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Green is gaining favour among the investing community. And in keeping with investor preferences, Indian firms are upping their game on ESG—environmental, social and governance—factors.

Last week, when Zomato Ltd kicked off its roadshows for its initial public offering, its ESG measures featured as a prominent slide in its presentation. India’s largest company, Reliance Industries Ltd, said recently it will invest 75,000 crore in green energy projects. Analysts said this will help improve its ESG score, as it will partly offset the overhang of the oil business. Elsewhere, India’s largest cement firm, Ultratech Cement Ltd, aims to cut its carbon emissions by 27% by 2032 and raise the share of green energy in its total power consumption. Even as companies have increased their thrust on ESG, experts say these are still early days, and investors will need to carefully evaluate how valuations will be impacted by ESG disclosures.

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“Although a few ESG indices have outperformed the market, the direct correlation with ESG-related factors is not easy to assess. It is one thing to make an ESG announcement but following up on changes in the business model to reap the benefits of the process takes time," said Anand Krishnamurthy, co-founder and partner at Envint, a sustainability and ESG services firm.

J.N. Gupta, a former executive director at Sebi and chairman, Stakeholder Empowerment Services, said, “Valuations will not change only on the basis of companies making statements on becoming more ESG-compliant; execution is the key."

Clearly, it is foolhardy to expect an immediate positive impact on the valuations of a stock because of ESG disclosures. A case in point is the RIL stock, which fell soon after the green energy announcements. While the likely boost to its ESG scores was positive, investors were also worried about the company’s capex remaining high, and cash flow estimates staying low.

“But there is a risk of a negative impact on valuations by not disclosing ESG metrics," Krishnamurthy added.

The path ahead is not rosy on this front for firms in certain industries. Firms in the tobacco, coal and oil sectors, for instance, will inherently find it more challenging to meet expectations on the ESG front. ITC Ltd, for instance, has laboured to improve its environmental and social engagements and offset the impact of its tobacco business on ESG scores and has even succeeded.

But investors still see it as a tobacco stock, and for many global investors, a tobacco stock remains untouchable from an ESG perspective.

Having said that, companies cannot afford to miss out on the potential boost to valuations that a better ESG rating could bring.

“ESG is all about attracting capital flows given that ESG investment has seen a big spike in flows in recent years. While this might increase near-term costs for firms and weigh on profitability, note that more capital would eventually translate into higher valuations and lower cost of capital for corporates," said Ritesh Jain, a global macro investor and a former fund manager.

In a report on 1 June, BofA Securities’ analysts said, “Flows into ESG investments in recent years have been extreme: so far in 2021, nearly $3 of every $10 of global equity inflows have been in ESG funds. Assets under management (AUM) in the 1,900+ global ESG funds we track hit a record $1.4 trillion in April, more than double the AUM of a year ago and growing at nearly three times the pace of non-ESG assets."

The ongoing covid pandemic has accelerated the pace. “Whilst ESG funds have witnessed increasing flows in recent years, a sharp spike in incoming funds was seen post the covid-19 pandemic struck the world. This probably explains why there is increasing attention to much softer aspects like E (environmental) and S (social)," pointed out a recent report by Ambit Capital Pvt. Ltd.

While there is a scramble to make ESG disclosures, investors need to be discerning. “Investors will need to look at the ESG framework from a holistic perspective to better understand whether or not the statements made by companies are matching their deeds," Gupta said.

One challenge here is that disclosures don’t follow a standard format.

“Unlike financial metrics, ESG or sustainability metrics have far more interpretation challenges due to non-standardization. That is also the reason sometimes for marked differences in ESG ratings for a company assessed by different agencies," said Krishnamurthy.

In this backdrop, market regulator Securities and Exchange Board of India’s (Sebi) Business Responsibility and Sustainability Report (BRSR) is expected to meaningfully improve ESG reporting standards. The BRSR is applicable to top 1,000 listed companies based on market capitalization and would be mandatory from FY23, although it is voluntary in FY22. The BRSR is intended towards having quantitative and standardized disclosures on ESG parameters. This would facilitate comparability across companies and sectors, thereby enabling investors to make better investment decisions.

One flip side to the ESG trend is that it may impact smaller firms that find it difficult to keep up with the investments needed.

“The bigger firms are likely to find it easier to work on ESG factors compared to the smaller firms. This also means the large will potentially become larger in future, as foreign institutional investors are going to be particular about responsible investing," said Swarup Mohanty, chief executive officer at Mirae Asset Investment Managers (India) Pvt. Ltd.

Some experts have highlighted that developing countries rely heavily on fossil fuels for growth. Given this, moving towards ESG would be relatively more challenging for them.

“The constant pursuit of ESG factors may eventually weigh on economic growth," Jain said.

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