THE EVOLVING ROLE OF ESG (ENVIRONMENTAL, SOCIAL, AND GOVERNANCE) FACTORS IN PRIVATE EQUITY INVESTMENT STRATEGIES

Author: Sindhuja Kashyap

Co-Author: Shashank Gupta

KING STUBB & KASIVA

ADVOCATES & ATTORNEYS

INTRODUCTION

The global drive towards sustainable development floods every facet of our surroundings to move towards sustainable development, including the trend of investing. This movement toward sustainability is reshaping how investors perceive and prioritize Environmental, Social, and Governance (ESG) factors, especially in the last decade. ESG-related assets under management (AUM) are forecasted to reach US$33.9 trillion by 2026, escalating from US$18.4 trillion in 2021. At a projected compound annual growth rate (CAGR) of 12.9%, ESG assets are poised to represent 21.5% of the total global AUM in under 5 years[1]. In India, ESG is estimated to contribute approximately 34% of the total domestic assets under management (AUM) by 2051[2]. Under such circumstances, Private equity firms are increasingly recognizing, or one might say are being “pressured” to recognize the importance of integrating Environmental, Social, and Governance (ESG) factors into their investment strategies for long-term value creation. A recent survey found that 90% of limited partners factor ESG into their investment decisions, private equity firms are now focusing on promoting a sustainability agenda and making net-zero commitments for carbon[3], reflecting a broader recognition of the importance of ESG considerations.

ESG AS A VALUE-CREATION DRIVER

The history of ESG integration into private equity can be dated back to 2009 when the United States Private Equity Council made an effort to implement guidelines for environmental, health, safety, labor, governance, and social issues[4]. Considering the present emphasis on the importance of environmental compliance, such compliances should not be seen as an ‘obligation’ but should rather be seen as an opportunity to increase the core value of the company which would yield results in the long run. In India, private equity firms are increasingly recognizing the significance of ESG factors in their investment decisions and operations. The pressure to disclose ESG metrics is expected to rise as investor-driven demand for ESG becomes more demanding. The Indian government has also taken steps to introduce regulations on ESG ratings, assurance, and disclosure, allowing investors to assess fund compliance.

1. SEBI’S GUIDELINES:

• SEBI proposed new disclosure standards for domestic ESG mutual fund schemes which would take effect from October 01, 2024, allowing mutual funds to launch multiple schemes with different ESG strategies, addressing industry demands and reducing the risk of greenwashing[5].
• It has revised the ESG reporting structure in the Business Responsibility and Sustainability Reporting (BRSR) framework to collect quantitative and standardised information on ESG parameters for comparative functionality of the data[6].
• SEBI prescribed additional disclosures in offer documents for the issuance of green debt securities, aligning these disclosure requirements with the International Capital Market Association’s Green Bond Principles (ICMA Principles).
• SEBI has mandated that the top 1,000 listed businesses provide ESG-related information in their annual reports, including carbon emissions, water usage, waste management, diversity and inclusion, employee health and safety, and board composition[7].

2. RBI GUIDELINES: –

The Reserve Bank of India (RBI) has also issued guidelines on ESG disclosure for banks and other financial institutions. These guidelines include:

• RBI’s Sustainable Banking Survey: The RBI’s Sustainable Banking Survey outline ESG principles and practices for banks. The survey encourages banks to adopt ESG considerations into their lending, investment, and risk management practices[8].
• Framework for acceptance of Green Deposits: RBI has come up with a framework for accepting Green Deposits to invigorate entities to offer Green Deposits. The objective is to tackle greenwashing and allow the credit to flow into sustainable projects.[9]

3. MCA GUIDELINES: –

The Ministry of Corporate Affairs (MCA) has been proactive in promoting responsible and sustainable practices through the issuance of the National Guidelines on the Economic, Social, and Environmental Responsibilities of Business (NVGs) in 2018^[10]. These guidelines provide a comprehensive framework for enterprises, encompassing nine interwoven principles that address economic, social, and environmental challenges. Emphasizing the interdependence of business activities with society and the environment, the NVGs serve as a robust guide for businesses seeking to implement ESG practices.

4. IFC’S GREEN BUILDINGS CERTIFICATION IN INDIA:

The International Finance Corporation (IFC) has played a significant role in promoting green buildings in India. Private equity investors interested in real estate can benefit from understanding the guidelines and certifications related to green buildings, ensuring that their investments align with sustainable construction practices.

5. NATIONAL CLEAN ENERGY FUND (NCEF):

Understanding government-backed initiatives, such as the National Clean Energy Fund, can be crucial for private equity firms looking to invest in renewable energy projects. Awareness of the funding mechanisms and policies supporting clean energy can inform investment decisions.

CHALLENGES TO INTEGRATION OF ESG GOALS

Despite the positive strides in ESG regulation, challenges persist, with greenwashing emerging as a significant obstacle to authentic ESG adoption. Greenwashing occurs when businesses falsely project commitment to sustainability, misleading stakeholders and eroding trust. Research shows that 67% of global consumers doubt their financial institution’s authenticity in sustainability. This undermines genuine efforts, erodes faith in ESG, and hinders support for responsible enterprises. Counteracting greenwashing is crucial for ensuring authenticity in ESG implementation, fostering trust across industries.[11]

CONCLUSION

In the realm of private equity, the rising prominence of ESG factors signifies a broader acknowledgment of sustainability, social impact, and governance in value creation. Firms are increasingly embedding ESG considerations into their decision-making processes, signaling a shift toward responsible practices. Despite challenges such as balancing profitability and sustainability and countering greenwashing, integrating ESG goals into core business strategies is imperative.

This aligns with the anticipated growth in ESG-related assets and heightened investor focus on sustainability, prompting a transformative re-evaluation of investment principles. As India continues on this journey toward responsible finance, the regulatory framework provides a solid foundation for authentic ESG implementation, ultimately fostering a sustainable and transparent financial ecosystem.

[1] https://www.pwc.com/gx/en/financial-services/assets/pdf/pwc-awm-revolution-2022.pdf.

[2] https://www.avendus.com/india/avendus-eye/why-esg-is-a-material-issue-in-contemporary-financial-analysis

[3] https://www.insead.edu/sites/insead/files/assets/dept/centres/gpei/docs/insead-esg-in-private-equity-2014.pdf.

[4] https://www.investmentcouncil.org/private-equity-council-members-adopt-guidelines-for-responsible-investment/.

[5] https://www.sebi.gov.in/legal/circulars/jul-2023/new-category-of-mutual-fund-schemes-for-environmental-social-and-governance-esg-investing-and-related-disclosures-by-mutual-funds_74186.html.

[6] https://assets.kpmg.com/content/dam/kpmg/in/pdf/2023/03/firstnotes-esg-sebi-supply-chain-disclosure.pdf.

[7] https://www.sebi.gov.in/legal/circulars/jul-2023/brsr-core-framework-for-assurance-and-esg-disclosures-for-value-chain_73854.html.

[8] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1215.

[9] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12487&Mode=0

[10] https://www.mca.gov.in/Ministry/pdf/DraftNationalGuidelines2018_20062018.pdf.

[11] https://mambu.com/insights/reports/disruption-diaries-green-banking.