The past events in the world with respect to the pandemic highlighted the pressing climate and environmental issues, which resulted in socially responsible citizens looking for the best next alternative. This led to ESG funds stealing the spotlight from other types of mutual funds. Globally, ESG funds are a huge deal. However, in India, they are still witnessing a growth stage. This article acts as an investment guide in ESG funds and everything you need to know about them before you decide to invest in these environment-friendly mutual funds.
What are ESG Funds?
ESG is short for Environmental, Social, and Governance. So, as the name suggests, ESG funds use these non-financial aspects as a portion of their investment framework which are often missed out in the financial reports of traditional non-ESG funds. Investing in ESG is similar to sustainable investing or socially responsible investing.
In essence, the asset allocation of these funds comprises of shares and bonds of companies that are evaluated based on the above-mentioned factors – social, environmental, and governance. ESG compliant companies are mandated to visibly reveal their social practices, environmental impacts, and governance process. ESG funds shortlist companies that score a good result on factors such as ethical and environment-friendly practices, corporate governance, and social responsibility. It further looks at the financial facets of the companies.
Parameters determining ESG compliance
The following parameters help to determine the ESG compliance:
- Climate change
- Greenhouse gas (GHG) emissions
- Pollution and waste
- Exhaustion of natural resources
- Conflict regions
- Working conditions that include slavery and child labour
- Local communities that include indigenous communities
- Diversity in workplace and employee relations
- Health and safety of the employees
- Board diversity and structure
- Donations and political lobbying
- Corruption and bribery
- Pay structure of executives
- Tax strategy
Formula of ESG risk score
Usually, ESG risk scores are allotted to firms basis their governance, social, and environmental standards. For example, poor labour standards or poor working conditions would increase the social risk score. Similarly, conservation of energy resources and efficient disposal of waste will decrease the environmental risk score.
The ESG risk score is calculated by subtracting managed risk from total exposure to ESG risk. The higher the score, the greater is the scope of ESG risk of a particular company. ESG risk scores near 30 are considered high and are usually ignored by ESG funds.
The following table clears this out in a better way:
|ESG risk score||Risk profile|
|0 to 10||Insignificant|
|10 to 20||Low|
|20 to 30||Medium|
|30 to 40||High|
|Above 40||Substantially high|
ESG is an umbrella term for the components of sustainable and responsible finance. Retail investors are struggling to achieve a proportionate balance between doing the right thing and risk vs returns of a fund. As the younger generation is being an active participant in the markets and wish to contribute as much as they can to the environment, there is a demographic shift towards EGS mutual fund investments. Happy investing!