Introduction
India’s carbon emissions account to 6.81% of the total global emissions. As per the recent Climate Watch Data survey, India is the world’s 3rd largest emitter of greenhouse gases. India is amongst the 10 most vulnerable nations ranked on the Global Climate Risk Index in terms of climate risks. India is also a signatory to the Paris Agreement (Climate Agreement), per which it aims to limit global warming to below 1.5 degrees Celsius.
India in its present ESG Avatar
The pandemic has transformed the DNA of everything that we believed in. COVID-19 has shaken investment priorities and has solidified ESG as a priority for companies. India’s investment environment is fast aligning itself to bend towards companies which have high ESG scores, or which retain a potential to develop high ESG scores. Growing number of financial investors look to integrate financial returns with ESG factors and non-financial considerations.
Turbulent change stemming from ever-evolving environmental, social, and governance (ESG) demands is affecting many private equity funds and corporations, and is in-turn requiring them to urgently transform their ESG strategies. Shareholders are requiring greater reporting from management on ESG initiatives and synergies.
India’s ESG-focused private equity funds rose more than 2 times in the last 5 years, as sustainability and climate integrated portfolios can provide between risk-adjusted returns to investors. Studies consistently demonstrate that ESG funds and businesses with strong ESG records are outperforming others.
In-line with the rigours of impact investment, the Indian government’s sovereign wealth Fund, i.e. the National Investment and Infrastructure Fund, has also endorsed a platform to help organisations understand climate change risks and explore investment opportunities around the transition to low emissions economy.
Recent ESG Intensification
Investors’ awareness intensification is supported by a research report from Goldman Sachs which has highlighted a 75% increase in the number of companies in the S&P 500 discussing key environmental and social terms, on the earning calls, with the peak of 41% as compared to their previous data collection from 2016 to 2017.
86% of the reporting asset owners said that they implemented ESG parameters in the request for proposals, investment management proposals / agreements, limited partnership agreements and other appointment processes. ESG assets are estimated to exceed US$53 trillion by 2025 and represent more than 1/3rd of the US$140.5 trillion in projected total assets under management according to Bloomberg Intelligence.
Existing ESG Legal Landscape in India
Presently, there is no codified and consolidated legal framework in India regulating and governing ESG matters. Instead, numerous regulations address ESG related matters concerning companies’ operations. Set out below are few key takeaways relating to the ESG specific regulatory environment in India:
The Securities and Exchange Board of India (“SEBI”), which is the Indian market regulator which regulates securities and is responsible for market protection, and protects the interests of the stakeholders in the market, is also responsible for the implementation of an efficient ESG mechanism.
Effective financial year 2022-2023, the SEBI has mandated top 1,000 listed companies by market capitalisation, to make disclosure through a new format and to prepare a business responsibility and sustainability report (“BRSR”), entailing ESG related disclosures. The BRSR is touted to be a single comprehensive source of non-financial sustainability information relevant to all business stakeholders – investors, shareholders, regulators, and public at large. The BRSR will be annexed to a company’s annual report, displayed on the company’s website, disclosed to the stock exchanges and made available for its shareholders. The BRSR has been built around the guidelines of the Indian Ministry of Corporate Affairs’ ESG reporting norms, and is a mix of the global reporting norms such as GRI reporting standards, etc. Other than this, the only global framework which has bridged the gap between financial and sustainability reporting is the Sustainable Accounting Standards Board. It requires detailed ESG disclosures, including quantitative and qualitative aspects.
The BRSR framework is not mandatory for smaller listed companies and unlisted public or private companies in India. This information will be used by companies, investors, asset managers and other stakeholders in making real-world business decisions, including decisions relating to M&A. Any Indian company wishing to engage in ESG reporting for the benefit of its shareholders should start with the National Guidelines on Responsible Business Conduct published by the (Indian) Ministry of Corporate Affairs in 2019. These guidelines have shaped the legislative framework governing ESG matters.
The (Indian) Companies Act 2013 lays down various provisions which puts forward a reporting framework in terms of ESG aspects. It requires the board of directors of a company to include information on energy conservation in the directors’ report, which shall include details of actions taken / their effects, usage of alternative sources of energy, capital investments in energy-saving equipment, efforts towards technology absorption, etc. Companies having a specified net-worth are required to frame a Corporate Social Responsibility (“CSR”) committee to oversee the CSR policy and activities. Companies that meet the specified turnover, net worth or profit thresholds are required to spend at least 2% of their average net profits from the previous 3 financial years on corporate social responsibility initiatives. Certain class of companies are also mandated to appoint women directors, in order to enhance inclusion.
ESG Rating and ESG Rating Providers (“ERPs”)
SEBI has also proposed a framework for regulation of ERPs, setting guidelines for a new accreditation framework. The setting-up of ERP framework will enable only SEBI-accredited agencies to provide ESG ratings to listed companies and, in effect, only SEBI-registered credit rating agencies would be eligible as ERPs. In May 2022, SEBI also constituted an advisory committee on ESG matters that will oversee various enhancements in BRSR reports from time to time, examining evolving corporate disclosures, establishing norms for ESG rating model for emerging market issues such as employment generation, social aspects, etc., and developing indicators for ‘governance pillar’. This committee will also consider setting-up a framework for ERPs to disclose the rationale for inclusion of qualitative factors in their rating and observation process.
Sovereign Green Bonds in India
For the first time ever, the Indian government’s Union Budget of 2022 covered issuance of sovereign green bonds to the tune of USD 3.5 billion, with the ultimate goal of India becoming a net zero economy while bolstering India’s green finance initiatives. This is being considered as an important step to develop and sustain a green economy. Per the global practises on green bonds, focus is aimed at transparency around the use of funds, accuracy in reporting and ensuring that management of such funds is done with utmost integrity. Several private companies, financial institutions, etc. have issued green bonds. The first green bond issuance was made by Yes Bank in 2015. Certain companies have also issued sustainability-linked bonds.
Certain other environmental laws in India govern the environmental reporting and framework. The Environment (Protection) Act of 1986 contains rules for managing electronic waste, biomedical waste, solid waste, ozone depleting substances, waste from construction and demolition, hazardous waste, hazardous chemicals, plastic waste, batteries, and rules to assess how a new industry will affect the environment. Companies are required to prevent, control, and mitigate water and air pollution under the Water (Prevention and Control of Pollution) Act, 1974 and the Air (Prevention and Control of Pollution) Act, 1981.
Global Platforms
Indian financial institutions are signing up to become signatories for globally recognised ESG platforms. Several recognised Indian investment managers have become signatories to the United Nations Principles for Responsible Investment, including asset management companies (AMCs) such as, SBI Funds Management Private Limited (a joint venture between the State Bank of India and Amundi, a European Asset Management Company); Axis Asset Management Company Private Limited; ICICI Prudential Asset Management Company Limited (a joint venture between ICICI Bank and Prudential Plc of UK); UTI Asset Management Company Ltd (sponsored by the State Bank of India, Punjab National Bank, Bank of Baroda, and the Life Insurance Corporation of India); Nippon Life India Asset Management Limited (a joint venture between Nippon Life Insurance (Japan) and Reliance Capital (India)); and Enam Asset Management Company Private Limited.
The United Nations Principles for Responsible Banking, the Task Force on Climate-related Financial Disclosures for Banks, etc. are few other international ESG programs to which Indian financial institutions / investors have recently signed up for.
ESG Diligence and Integration
ESG compliance is increasingly becoming an important requirement for conducting a legal due diligence in India and such factors are increasingly being taken into account when choosing targets for potential merger and acquisitions. Despite its newness, ESG due diligence has been a core element of investment processes. Most investors are mindful of the liability and business risks a poor ESG standard can bring to an asset. Given the difficulty in assessing ESG factors at the time of acquisition, per several recent surveys, ESG is linked more with risks than with opportunities by buyers. ESG factors bring risk assessment and value creation opportunities. The biggest challenge the investor community faces when conducting ESG due diligence is the comparison of the target’s performance on ESG metrics to the broader market.
Assessment of risks: ESG diligence combats the risks (existing and future) associated with a target and provides solutions and way forward to mitigate and address the risks. While it also allows the companies to efficiently self-evaluate themselves, it also showcases to the investors the risk profile and the future financial liabilities, thereby building-in process for the post-closing phase of the transaction.
Key diligence aspects: Specific aspects which can be assessed and remain a key focus of the ESG due diligence from a legal standpoint include:
(i) Environmental: Environmental compliances, hazardous materials and waste compliance, air and water pollution, land contamination, energy usage, fire, safety and other compliances, etc.
(ii) Social: Labour law compliances, diversity, equality and inclusion, human resource violations, talent attrition and retention, employee welfare and relations, data security and privacy, cyber security threats, consumer relations, working conditions, discrimination and harassment and health and safety.
(iii) Governance: Anti-bribery and anti-corrupt business practices, board independence, governance matters, executive compensation, business ethics and conducts, shareholder rights, shareholder management and alignment of interests, fiduciary responsibilities, grievance procedures, involvement of board of directors towards overseeing ESG risks, financial policies, etc.
In general, ESG diligence proposition varies with the specific sector in which target operates and the specific geography. For instance, companies operating in the real estate sector have risks associated with environmental risks more than governance and social factors.
Integration of ESG findings post deal completion
ESG integration post deal completion remains a critical aspect of M&A and can often be the determining factor for investors. Integration efforts must be sensitive to existing ESG processes to ensure that the company’s combined ESG profile is not adversely impacted. Focus should be placed on business continuity, and human capital including management and employee retention and preservation of employee morale. During the integration, value should be derived through stakeholder consultation, harmonizing ESG targets and consolidation of the company’s ESG infrastructure.
Crisp ESG diligence process finds its way into the transaction documents, by being addressed in conditions precedent and conditions subsequent clauses, or in the representations, warranties and indemnities package, thereby transporting good strategies and avoiding bad ones.
What have Indian companies done
Indian companies are striving to make the company environment sustainable. Several Indian conglomerates have adopted sustainable features. For instance:
(a) HDFC Bank has adopted Project Footprint in its mission to head towards an environmentally sustainable world, by intervening in about 30 villages in India and implementing climate action emission reduction and verification, which in turn aims at introducing climate friendly interventions.
(b) Bosch Limited: Bosch Group, a global supplier of technology and services, has undertaken lake rejuvenation activities in India, affecting population of close to 6000 villagers, thereby impacting an increase in water storage, development of Green Zones, creation of islands, environment conservation and restoration of biodiversity.
(c) Indigo: Indigo, an Indian flight carrier, has implemented the upcycle project which aims at creating social opportunity through innovative products, recycling of retired seat covers, and marketing these products by providing livelihood to several small and medium enterprises and substantially reducing waste generation through prevention, reduction and recycle.
(d) Many other conglomerates in India have introduced similar programs for the larger benefit of the community and sustenance of the environment. This includes: (i) the Water Stewardship Program implemented by ITC (India’s foremost FMCG player) which aims at ensuring ‘Water-for-all-today-and-tomorrow’ – by offering water conservation and soil development, community management, climate smart agricultural practises, etc.; (ii) water development and management programme introduced by IndusInd Bank Limited; (ii) ReNew India Initiative by Renew Power Private Limited; (iii) focus on biodiversity conservation by Tata Power Company Limited; (iv) community and social work by Cognizant Technology Solutions India Private Limited, etc.
ESG’s potential in resolving Indian social conflicts
ESG reporting will also result in resolving several social problems which are presently faced by India. In order to enhance the companies’ social reporting scores, companies will have to start working on all the ESG factors, which will result in companies involving smaller businesses. 50% of employment in India is generated through smaller companies.
ESG reporting in India when made mandatory for all companies small and big will also help in advancing interests of all communities including LGBTQ plus community, more importantly, when such communities today are discriminated against in India. This will also help in resolving or addressing issues like gender violence and discrimination, caste system, drug addiction etc. Having women leaders and offering their presence in the boardroom would also be a way up to address the ESG positive scores, according to the International Finance Corporation. Board Gender Diversity in ASEAN. Several ESG academics studies have found a correlation and a positive relationship between financial performance and returns on one hand and ESG scores on the other hand.
ESG Incentives for Employees
Over 52 Indian companies have taken science-based target initiatives to incorporate ESG metrics as compared to ~ 200 companies in the US, ~ 128 companies in the United Kingdom and ~ 107 companies in Japan. ESG incentives in annual executive compensation has been viewed to be a step towards value creation. Over 44% of S&P 500 companies include ‘human capital’ measurements in their incentive plans.
Almost 78% of senior leaders and 86% of investors believe that linking ESG incentives in a company’s strategy leads to an enhancement of the shareholder value. Quantitative measurement factors used in annual bonus plans include factors such as employee health and safety, governance, people & HR, diversity and inclusion and customer services.
Voluntary ESG Disclosures
The BRSR framework and regime does not apply to private companies, public unlisted companies and to small listed companies. Implementation of ESG reporting is high on costs and may outweigh potential benefits.
Companies other than top 1000 listed companies can adopt best ESG practices and reporting norms depending on agreements with their shareholders, investors and key contracting parties. These inter-se frameworks have increased exponentially over the past few years, given woke capitalism and investor obligations to their funds, fund of funds and limited partners. Global ESG reporting standards, such as the Global Reporting Initiative and the Sustainability Account Standards Board are adopted by several Indian companies which are not subject to mandatary reporting requirements under Indian law.
Conclusion
The existing Prime Minister of India has pledged to reduce India’s carbon emissions by 45% and meet 50% of its energy requirements from renewable energy by 2030, in order for India to be a net zero economy by 2070. It will be a tumultuous and long road map for India, given Indian government’s projection of being a US$ 5 trillion economy by 2025. Major Indian companies have agreed to go net-zero by 2030, which is following their reporting requirements. The BRSR framework is a welcome move by the SEBI. However, in order to be net-zero economy, the sustainability reporting requirement will have to extend the companies beyond top-1000 listed companies by market capitalisation. It will not be surprising if the Indian regulatory authorities soon work to establish a universal disclosure system for all enterprises in India.
ESG disclosure standards both internationally and in India, as well as the increasing value placed on ESG compliance, show that corporations are no longer free to choose whether or not to comply with ESG standards. We are certain for woke capitalism to change the companies’, investors’ and most importantly its stakeholders’ future for ever.
Vanita Bhargava and Pavi Jain are part of Khaitan & Co LLP.