The ESG rating system: snowball or avalanche?

ESG may be virtuous, but it's rating system can become its pitfall.

ESG (Environmental, Social and Governance) is gaining greater importance in India. SEBI recently introduced a business responsibility and sustainability (BRSR) framework based on ESG disclosures for top 1000 listed companies from FY 23. It’s also working on developing regulations for ESG Rating Providers (ERPs) and disclosure requirements for ESG investment funds. These funds are to invest 65% of their AUM in companies providing assurance on BRSR Core disclosures from 1^st October 2024 onwards.

Although ESG investing is relatively new in India, global ESG investments are estimated to exceed $53 trillion by FY 25.

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ESG investing is the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process.

But to invest based on ESG factors, an investor has to first quantify them. This becomes challenging when dealing with qualitative elements which cannot always be accurately measured. It can also get confusing when the definition of ESG and it’s measures have changed multiple times since the concept was first introduced in a 2004 United Nations report.

Even if we develop a methodology of measurement, ranking companies from different industries and stages of growth has its own risks and challenges. This will require thorough deliberation from all stakeholders before regulations for rating agencies can be rolled out. Existing perspectives and methodologies used by global agencies and think tanks will need to be challenged and re-assessed if India is to have ESG norms which incorporate its unique position in the world economy.

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India is one of the few countries which has achieved its environmental targets set in the Paris Agreement, and is on track to zero net emissions by 2070.

When dealing with activities relating to social factors, the debate is bound to become political in nature. We live in a world where fault lines exist along most social issues, so it’s difficult to arrive at a consensus as to what is good and how far you can ask companies to go to achieve the ‘S’ in ESG.

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Who decides what is good and when to stop?

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The existence of exclusively western agencies to monitor ESG targets can become problematic, since they will be in a position to influence the policy decisions an Indian company needs to take in order to have a good ESG rating.

This in turn affects how investors will view the company and more importantly, influence its credit ratings. It may not seem significant right now, but it’s like a snowball which can soon turn into an avalanche. The regulators will have to ensure all serious biases and failures otherwise historically seen in credit rating companies will find no place in ESG rating companies.

Additionally, there is a possibility that these norms and how they will be applied will be decided by a small group of western agencies. Their biases against India with respect to social, cultural and environmental viewpoints cannot be ruled out.

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Either way, it is imperative for India to speak out on this matter across different platforms on the world stage. India stands to gain by ESG adoption, as it lines up perfectly with the country’s long-term energy, finance and technological aspirations. However, the regulators must tread with caution in order to achieve fair ESG norms and measurement methodologies.

We need to ask ourselves another important question – why ESG at all? This remains to be explored for another time…

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