The FY24 budget is likely to focus on building a market for carbon. This is welcome, as India is committed to achieving net-zero emissions by 2070. The transition requires investments—estimated to be almost $28 billion yearly—to move from coal and fossil fuels to renewables.
The Environment-Social-Governance (ESG) investing landscape will help India make this transition. ESG are a set of standards used by socially conscious investors to decide which companies to invest in. But we must overcome two challenges to harness these funds. First, we need to reduce the opacity on what qualifies as ESG to achieve credibility in the eyes of investors. The second and bigger challenge is to improve the overall policy environment that will make our energy sector an attractive investment destination.
Attracting ESG investors
Driven both by regulatory mandates and demands from investors, global funds are seeking investment opportunities that incorporate ESG considerations and not just financial returns. Survey data shows that 32 per cent of European investors say that ESG is essential to their investment approach. ESG funds are expected to become almost one-third of the total assets under management by 2025. A small domestic mutual fund industry is also looking for ESG investments. The Indian energy sector has an opportunity to harness global and domestic funds for its energy transition goals.
Investors, however, worry about ‘greenwashing’, that is, the difficulty of credibly gleaning information about the truth of a firm’s ESG qualities before investing. The environmental disclosures are more clear-cut than ‘social’ or ‘governance’ disclosures. And yet, research finds a weak correlation between ESG scores and emissions growth across large emitters.
In response to the rise of the ESG movement, the Securities and Exchange Board of India (SEBI) made the Business Responsibility and Sustainability Report (BRSR) mandatory for the top 1,000 listed companies in India from FY23. Mandatory disclosure regimes, however, can quickly become over-prescriptive and cease to provide meaningful information, as we have seen in the case of rating agencies. Mandatory disclosures can also add to information overload, reducing the ability of smaller investors to discover the true substance of what is on offer.
Large institutional investors driven by an ESG mandate are incentivised to obtain the necessary information themselves. The parameters that the regulator finds useful may not be the parameters that matter the most to them. Similar concerns have been raised about the SEBI disclosures, especially that Indian firms might find it challenging to implement them, given the reliance on coal. The costs of a mandatory disclosure regime may, therefore, not provide commensurate benefits.
Developing credible third-party agencies that certify ESG standards will take time, and different agencies may take different routes for certification. This idea should not be immediately discarded in favour of entry barriers on who can provide ratings and imposing uniformity on how ratings are done. The evolution of differential standards by multiple players is more likely to be sustainable in reducing the information asymmetry between investors and companies in the long run.
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Improving policy environment
Let’s assume that the industry was able to find a solution vis-à-vis the credibility of ESG scores. (rephrased for clarity, please see if this is okay) Investment in the energy sector would continue to be poor. This is because investments in energy imply dealing with the electricity sector, which is beset with problems.
The biggest among these is that of contract enforcement. Electricity regulators in several Indian states have reneged on power purchase agreements signed with solar producers. In the case of Uttar Pradesh, the electricity regulator proposed a reduced tariff from what was agreed upon in the original power purchase agreement (PPA). In Tamil Nadu, the state electricity board got into a tussle over payment to various solar power producers. While both regulators lost at the Appellate Tribunal for Electricity (APTEL), the signal to the private sector has been that of an unpredictable and risky investing environment. Lack of clarity on clearances by the government before projects can start add to the risk of investing in India.
Another concern is the poor financial health of the state electricity boards. Private power producers have to sell to state electricity boards, which may default on payments due to their poor balance sheets. As of April 2022, distribution companies (discoms) owed Rs 1,23,244 crore to power-generating firms, of which almost Rs 21,000 crore was to renewable energy providers. As a consequence, private players are going to exercise caution before entering into risky contracts.
Our energy transition requires a fundamental reform of the power sector. While ESG disclosures are important, the real challenge is to improve the ‘investibility’ of the sector that will bring in the pools of private capital.
The author is an associate professor at the National Institute of Public Finance and Policy (NIPFP). She tweets @resanering. Views are personal.