ESG is quite a buzzword today and the regulators and the regulated alike all looking to ensure compliance. New financial products have entered the fray and even the government had spoken of issuing green bonds in the Budget. But are we going too fast?

It must be remembered that the acronym, standing broadly for environment, social and governance, connotes three different, unrelated issues and ideally should not be looked at in unison. The reason is that the motivations and consequences of non-compliance have a different set of implications for society.

Governance is a micro level issue while the environment is global, as the consequences of climate change are now visible to everyone the world over. Social responsibility is more in the domain of ethics.

Whenever there are compliance issues the attempt is to have objective yardsticks to measure them. Credit rating agencies such as CARE or CRISIL are already immersed in this endeavour which is good for the system. But clubbing all three together runs the risk of bundling objectives which are diverse and could lead to convoluted results.

Companies may have very high governance standards but could be environment unfriendly given the nature of the business and hence giving a combined measure of performance can be misleading. The solution is to unbundle these three and look at them separately.

One of the negative outcomes with ESG is there is a lot of ‘washing’ which takes place in all the components. Washing refers to companies doing what is required to send the right signals to gain favour of the evaluator while paying only formal obeisance to the set standards. Annual reports of companies have eloquent statements on how they comply with all the three objectives quite comprehensively.

Contradictions galore

For example, a company will write on the concern for environment and speak on the use of energy-saving bulbs or recycling of water. But the basic activity of a construction or chemical company would be highly polluting. Executives keep flying across the world for striking deals, and it is well known that air travel and environment are always at odds.

Use of bottled water is common in all companies which talk ‘green’. Fancy glass buildings are known to be environment unfriendly but are the order of the day for all new commercial constructions. Such contradictions tend to exist in the ‘washing’ process.

It should be remembered that companies are entities run on the principles of capitalism. Their job is to make good returns for the shareholders, and the rest becomes secondary. Normally, everyone would like to operate on the right side of law and regulation but the boundaries for that have to be defined. Most companies follow the law in letter but often not in spirit.

The government has in the last few years made it also mandatory for them to keep aside 2 per cent of their profit for social spending. Such activity is the job of the government and not companies, which are already paying taxes to the state.

Yet, most of them do declare their spending on such activities in their Annual Report and often end up treating it as ‘business compliance’. Therefore, annual reports may not be the best source of information on the true nature of these activities. For companies, keeping special teams to tackle the environment or social responsibility merely increases their costs; this may not be the ideal way of achieving compliance.

The issue with governance is also similar. There are regulatory disclosures which ensure that there is the right composition of Directors and also that there is a certain level of attendance which is ensured. There is also a rule which makes Directors take a qualifying exam. Therefore, from the regulatory end a lot has been done.

Governance problems crop up when there are issues over ownership, when it is an unregulated entity, or when there is a crisis — as was the case in the financial sector including both banks and NBFCs. This is when it is realised that governance has been breached in spirit.

At times a strong head of the organisation or an owner gets in well-known names as Directors but ensures that they remain malleable to their wishes.

Complex exercise

Therefore ESG evaluation is complex and not straitjacketed. Often, most companies pay obeisance to regulation and cannot be faulted. What is suggested is that these three objectives need to be evaluated independently. There need to be rigorous standards for environment compliance which go beyond what is written in Annual Reports. Practices pursued within the organisation need to be studied through personal visits to gauge how truly ‘green’ companies are.

This can be done by rating agencies or research institutions which are paid by the government to ensure there is no conflict of interest. They would be more like how regulators carry out inspections in the financial sector.

Social responsibility ideally falls outside the purview of capitalism as there are inherent contradictions. Companies which build schools in villages see nothing wrong in laying off staff in the name of efficiency and hence make a mockery of the concept of social responsibility. The government should instead increase the corporate tax rate by 2 per cent and use this amount for fixed projects such as equipment in public hospitals, or furniture in village schools.

Similarly, governance evaluation should be given the skip; while there are rules to be followed, it is hard to get everyone to follow in spirit. What is more important is that when there are scams in companies, the Directors need to be moved out from similar positions in other companies. This can be a signal for performance.

Otherwise, these micro issues which pertain to companies are more internal in nature and need not be clubbed with environment and social responsibility.

At any rate having a consolidated ESG evaluation should not be attempted.

The writer is Chief Economist, Bank of Baroda. Views expressed are personal