What next for sustainable finance in India?
By Suranjali Tandon, Assistant Professor, National Institute of Public Finance and Policy (NIPFP), India
In this post for the Sustainable Finance Leadership series, Suranjali Tandon examines the key features of India’s approach to connecting capital markets and environmental imperatives, a drive that is set to accelerate following COVID-19, with a sovereign green bond on the horizon.
India has emerged as an important destination for investors seeking assets that are aligned with the Sustainable Development Goals (SDGs). However, the incorporation of environmental, social and governance (ESG) factors is still not fully developed. The COVID-19 pandemic has further highlighted why sustainable practices need to be at the core of both economic practice and financial thinking, not least in terms of the importance of setting high social standards in corporate India and beyond. But India is also particularly vulnerable to deepening climate change and responding to this threat will require unprecedented flows of finance. One estimatesuggests that US$4.5 trillion is needed to achieve India’s goals for urban sustainability and renewable energy by 2040. This dwarfs India’s fiscal capacity: its annual budgeted expenditure on all sectors is approximately $300 billion per year. Limited public resources mean private finance will have to play a major role.
Vanguard actions: disclosure and bond markets
One of the first signs of efforts to connect finance, social and environmental issues came back in 2008 when the central bank, the Reserve Bank of India (RBI), issued a circular (PDF) to raise awareness in the banking sector of the growing global prevalence of corporate social responsibility (CSR), sustainable development and non-financial reporting (NFR). Since then, two actions have driven forward the sustainable finance agenda most powerfully: pressure to improve corporate disclosure on capital markets and the growing issuance of green bonds.
Building on the global momentum behind corporate disclosure, in 2012 the Securities and Exchange Board of India (SEBI) introduced a requirement for the top 100 companies by market capitalisation to issue Business Responsibility Reporting (BRR). Published alongside the annual report, the BRR consists of nine principles: ethics, product lifecycle, employee wellbeing, engagement of stakeholders, policies for group, joint ventures, suppliers and NGOs, environmental strategy, the company’s membership of any trade association, how it delivers inclusive growth and its focus on the customer. Since 2016 the number of companies involved in BRR has expanded from 500 to 1,000 (PDF).
Analysing the reports submitted by 100 of these companies, the National Stock Exchange (NSE) found notable progress in 2017–18 on certain principles. For example, 87 of the 100 companies had identified environmental risks and 99 companies made employee disclosures. At the moment, SEBI does not require the BRR to be audited. However, the NSE study (PDF) observed that approximately 70 per cent of companies reported having been independently audited on the nine principles.
If the BRR is going to be more than regulatory compliance, it will be important to show the link between better scores in the BRR and improved financial performance. Promising signs are emerging that ESG funds that adopt strategies such as norm based screening, and shareholder/stakeholder action, are gaining traction in India. Five institutions in India have also signed the Principles for Responsible Investment (PRI): ECube Investment Advisors, SBI Funds Management, Equicap Asia Management, Indus Environmental Services and Malabar Investments.
Since the first issuance of green bonds by Yes Bank in 2015, India has emerged as the second largest emerging green bonds market, with US$7.2 billion in issuance, most of which has been used to fund renewable energy projects. Green bonds can help alleviate the maturity mismatch problem and so far have been popular among Indian issuers. A positive trend has been the high demand for international issuances, which have been oversubscribed in many cases by two to three times. These issuances are of comparatively large ticket size and are able to attract investors (PDF) through higher coupon rates.
Yet, issuance so far remains too small to meet the country’s green finance needs. To help expand the market, SEBI issued guidelines in 2017, which provided definitions and securities and laid down disclosure requirements. Nevertheless, concerns over currency risk that brings higher hedging costs, along with poor sovereign ratings and lower tenure (PDF), are constraining foreign investors.
A stronger ESG score equates to stronger performance
The COVID-19 pandemic has severely tested markets. Yet, early evidence in India suggests that companies that score more strongly on ESG are performing better, matching the global trend. Since the lockdown was declared in India on 24 March 2020, the NIFTY 100 ESG index (the flagship benchmark of the National Stock Exchange) has outperformed the conventional NIFTY 50 index. I estimate that the average daily increase in closing value for ESG has been 0.24 per cent, compared with 0.17 for NIFTY 50. This confirms a longer term trend, with companies in the NIFTY 100 ESG index outperforming the benchmark NIFTY 50 in 2017, 2018 and 2019.
Figure 1. Annual performance of NIFTY 50 and National Stock Exchange ESG 100
Not only has ESG outperformed in the crisis but also it has proved more resilient. From January to March 2020, foreign portfolio investors accounted for a third of the assets under custody reported for various categories of investors in India’s capital market, and sold off assets worth US$18.5 billion. Despite the sell-off, India’s ESG funds actually remained resilient, attracting $500 millionduring the lockdown. In fact, there was a record inflow (PDF), driven in part by the launch of the Axis ESG Equity Fund, which received $239 million.
Credit rating agencies are also identifying ESG factors as material for bond investors. For example, Moody’s in 2019 considered ESG risks as material credit considerations in 33 per cent of the 7,637 private-sector rating actions published, and sectors such as automotives, coal and electricity generation, with their high carbon footprints, have received maximum rating actions. In India, the growing use of ESG considerations by credit rating agencies such as Fitch for ratings purpose is expected to nudge investment.
Signs of growing central bank focus
Central banks can profoundly influence the flow of sustainable finance and in 2019, a decade after its first cautious circular, the Reserve Bank of India returned to the subject. In its report on trends and progress in banking, the RBI argued that India’s banks need to be sensitised to international initiatives (such as the Equator Principles) and urged financial institutions to adhere to sustainable practices. Then in April 2020, the RBI published a study showing that climate change has a significant impact on food price inflation. To mitigate these risks, the central bank may begin to incorporate environmental factors into its prudential policies, requiring climate-related disclosures by banks, calibrating reserve requirements on the basis of green assets, starting to invest in green assets and providing liquidity to banks investing in environmentally-friendly projects.
India also has another way of steering capital to social and environmental goals – through priority sector lending targets for banks. Currently 40 per cent of bank lending, adjusted net credit or credit equivalent of off-balance-sheet exposure – whichever is higher – has to be channelled to sectors deemed crucial for economic development, such as agriculture, micro-enterprises and social infrastructure. So far, the RBI has included lending to social infrastructure and small renewable energy projects within the priority sector lending targets. But these remain a small part of the loan portfolio. For example, urban cooperative banks only have lending exposure of 0.1 per cent to renewable energy and 0.3 per cent to social infrastructure.
There is no doubt that banks can play a strategic role. However, the Indian banking system is riddled with non-performing assets (NPAs). In March 2020, gross NPAs accounted for 9 per centof total bank lending. With pressure on the banking system to resolve financial distress, there is need for deepening of markets for other instruments (such as bond markets). This does not preclude the RBI from laying out a strategy for revival, one where lending in the future may be tethered to climate and sustainable development goals.
The way forward
The resilience of ESG investments during the COVID-19 crisis, growing demand for green bonds and the RBI’s renewed interest all signal the vast potential for re-orienting finance as India emerges from the lockdown. There is certainly no lack of ambition to drive forward climate positive development. In the midst of the crisis, India’s government announced its ‘One Sun, One World, One Grid’ plan, a new initiative to connect solar energy supply across the borders of countries from South and South East Asia, the Middle East and Africa. This follows India’s establishment of the International Solar Alliance and its proposal for a World Solar Bank.
For Mukund Rajan, co-founder of the new ESG firm ECube, climate change and the need to improve corporate governance are both driving change in India. “Fairly soon,” he says, “these will drive a requirement for all major capital flows, whether in the form of debt or equity, to demonstrate a strong ESG and ‘green’ orientation.” Rajan says that ESG-based finance is being driven by three factors:
- “Tighter regulations, resource efficiency and waste management are driving more businesses to seek innovative financing options.”
- “Large institutional investors across the mutual fund, insurance and pension fund industries are being tasked by their regulators to exercise more diligence on ESG matters and adopt a stewardship approach when committing capital to potential investee companies.”
- On the liability side, additional incentives are being created for investors through the availability of low-cost capital, particularly from overseas foundations, family offices and some institutional investors who are seeking greater impact and are willing to share some of the risk in greening Indian industry.
A system-wide strategy to drive forward sustainable finance in India is now needed, one that includes the RBI’s risk-based focus and its priority sector lending programme as well as the government’s macroeconomic approach to fiscal management.
One priority is to drive a wedge between returns on conventional instruments and those that finance sustainability transitions. This can be done through the use of tax incentives. India has already launched tax-free bonds to raise capital for the Indian Renewable Energy Development Agency (IREDA). While these proved a huge success with investors, it is imperative that the impact of such incentives is evaluated so that public resources are used most effectively to mobilise sustainable finance (I discuss this in more detail here).
Another priority is to connect public finances with the sustainability agenda. In 2019, the first discussions about a sovereign green bond took place but were not followed through. Given India’s current borrowing needs to finance the COVID-19 recovery, now is perhaps the time for its first sovereign green bond.
The views in this commentary are those of the author and do not necessarily represent those of the Grantham Research Institute.