SEBI Proposes New Changes to ESG Rating Framework

In recent years, the concept of ESG—Environmental, Social, and Governance—has taken center stage for companies, investors, and regulators worldwide. It’s no longer just about profits; it’s about how a company impacts the planet, treats its people, and manages its business ethically. Recognizing this shift, the Securities and Exchange Board of India (SEBI) introduced guidelines for ESG Rating Providers (ERPs) last year, aiming to bring transparency and consistency to how these ratings are issued. Now, SEBI is proposing a significant update to this framework. But what does it all mean, and how might it affect companies and investors alike?

What is SEBI Changing?

The latest changes proposed by SEBI involve several key updates:

1. Inclusion of Unlisted Securities: Traditionally, ESG ratings have primarily been used by listed companies—that is, companies whose shares are available on the stock market. However, SEBI’s new proposal aims to expand the scope, allowing ERPs to rate unlisted securities as well. This opens up ESG assessments to a broader range of companies, including private firms, who may not yet be publicly traded but are significant players in sectors where ESG concerns are high.

2. Shared Reporting with Issuers: In the current setup, ERPs that follow the “subscriber-pays” model—where the subscriber (such as a mutual fund or institutional investor) pays for the rating—are required to share the ESG rating report with the company being rated before it reaches the subscribers. This gives the rated company an opportunity to review and respond to the report, especially if they feel there are inaccuracies or misunderstandings about their ESG practices.

However, SEBI’s new proposal allows ERPs to share the report with both the rated company (issuer) and subscribers simultaneously. This change aims to speed up the process, while still enabling the rated company to provide clarifications if necessary.

3. Addressing Appeals and Clarifications: Under the revised framework, ERPs must handle any appeals or requests for clarification from the rated companies in a timely manner. If a company feels its ESG rating was based on outdated or inaccurate information, it can now request ERPs to incorporate a formal addendum with the report. This ensures that subscribers are aware of the company’s clarifications, potentially reducing misunderstandings and improving transparency.

Why Does This Matter?

The move to include unlisted securities and streamline the reporting process has several implications for different stakeholders in the financial world:

• For Investors: With unlisted companies now under the ESG rating umbrella, investors have access to a broader pool of information, which could influence their investment choices. Imagine a venture capital firm interested in backing a promising private tech company. If this company has an ESG rating, the firm can assess its environmental, social, and governance commitments more objectively, rather than relying solely on internal disclosures.

• For Companies (Issuers): The simultaneous sharing of ESG reports means companies no longer have a buffer period to privately review their ESG rating before it’s made public to subscribers. This transparency pushes companies to be more proactive about their ESG practices and encourages them to maintain accurate data, knowing that any inaccuracy could be noticed immediately by investors.

• For ERPs (Rating Providers): ERPs are now required to streamline their communication and rating process with the rated companies, making it more efficient. This could foster stronger relationships between ERPs and companies, as companies can now appeal for immediate clarifications if their rating doesn’t reflect their true ESG status.

What’s Driving This Change?

The essence of this change is to enhance transparency and efficiency. SEBI’s original ERP framework, introduced just last year, focused on ensuring that companies seeking ESG ratings would go through registered, credible providers. The new revisions aim to take this a step further by addressing some limitations ERPs faced under the existing framework.

ERPs, particularly those using the subscriber-pays model, reportedly lost business due to the previous requirement of exclusive pre-report sharing with the rated entity. By changing this, SEBI is trying to create a more competitive, fair market for ERPs, potentially encouraging new entrants and innovations in ESG assessment methods.

The Broader Impact on ESG Investments in India

The proposed revisions also align with India’s larger push towards sustainability. As environmental and social concerns gain prominence worldwide, India’s regulatory bodies are taking steps to ensure that investors and stakeholders have reliable tools to assess these factors. By tightening regulations around ESG ratings, SEBI aims to prevent “greenwashing”—where companies falsely portray themselves as more environmentally or socially responsible than they truly are.

For instance, consider a company operating in the renewable energy sector. Without rigorous ESG assessments, such a company might get away with inadequate environmental practices despite its “green” branding. But with SEBI’s strengthened framework, companies across sectors are encouraged to align their operations with true sustainability standards, knowing that investors will hold them accountable.

A Step Towards Better Corporate Responsibility

SEBI’s proposed changes to the ERP framework reflect an ongoing effort to bring clarity and trust to the ESG rating landscape. By expanding the scope to include unlisted securities, mandating shared reporting, and allowing issuers to appeal inaccuracies, SEBI is not only facilitating better investment decisions but also encouraging companies to adopt genuine, verifiable ESG practices. This is a win-win for investors looking to make informed, ethical investments and for companies striving to build a sustainable future.

Ultimately, as these changes take effect, the onus will be on companies to embrace ESG not just as a rating but as a core value, making Indian businesses more resilient and sustainable in a world that increasingly values responsible growth.

The Importance of ESG and Benchmarks in Today’s Economy

Environmental, Social, and Governance (ESG) factors have become essential benchmarks for assessing a company’s long-term value, resilience, and ethical standing. As climate change, social inequality, and corporate scandals make headlines worldwide, investors and regulators are demanding more transparency and accountability. ESG benchmarks provide a standardized way to evaluate companies on their environmental footprint, labor practices, and corporate governance policies. They help investors identify risks and opportunities that might not be evident through traditional financial metrics alone. For example, companies with strong ESG scores often have robust risk management strategies, better regulatory compliance, and are generally more resilient to economic shocks. Economically, a firm’s high ESG rating can lower its cost of capital by reducing perceived risk, thereby attracting more investment and potentially boosting long-term profitability.

Various ESG benchmarks, such as the MSCI ESG Ratings, Sustainalytics, and FTSE4Good Index, provide comprehensive assessments based on criteria like greenhouse gas emissions, labor standards, diversity, and anti-corruption practices. These benchmarks create a level playing field by giving investors reliable metrics to compare companies across industries and geographies. For instance, MSCI ESG Ratings grades companies on a scale from CCC (worst) to AAA (best), giving investors a clear idea of where a company stands in terms of sustainability practices.

India’s Progress and Compliance Gaps

While India has made strides in adopting ESG standards, it still lags behind global leaders. According to a 2023 report by the International Finance Corporation, only about 24% of companies in the National Stock Exchange (NSE) Nifty 500 index fully comply with global ESG reporting standards. In comparison, the compliance rate is close to 80% in the United States and Europe. India’s progress is hindered by a lack of uniform regulations, limited awareness among smaller companies, and inconsistent data collection practices. The Global Sustainable Investment Alliance (GSIA) reported that sustainable investments represented 3% of total investments in India in 2022, while this figure reached approximately 33% in Europe and 25% in the United States.

From an economic perspective, this gap in compliance and reporting creates an information asymmetry in India’s capital markets. Investors might be wary of committing funds to Indian companies if they cannot accurately assess ESG risks. This leads to higher costs of capital for Indian firms and makes them less competitive on the global stage. As SEBI introduces tighter regulations, and more companies adopt global ESG benchmarks, India could see an influx of sustainable investment, which can drive economic growth, create jobs, and reduce environmental harm.

India’s ESG Future : a new era of Sustainability and Investment

Let me try an analogy to make it more understandable. Imagine that a company is like a school - it has many students (employees), teachers (management), and a principal (CEO). The principal wants to make sure that the school is a good place to learn and grow. To do this, the principal decides to evaluate the school using an "ESG report card" - this is like a report card that rates how environmentally friendly, socially responsible, and well-governed the school is. Do you like this analogy? 

So, let's imagine that the school's ESG report card has three sections: environmental, social, and governance. The environmental section evaluates how the school impacts the environment, like how much energy it uses, how much trash it produces, and how much water it conserves. The social section evaluates how the school treats its employees and students, like how diverse the student body is, how inclusive the school culture is, and how well students and teachers are supported. The governance section evaluates how well the school is managed and whether it follows ethical practices. This can include things like whether the school has an anti-bullying policy, whether the principal is transparent about school finances, and whether the school has a code of conduct that is followed by all staff and students. So, when people look at a company's ESG report card, they can see how the company performs in each of these areas. Then, they can decide whether they want to support the company by buying its products or services or stock. 

ORIGIN OF ESG

The concept of ESG can be traced back to the 1960s, when socially responsible investing (SRI) emerged as a way for investors to consider environmental and social factors when making investment decisions. The idea behind SRI was that companies that did well in these areas would also do well financially. Over time, the concept evolved into what is now known as ESG, which takes a more holistic approach to evaluating companies. Today, many investors, consumers, and employees consider ESG factors when making decisions about which companies to support.

ESG REPORTING IN 2023

The importance of ESG reporting is growing rapidly, especially in the year 2023. Companies are under increasing pressure from investors, consumers, and employees to be transparent about their ESG performance. There are several reasons for this. First, people are becoming more aware of the environmental and social impacts of companies, and they want to support businesses that are making a positive difference. Second, there is a growing body of research that shows that companies with strong ESG practices tend to perform better financially.

There is this important concept called as GREENWASHING. Greenwashing is when a company makes misleading or false claims about its ESG performance in order to appear more sustainable than it actually is. This can lead to inaccurate ESG reports and can make it difficult for investors and consumers to make informed decisions. There are several reasons why companies engage in greenwashing. Sometimes it's a deliberate attempt to mislead, but it can also be the result of a lack of understanding or inadequate resources for accurate ESG reporting. 

Let's take the example of Volkswagen. In 2015, the company was caught using software to cheat on emissions tests, which led to a huge scandal. The company had been claiming to have low emissions, but it was actually emitting much more pollution than it was reporting. This is an example of how greenwashing can lead to serious consequences for a company. It damaged Volkswagen's reputation and led to significant financial losses. Many other companies have been accused of greenwashing as well, such as Coca-Cola, BP, and Nike.

CLIMATE IMPACT

ESG reporting is playing an increasingly important role in the fight against climate change. This is because it provides a way for companies to measure and report on their carbon emissions, as well as their plans to reduce those emissions. Many companies have made public commitments to become "carbon neutral" or "net zero" by certain dates, and they are using ESG reporting to track their progress towards those goals. Investors and consumers are using this information to hold companies accountable for their actions and to make informed decisions about which companies to support. Let's take a critical look at the current state of ESG reporting and climate change. While ESG reporting is definitely a step in the right direction, there are some limitations to consider. First, there is no standardised framework for ESG reporting, so companies can vary widely in how they measure and report on their ESG performance. This can make it difficult for investors and consumers to compare companies. Second, some companies may "game" the system by cherry-picking which metrics to report or by setting overly ambitious goals that they have no real intention of meeting.

ESG IN INDIA

Let's start with the business responsibility and sustainability reporting, or BRSR, that was introduced by SEBI in July of 2023. This framework requires certain listed companies in India to disclose a wide range of ESG metrics, including their greenhouse gas emissions, water and energy usage, diversity and inclusion policies, and community engagement initiatives. This is a significant step forward in terms of increasing transparency and accountability around ESG issues in India. However, there are some challenges with this framework. For example, the requirements are quite detailed and complex, which could be difficult for some companies to comply with. 

The two main stock exchanges in India, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), have played a significant role in encouraging companies to adopt ESG reporting. For example, they have both launched sustainability indices, which track the ESG performance of listed companies. As stated above, SEBI has also been instrumental in developing the BRSR framework and in promoting awareness of ESG issues among Indian companies. Overall, it's clear that there is a strong push for improved ESG disclosure and transparency in India.

INDIA’s TOP FIVE

The top five ESG-performing companies in India are ITC Limited, Mahindra & Mahindra, Wipro, HDFC Bank, and Adani Green Energy Limited. ITC Limited is known for its strong environmental practices, including water conservation and waste management. Mahindra & Mahindra is known for its efforts in corporate social responsibility and employee welfare. Wipro is recognized for its commitment to sustainability and community engagement. HDFC Bank has made significant strides in promoting diversity and inclusion, and Adani Green Energy Limited is a leader in renewable energy.

I'll give you a few examples of the most commonly used metrics. The first is greenhouse gas emissions, which includes the amount of carbon dioxide and other greenhouse gases a company emits. This is usually measured in tons of carbon dioxide equivalent (CO2e). Another important metric is water use, which tracks how much water a company uses and how it manages water resources. There is also energy use, which measures how much energy a company consumes. In addition, there are metrics for waste management, which includes the amount of waste a company generates and how it disposes of it. Under the environmental category, there are many subcategories. Some examples include air emissions, water use, water quality, solid waste management, biodiversity, land use, energy consumption, climate change, environmental management, and more. Now, let's discuss social metrics. Social metrics often include labor practices, human rights, employee health and safety, gender diversity, community engagement, product safety and more. Finally, governance metrics measure a company's policies and procedures around topics like ethics, transparency, and management.

ESG FOR INVESTORS

ESG reporting is becoming increasingly important for investors because it helps them understand the risks and opportunities associated with a company. This is because ESG factors can have a significant impact on a company's long-term performance. For example, if a company has poor labor practices, this could lead to strikes or boycotts, which would negatively affect the company's stock price. Or, if a company is heavily reliant on fossil fuels, it might be at risk if stricter environmental regulations are put in place.

One way that investors utilize ESG reporting is by using it to screen potential investments. For example, an investor might use ESG data to identify companies that align with their values or that are well-positioned to capitalize on trends like the transition to a low-carbon economy. In addition, many large institutional investors, like pension funds, are starting to use ESG criteria to guide their investment decisions. This is because they want to ensure that their investments are not only profitable, but also sustainable and responsible.

Have you heard about the rise of "green bonds" in India. Green bonds are bonds that are used to fund projects that have a positive environmental or climate impact. They have been growing in popularity in India in recent years, and they're an example of how ESG can be used to finance projects that have a positive impact. One example is the Indian Renewable Energy Development Agency (IREDA), which is a government-owned institution that issues green bonds. They've issued over $3 billion in green bonds to date, which have been used to fund solar and wind energy projects in India. 

To conclude, ESG reporting is becoming increasingly important for companies in India, as it can help them to attract investment, manage risk, and improve their environmental and social impact. While there are some challenges in implementing ESG reporting, there are also many opportunities for companies to make positive changes. India has a unique opportunity to become a global leader in ESG reporting, and there are many success stories that demonstrate the benefits of taking a proactive approach to sustainability. With continued efforts, India can create a more sustainable and prosperous future for its people and the planet.