ESG framework

Most investors start and end with profit. An ESG framework adds 3 other questions before that.

What does the company do to the environment? What does it do for society? And how well is it governed?

This began as the concern of a small group of impact investors. It spread because it turned out to pay as well, not only to feel right.

One point is easy to get wrong. ESG is a filter, not a decision. A company that passes the ESG screen does not become an investment on that account. The ordinary analysis still has to be done.

The 3 criteria. Section 7.9 sets out what an ESG investor evaluates.

1. Environment — how the company's activities affect it. The workbook's marker is emissions and pollution: low carbon emitters and low contributors to pollution rank better than others.
2. Social — what the company does for social development. It names human rights and gender equality among the factors, and again companies that contribute more rank better.
3. Governance — the corporate governance standard the company follows, which is the whole of section 7.6.

How it is actually used. ESG investors apply the filter to short list potential investments. A shortlisted stock, the workbook says, "does not become an automatic investment." All the other regular analysis still has to be performed to identify a suitable one.

The 3 financial arguments. The workbook concedes the framework looks more ethical than financial, then sets out what its proponents claim in its favour.

• Environmentally focused companies face minimum disruption from regulatory intervention or environmental activism.
• Socially active companies build recall value in society, which makes recruiting employees and attracting customers easier.
• Strong governance reduces risk perception, and through that "reduces the cost of capital for that organization."

That third claim is the sharpest, because it converts governance directly into a valuation input.

The disclosure regime, with the workbook's figures. SEBI has proposed strengthening ESG disclosure rules for listed entities, and has named the top 1,000 listed companies to make ESG disclosures on Business Responsibility and Sustainability Report (BRSR) parameters from FY2023. On uptake before that became due: in FY22, more than 175 companies reported on the BRSR framework voluntarily.

A dating note. The workbook frames the SEBI move as proposed, puts the BRSR start at FY2023, and gives the 175-plus voluntary filers for FY22. Those are the figures the exam is set from. Requirements in this area have moved on since, so answer with the workbook's numbers and treat a differently-worded current rule as outside this paper.

The analyst's own duty. Equity analysts can include a discussion of ESG parameters in their reports, so that investors who care about those factors are guided on them. Section 7.10 lists the BRSR report itself among the sources of information on a company.

Illustrative. A fund screens 240 listed companies on the 3 ESG criteria and shortlists 62.

One of the 62 is a cement maker. The fund now does the regular analysis — and this is the step the workbook insists on.

The ESG profile is strong. The business, on those last 3 lines, is earning 9% on capital and trading at 24 times earnings. The fund passes on it. Passing the ESG filter did not make it an investment, exactly as section 7.9 says.

Now the cost-of-capital argument, put in rupees. Take a company with Rs 5,000 crore of debt. If strong governance lowers the risk perception enough to cut its borrowing cost by 50 basis points, that is:

Rs 5,000 crore × 0.50% = Rs 25 crore a year of interest saved

On a company earning Rs 400 crore of profit after tax, that Rs 25 crore of pre-tax saving is worth about Rs 19 crore after tax at 25% — close to 5% of earnings, created by governance rather than by selling more cement. That is the workbook's third financial advantage with a number attached.

Section 7.9 (ESG framework for company analysis) closes the chapter on business and governance, and 7.10 lists the BRSR report as a source of information.

The reliable questions are the 3 criteria and, above all, the 2 figures: the top 1,000 listed companies and FY2023 for BRSR-based ESG disclosures, with more than 175 voluntary filers in FY22. Expect also a conceptual question on how an ESG framework is used — as a shortlisting filter followed by regular analysis, not as a decision in itself. The governance limb ties back to the whole of 7.6, so a question can cross from ESG into board composition or auditor independence.

• ESG is a filter, not a verdict. The workbook states that a shortlisted stock "does not become an automatic investment."
• Top 1,000 listed companies, from FY2023. The 1,000 figure also appears in 7.6.2 for the separation of chairman and CEO — same number, different rule, so do not merge them.
• 175-plus companies filed BRSR voluntarily in FY22, which is the year before the requirement. A question may use the FY to test whether you read the sentence or the number.
• The G in ESG is corporate governance, not general governance or government policy, and it is the same material as section 7.6.
• The financial case rests on 3 specific claims, of which the cost-of-capital one is the only direct valuation link. "ESG companies grow faster" is not one of the workbook's claims.
• BRSR is the disclosure vehicle; ESG is the framework. They are related but not interchangeable.