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An evening with Dr Mukund Rajan: Corporate India and the new focus on ECG

On Friday, December 10, we had a fascinating session by Dr Mukund Rajan, Chairman, ECube Investment Advisors, a first of its kind platform created in 2019 to catalyze ESG changes in India. Dr Rajan spoke about the evolving ESG landscape in India.

About Dr Rajan

Dr Rajan holds a BTech from IIT Delhi (1989) and Masters and PhD from Oxford which he completed on a Rhodes Scholarship. He spent 23 years with the Tata group holding various key responsibilities: Brand Custodian, Chief Ethics Officer, Chairman of the Tata Global Sustainability Council, member of the Executive Council of Tata Sons, board member of various Tata companies such as Tata Teleservices, Tata AIG, Tata Communications and Tata SIA Airlines. He is currently Chairperson of the environment committee of FICCI. In 2007, he was nominated as a young global leader by the WEF. Dr Rajan’s third book, “Outlast- How ESG can benefit your business” has just been released.

What is ESG?

ESG stands for Environment, Social and Governance.

Environment: Refers to the consumption of natural resources, pollution, carbon footprint, etc.

Social: Refers to the links and ties with the local community, treatment of employees, focus on diversity and inclusion, etc.

Governance: Includes board effectiveness, audit practices, senior management compensation, independent directors, etc. ESG factors strongly influence the sustainability and resilience of the enterprise. The pandemic has revealed the short termism of many Indian companies. The values of these companies have come under scrutiny for their shoddy treatment of stakeholder groups and job cuts. Think of the migrant workers.

An ESG crisis

Indeed, we could argue that India is in the midst of an ESG crisis. India has one of the worst records when it comes to the environment. 22 out of the 30 most polluted (air) cities in the world are in India. It is estimated that air pollution causes 1,000,000 deaths in the country every year. Land degradation, desertification, and ground water depletion (affecting almost half of the total land area) are widespread. Many cities are expected to run short of ground water.

On the social front, we have major challenges to address including participation of women in the workforce (At 22.2 %, India has one of the lowest participation rates in the world, compared to the global average of 45.8%.) and safeguarding the rights of scheduled castes and scheduled tribes.

Poor corporate governance is reflected in the large number of bankruptcy/resolution cases before the IBC and NLT, rising NPAs of the banking sector, and the various incidents of ethical misconduct and weak corporate governance.

Positive developments

Against this backdrop, there are also some positive developments. Public concern and judicial activism are increasing the pace of change. Measures to improve the quality of air in the National Capital Region (odd even rules for movement of cars, restrictions on the use of diesel engines), more stringent environmental standards for cars, the move towards electric vehicles and the Madras high court judgment against Sterlite are good examples.

Regulations are also being strengthened. Measures taken in recent years include Rules of Business Conduct and National voluntary guidelines on ESG prepared by the Ministry of corporate Affairs, SEBI’s requirements on ESG reporting and stewardship codes developed by IRDAI and PFRDA.

The Companies Act has been amended since 2010 to ensure better protection of minority shareholders. In recent years, these shareholders have come down heavily on excessive management compensation and opposed the reelection of non-performing directors. Mandatory rotation of auditors was introduced in 2013. Investor activism has also increased. In the four years, following the intervention of activist investor Elliott in Cognizant (which questioned the inefficient use of free cash flows by a company which had never paid dividends) cash rich Indian IT services companies have completed share buy backs exceeding Rs 100,000 crores. Today, India is considered one of the best countries in the world for shareholder protection in the World Bank’s Doing Business Report, 2020.

Note:

BRSR The SEBI circular mentions that the BRSR (Business Responsibility Sustainability Reporting) aims at providing investors access to standardized disclosures on ESG parameters and relevant and comparable information. This will help them to identify and assess sustainability related risks and opportunities and make better investment decisions. At the same time, companies can better demonstrate their sustainability objectives and performance. Overall, higher standards of ESG disclosures and transparency, will help companies in attracting more capital and investment.

Note:

Ministry of Corporate Affairs: National Guidelines on Responsible Business Conduct.

  • Principle 1: Businesses should conduct and govern themselves with integrity and in a manner that is ethical, transparent and accountable.
  • Principle 2: Businesses should provide goods and services in a manner that is sustainable and safe.
  • Principle 3: Businesses should respect and promote the well-being of all employees, including those in their value chains.
  • Principle 4: Businesses should respect the interests of and be responsive to all its stakeholders.
  • Principle 5: Businesses should respect and promote human rights.
  • Principle 6: Businesses should respect and make efforts to protect and restore the environment.
  • Principle 7: Businesses, when engaging in influencing public and regulatory policy, should do so in a manner that is responsible and transparent.
  • Principle 8: Businesses should promote inclusive growth and equitable development.
  • Principle 9: Businesses should engage with and provide value to their consumers in a responsible manner.

Global environmental issues

To safeguard our environment, cooperation among nations is a must. The argument is like what we are hearing during the pandemic. Nobody is safe unless everybody is safe!

The revised plan under the Paris agreement is to reduce the temperature increase to 1.5 ° compared to the earlier target of 2° by the turn of the century. Various initiatives have been announced across the world. These include the EU’s carbon border adjustment mechanism, and insistence on companies in the UK to announce net zero plans. (The Carbon Border Adjustment Mechanism is a carbon-pricing system for imports into the European Union. It adjusts the price of certain imported products for the CO2 emissions caused by them, to put them on par with EU products.)

Meanwhile, MNCs like Unilever and Nestle have announced plans to achieve net zero by 2039 and 2050. They are demanding the same from supply chain partners in India. Norges Bank, which runs one of the largest investment funds in the world, has started decarbonizing its portfolio. Detailed disclosures on environmental issues are becoming the norm in many countries.

There is a growing preference among consumers for purpose driven brands such as Patagonia and Body Shop. Unilever has started to mention the carbon footprint in all its product labels. Activism is on the rise. Greta Thunberg has led an international movement of school students who skip Friday classes to participate in demonstrations to demand action   from political leaders to arrest climate change.

India’s climate commitments

India is the third largest producer of greenhouse gases in the world after China and the US. Under CoP 26, (26 th meeting of the Conference of the Parties to the UN Framework Convention on Climate Change), we have committed to reach Net Zero by 2070. By 2030, we will put in place 500 GW of non-fossil fuel-based energy and achieve a 45% improvement in energy efficiency compared to 2005. India is anchoring the International Solar alliance that espouses One Sun, One World, One Grid.

Indian businesses have no option but to embrace the UN Sustainable Development Goals. Asset managers are insisting on disclosure of ESG performance. Indian businesses that are non-compliant may be left out of the investment portfolio.

At the same time, there is increasing investor interest in companies which are more committed to ESG. There is evidence to indicate that better ESG practices lead to greater resource efficiency, lower cost of operations, lower risk, lower cost of capital and a higher possibility of earning alpha. The MSCI Indian ESG leaders index shows that they are outperforming the peers. We can expect capital to flow towards the well governed companies.

Global actions will have an impact on India companies. Under the UK bribery act, Indian companies, with some presence in the UK, can be penalized for corrupt practices in another geography such as Africa.

Best practices

Forward looking Indian companies are recognizing the importance of ESG and doing the following:

  • Recognize the new reality and the need for change: Reliance has announced plans to achieve Net Zero by 2035.
  • Create a governance focus: Identify the material ESG issues which are relevant to them (e.g. climate change for steel) and create ESG committees on the board like Infosys, Ashok Leyland and Airtel to focus on them.
  • Invest in training and strong evaluation protocols.
  • Put in place diversity mechanisms starting with  the board.
  • Appoint good Independent directors and a strong chairperson for the board: As Mr. NR Narayana Murthy has advocated, a strong chairperson is important.
  • Have a strong code of conduct that covers dignity of work, conflict of interest, bribery, whistle blowing mechanisms.
  • Focus on circular economy practices, thereby also minimizing their exposure to raw material price volatility. (According to the WEF, “A circular economy ---shifts towards the use of renewable energy, eliminates the use of toxic chemicals, ….. and aims for the elimination of waste through the superior design of materials, products, systems, and business models.”)
  • The best companies also realize that commitment to ESG does not necessarily imply very heavy investments. In fact, the returns can come very quickly in some cases. A good example is the use of LEDs, which can pay for themselves in a year.
  • The best companies will also include the supply chains in their progressive actions. After all, the MSMEs account for about 50% of the resource consumption in the country.
  • The best companies demonstrate leadership by moving towards Scope 3. Greenhouse gas emissions are categorised into three groups or 'Scopes' by the Greenhouse Gas (GHG) Protocol. Scope 1 covers direct emissions from owned or controlled sources. Scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the reporting company. Scope 3 includes all other indirect emissions that occur in a company’s value chain.
  • Investments in innovation, R&D and nontraditional collaborations can help. For example, Tata Power chose to pivot from fossil to renewable energy and is supplying green power to subscribers who are willing to pay higher prices.
  • When it comes to diversity, companies are showing more commitment to women, SC/STs and the physically challenged. These measures do not cost much and there can be outsized gains in terms of employee motivation and brand image.
  • ESG performance is being linked with executive compensation.
  • There is an increased focus on measurement.

Concluding notes

In the coming years, ESG Disclosures will become more transparent. There are various reporting standards like Global Reporting Initiative (standards setting body headquartered in Amsterdam) and Integrated Reporting. In India, companies will have to embrace BRSR introduced by SEBI. These reports will be carefully dissected, and the gaps will be analyzed. “Naming and shaming” will become common along with withdrawal of investments from companies which do not meet the required standards.

ESG ratings by analysts and data processors like MSCI, CRISIL, Sustainalytics (a Morningstar company) will become important. Responsible companies will provide them all the data in a transparent and proactive way and secure high ESG ratings for themselves.

In short, ESG parameters are becoming critical indicators of a company’s performance. Indian companies must move away from shareholder primacy towards value creation for all the stakeholders.

Q&A

India’s agenda

The Environment Secretary recently indicated that the government is working on a road map towards Net Zero by 2070. By 2030, the plan is to generate 50% of the energy through receivables and improve energy efficiency by 45%. These are challenging targets. India has had a national action plan on climate change since 2008.Many ministries have been working on environmental issues. But often different parts of the government are not aligned. For example, new licenses have been awarded for coal mines. With a commitment of almost Rs 100,000 crores of investment, mining of coal may continue till 2050. Similarly, electric vehicles, which are environment friendly, were first considered a luxury item under GST.

But we also need to understand the compulsions of the government. Coal India Limited employs 300,000 people, pays Rs 50,000 crores of tax and has millions of pensioners. So, stopping the mining of coal overnight will not be possible. We need a just transition to ensure that the displaced labor is reskilled. It is important to involve the private sector.

How do we compare with other countries?

We are lagging. China is planning to achieve net zero by 2060, 10 years ahead of us. The renewable energy capacity in China is 700,000 GW compared to 100,000 GW for India. The EU has announced various measures to cut emissions, not just slow them down. The UK has announced that by 2023, listed companies will have to announce their net zero transmission plan. By 2025, UK financial services companies will have to provide detailed ESG disclosures.

If India does not act quickly, it could run into rough weather. The EU may impose tariffs on products which do not meet the necessary environmental standards. Even otherwise, we have started to face the impact of climate change. Consider the unexpected cyclones in Mumbai for the past 2 years and the heavy rainfall in Chennai (comparable to 2015). This is just the beginning. We will have to get our act together quickly.

Role of corporate India

The best Indian companies are seeing the current situation as an opportunity. They are embracing change and pursuing early mover strategies. Reliance and Adani are good examples. The situation today is very similar to the liberalization of 1991. After the economic reforms were introduced, companies which did not embrace change vanished from the league tables. It is important to take some risk, make the necessary investments and move forward. Investors and customers may boycott companies which

do not meet the standards. If the large companies pull their supply chains along, the entire corporate sector will be benefited. The most affected sectors are oil and gas, thermal power, steel, aluminum, cement and automotive. Some companies may use a tick the box approach. But the best companies will pursue a comprehensive approach that tries to create value for all shareholders.

The best companies have set up ESG committees on the board. These include Infosys, Airtel and Ashok Leyland. Others like Tata Steel have a CSR committee to address ESG issues. In the well managed companies, the following best practices are used:

  • Senior leaders own up the agenda and execution plans.
  • Executive compensation is linked to ESG outcomes.
  • Frequent communication.
  • Systems and processes.
  • Measurement and reporting.

Investments in clean tech

The National Solar Power Mission has a target of creating a capacity of more than 100 GW. The large renewable energy players are well funded. Tariffs are also among the lowest in the world. When it comes to small scale clean tech such as roof top solar, it is difficult to get finance. Same is the case with battery technology as it is relatively new, and banks are unwilling to lend. One would have expected NBFCs to step in, but they have been caught in their own problems: NPAs earlier and now the pandemic. In short, while big ticket funding is easily available, small ticket funding is not easy to come by.

Implementation challenges

The reporting system is still inadequate. There is not enough information available for investors, analysts, public. So many companies are getting way with it, even if they do not meet the standards. The financial penalties for poor disclosures are less. But now things look set to change.

Indian companies must learn from their global counterparts. Unilever is indicating the carbon footprint in its product labeling. Now setting higher standards this way can be costly and educating customers can be risky (they may walk away) but the rewards can be handsome in the long run.

On the role of political parties

There is a need for political parties to be more responsible, understand the issues and educate customers. Dr Rajan wonders why India does not have a green party when green parties are on the rise in other part of the world, like Europe. In Germany, one of the most important countries in the world, a green party is controlling the government. Political parties must cover environmental issues in their manifestos. They should communicate strongly on climate issues. It is also important to involve the civil society and the youth.

Happiness index for employees

Employee engagement levels in India are quite low. Even across the world, it is low at about 13% according to Gallup. Employees must have pride in their work. They must feel included. Compensation should be equitable. People should not look at the job as a source of their monthly income and look for satisfaction outside the work. Leading Indian businessman, Mr. Harsh Goenka of the RPG group has talked about the need to keep people happy. India has traditionally had a hierarchical culture. Companies have been dismissive of employee feedback. Those companies which encourage dissent make employees feel better, avoid big mistakes and are more likely to be innovative.


We thank Dr. Vedpuriswar for bringing out the highlights in the form of this note