Catastrophic events such as the 2008 financial crisis or the Covid pandemic have time and again reinforced the need for tools that can estimate the impact of crisis on financial investments.

Credit rating for many decades has proven to be effective in estimating probability of default for Fixed Income instruments, but there is a need for newer tools to estimate the impact of governance, climate and social changes on equity, fixed income equity and alternate investments.

In the post 2008 financial crisis world, ESG assessment frameworks are turning out to be fairly effective in predicting long-term ability of companies to surmount, mitigate and monetise sustainability risks and opportunities. Investors have also seen the benefits and have started embracing ESG assessments as an investment evaluation tool.

As with adoption of many best practices, the financial market regulators play an important role of an enabler and catalyst.

Market regulator SEBI has taken two crucial steps in this direction.

First, it updated the already detailed BRR norms with BRSR that will come into effect from 2022. BRSE disclosures will make extensive amount of data available to investors, who in turn can take informed decisions and where required hold corporates accountable.

Second, SEBI has introduced a consultation paper inviting suggestions from public on use of ESG frameworks by the mutual fund schemes. The paper proposed that these funds choose an appropriate benchmark that measures contribution of the investments.

SEBI has also proposed that mutual fund houses should adopt an ESG investment policy related to investments and make necessary disclosures in simple language. They have also suggested use of a scoring methodology to decide which investments are true to label and which aren’t. Certainly SEBI is ahead of the curve when compared to most emerging markets and some developed markets too.

Further, as ESG frameworks mature and more data is disclosed, they will also be adopted by banks to aid their lending decisions. Appropriate ESG assessment frameworks can assist in estimating probability of default over long-term horizons as it has the potential to predict the financial impact of governance, climate and social risks.

As ESG green lending gains traction, banking regulators worldwide have started to recommend adoption of ESG assessments for credit evaluation.

For these initiatives by regulators to succeed, all the stakeholders will have to understand what ESG is, and more importantly what it isn’t.

According to some popular myths, ESG is synonymous to identification of sinners versus companies that are pious. It is easy to say that all industries producing weapons are sinners. Or selling liquor as a business is unjust. The job, of ESG models is not to judge, but to measure. ESG frameworks do not aim to be a tool for activism. Activism may be necessary as the society’s moral compass, but ESG investment tools cannot play that role. So while weapons are used in warfare, we cannot expect defense to be unimportant anytime in human evolution.

We would like to see proof of commitment on part of the company to be responsible, by avoiding unconventional weapons, promoting responsible alcohol consumption and in general ensure the adverse impact of their products are reduced through a robust policy framework and a solid track record of execution.

Also one gets an impression from discussions in various forums, that ESG experts can and should predict climate events. Prediction of climate events and measuring their impact is in the domain of climate scientists. ESG professionals on the other hand use data and analytics to measure how well is a company prepared to safeguard investors’ interest, in case an adverse climate event should occur.

Another common misconception about ESG assessment frameworks is that they can only measure risks. But opportunities and risks both need to be evaluated to measure potential impact on future financial performance.

Lastly, we need to understand that the purpose of credit rating and ESG ratings is different, thus one cannot replace the other. Established statistically tested credit rating models, can predict default better than any other system and ESG ratings can help investors identify which companies are most vulnerable to sustainability risks in the long term. Therefore, investors need to select the tools based on their use cases.

We expect that Indian regulators will soon propose ground rules for ESG Ratings, thereby creating a common understanding of what it is and more importantly what it is not.

We also expect that regulators will ensure that ESG ratings are not misused as marketing tool; a risk that remains if ESG ratings remain unregulated. Also we expect the usual safeguards of avoiding conflict of interest will be made applicable just like the credit ratings. ESG rating providers most certainly will have to be barred from providing investment advice, managing wealth, providing trading platforms/tools.

The writer is Group CEO acuite and Chairman, ESGRisk.ai

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