There are two emerging trends visible in the Indian capital market for the past couple of years. The first is the sharp increase in the number of retail investors and the second is the increasing demand for sustainable finance. In line with these trends, there is an emerging market of rating companies that assess environmental, social, and governance (ESG) risks and opportunities of investments, not only in India but also globally. Aligned with this global trend, the Securities and Exchange Board of India (SEBI) has come up with suggestions to regulate ESG Rating Providers (ERPs).
The Indian market regulator has published a consultation paper on its website with a proposed framework to regulate ERPs for securities markets and is seeking suggestions over its proposals. The paper raises questions such as who should be accredited as ERPs and what should be the condition of giving this accreditation? It also includes ERPs infrastructure, products, transparency, rating process, prevention of conflict of interest, etc.
Labanya Prakash Jena, regional climate finance advisor with the Commonwealth Secretariat, terms it a need of the hour. “ESG rating is highly unregulated and there are no uniform methodologies that these rating agencies are using. There are several types of research that highlight the crisis of the existing ESG rating system. It threatens the real purpose of rating. The purpose of any rating is to give the right signal to all stakeholders, which is not happening,” he adds.
Jena says that SEBI has taken the right steps and it will bring uniformity and transparency to the whole process. This will help investors to understand the value of their investment in terms of ESG standards.
As the challenges related to climate change are increasing, there is also a push for sustainable finance, globally. A KPMG report says that globally 85% of institutional investors are driving (pdf) interest in ESG. There is a prediction that by 2025 one-third of the total global assets will consider ESG for direction.
The trend is visible in India as well. At least, 17 mutual funds based on ESG are already in the Indian market. Several big asset management companies such as Aditya Birla Sunlife, Axis Equity Fund, ICICI Prudential Fund, Invesco India Fund, Kotak Fund, MIRAE Asset Fund, SBI Magnum, and others have specific schemes based on ESG.
In December 2021, while speaking at an event, SEBI Chairman Ajay Tyagi said that a total of 11 mutual fund schemes in India have ESG as their theme with 13,000 crore rupees ($1.72 billion) under management. For perspective, mutual fund asset under management was Rs37.92 lakh crore as of Dec. 31, 2021. Tyagi underlined the importance of regulating the ESG rating process. Now, the market regulator’s recent consultation paper gives a glimpse of future regulation of ERPs in India.
Kaustubh Belapurkar, director for fund research at Morningstar India, an investment research firm, terms the consultation paper as a welcome step by the market regulator. In developed markets like Europe and others, ESG has been around for a while. From the Indian perspective, the trend is visible over the last couple of years. The first ESG fund was launched in 2018. So, it is a very good start as the industry is just catching up, he says.
Regulating rating providers
In its 19-page consultation paper, the market regulator has asked for comments on several issues. The paper has created a buzz in the market. CFA Institute and CFA Society of India even organised a round table (pdf) to discuss the nitty-gritty of this paper.
SEBI suggests that all listed companies should use only accredited ERPs if they need ESG ranking. These ERPs should be accredited by SEBI only. Other companies (beyond 1,000 listed) should make public disclosure as per the Business Responsibility and Sustainability Reporting (BRSR) (pdf). It is mandatory for listed companies to file BRSR from the financial year 2022-23.
The government body delves into the possible entity that should be eligible as ERP. It asks suggestions over whether SEBI-registered Credit Rating Agencies (CRAs) and Research Analysts (RAs) should only be considered for accreditation. Or any other entities should also be included in the ERP list.
In the next question, SEBI has dealt with is the condition for giving accreditation as ERPs. It has asked whether the minimum criteria for a company to get accreditation as ERP is to have a net worth of Rs10 crore. Regarding human resources, it suggests that every ERP should have at least one specialist in data analytics, sustainability, finance, information technology, and law.
These ERPs are offering several products. The SEBI paper talks about it and says that there is no clarity on what exactly ESG rating means. It includes multiple products such as ESG ‘Risk’ Ratings, ESG ‘Impact’ Ratings, and so on. While different products have different objectives and cater to a different set of stakeholders, all these products are marketed as ESG Ratings.
It proposes products such as “ESG corporate risk ratings” or “ESG financial risk ratings” and suggests the use of proper terminologies for the product to avoid any confusion among stakeholders.
Regarding standardisation of symbols and scales for ESG rating, SEBI’s paper draws a parallel to credit rating agencies in India. It goes on to suggest that rating companies must disclose all the details like symbols and definitions they are using. The companies should disclose these details on their websites, it suggests. As the industry is still evolving, whether it should be put on hold for now, the paper asks.
The other three subjects SEBI has dealt with are transparency, the ESG rating process, and conflict of interest. In a process to ensure transparency in ratings, it asks agencies to display rating reports and products on their website. It also asks for disclosing the rating methodology. ERPs should also clarify how they define the environmental, social, and governance components of the rating.
Regarding the ESG rating process, SEBI suggests, “the ERP shall have written policies and procedures. Further, rating methodologies should be reviewed and updated periodically.”
To avoid conflict of interest, it asks ERPs to formulate clear policies and disclose them on their websites. It suggests, “An ERP should not provide ESG ratings to its related entities or securities issued by them or the ERP.”
“In its consultation paper, SEBI is clearly saying that it is not going to ask ERPs to follow a common guideline but be transparent about the methodologies and be objective. We at Morningstar welcome this move because all of our ratings are for the purpose of the investors only. The regulators are trying to set a common playing ground for everyone. For investors, it will empower them and they will get to know what these rankings convey,” says Kaustubh Belapurkar.
Commenting on this, Jena says that it will help rating agencies as well. Best practices will replicate and much more convergence will take place in ESG rating.
Investors setting the momentum
According to a survey (pdf) conducted by the consultancy company PwC and released during COP26, the majority of the 325 investors surveyed globally, expressed commitment to ESG goals. The survey found that over a third of investors think that the quality of information they get on environmental issues is good enough.
Also at COP 26, a global non-profit IFRS Foundation announced the creation of the International Sustainability Standard Board, with an aim to provide globally consistent and trusted reporting on climate and other ESG matters.
Though the ESG reporting is still in a nascent stage in India, there are clear signals that investors are considering ESG ratings while making their investment decisions. A survey by the CFA Institute highlights this trend. The global survey of 200 retail and 75 institutional investors, found that around 60% of Indian investors consider ESG funds for risk adjustment. While more research, with larger sample sizes, is needed, a trend is clearly witnessed.
In India, there is a sharp surge in retail investors. Till Oct. 31, 2021, India had a total of 73.8 million demat account holders. In a span of just two years (2020-22), around 32.9 million new demat accounts were added to the existing list. Pankaj Chaudhary, minister of state in the ministry of finance had shared this information while responding (pdf) to a question in the Lok Sabha on Dec. 13.
A lot of activities are happening to inform citizens about the importance of investors, says Belapurkar and added asset managers in the Indian market cater to domestic as well as foreign investors. Now, when asset managers are looking to serve foreign investors, they have to integrate ESG factors. “When you think about financial investors’ portfolios then it is not only about the message going well. It is also about the fact that these risk factors could impact the financial health of a company. If these risks are not managed, it could lead to a situation where companies’ profits will take a hit. So, evolution around ESG is the culmination of both,” he adds.
Setting the background of its paper, the market regulator itself says that the ongoing covid-19 pandemic and climate change issues underlines the vulnerability of traditional business models. There is a need for organisational resilience. It also underlines the role of investors, saying that they are realising the risks and factor it in while making their investment decisions. This leads to increased demand for ESG reporting and ratings.
“There is also an increasing demand from the investors on evaluation and ratings of ESG related parameters by ESG ratings providers (ERPs),” the paper says.