle, should the regulator prescribe how fund managers construct their portfolios, or just focus on transparency and better disclosures? On the other hand, ESG funds are given the flexibility of adopting ESG considerations only up to 80% of the investments. Investments beyond the top 1000 companies, which are micro-caps, are likely very small, making this rule moot. Still, regulations should afford due flexibility to fund managers to exercise discretion and judgment, whether about ESG factors of a company, or more generally how they construct portfolios, while staying within their investment mandate and applicable rules.
Globally, ESG disclosures forms a basis for investors and advisors to evaluate products, understand which products might be suitable given their (or their clients’) ESG preferences, and invest (or recommend) accordingly. But investment advisor penetration in India is miniscule, and the ESG disclosures are proposed to be situated within the lengthy scheme information document. Therefore, the role of fund managers become paramount. Fund managers need to provide ESG disclosures in simple, relevant, and decision-useful manner across their factsheets or other promotional materials. They should also invest in investor education that focuses on material ESG risks considered in portfolios, how ESG products might perform in different market scenarios, and the desired time horizon for investments. And given the nascent stage of ESG investing in India, regulators and policy makers are well-advised to steer clear of overly prescriptive rules, both around investing and disclosures, which may lead the industry into a homogenous set of players, leaving little scope for further innovation.
(Sivananth Ramachandran is CFA, CIPM – Director, Capital Markets Policy, India at CFA Institute. Mohan Kumar Prabhu is CFA, FRM – Director, Investment Consulting at AON Consulting Private Limited. The views expressed in this article are those of the authors and not necessarily of FE.com)