ESG: the core ideas

ESG stands for Environmental, Social and Governance. These are three groups of issues that do not show up neatly in today's financial statements but can change a company's future cash flows, its risks and its cost of capital.

The idea is simple. A cement plant that emits a lot of carbon may face a carbon price. A factory with poor safety may face shutdowns and lawsuits. A company where the promoter treats minority shareholders badly may lose value through related-party deals. None of this is fully visible in last year's profit and loss account, but all of it can hit future earnings.

ESG is not the same as charity or CSR. CSR is about what a company gives back. ESG is about how the company makes its money, and the risks and opportunities that come with it.

In India, ESG has moved from voluntary to regulated. SEBI requires the top 1,000 listed companies by market capitalisation to file a Business Responsibility and Sustainability Report (BRSR), which has applied since FY 2022-23. A smaller set of key indicators, called BRSR Core, must also be independently assessed or assured, phased in by company size. And since July 2023, only entities registered with SEBI may provide ESG ratings in India.

A good analyst treats ESG with both interest and doubt. The issues are real, and some are very material. But ESG data is still mostly reported by companies themselves, ratings from different providers often disagree, and the link between high ESG scores and higher stock returns is not proven.

The three pillars

Environmental (E)

• Greenhouse gas emissions (Scope 1, 2 and 3)
• Energy use and the share of renewable energy
• Water withdrawal and consumption
• Waste and pollution
• Biodiversity and land use
• Exposure to physical climate risks such as floods and heat

Social (S)

• Employee health and safety (for example LTIFR, the lost time injury frequency rate)
• Diversity, pay and treatment of the workforce, including contract workers
• Labour and human rights standards in the supply chain
• Impact on local communities, including land and resettlement
• Customer data privacy and product safety

Governance (G)

• Board independence, skills and diversity
• Promoter holding and pledged shares
• Related-party transactions
• Executive pay and its link to performance
• Audit quality and internal controls
• Anti-bribery and whistleblower systems

Materiality: the key filter

Not every ESG issue matters for every company. Water matters a lot for a beverage maker and much less for a software firm. Carbon matters a lot for steel and cement, and much less for a bank's own offices (though a great deal for what the bank lends to). The first job in any ESG analysis is to pick the few issues that are material for that industry.

There are three ways to define materiality:

• Financial materiality (outside-in): how ESG issues affect the company's value. This is the ISSB's approach.
• Impact materiality (inside-out): how the company affects people and the planet. GRI is built on this approach.
• Double materiality: both together. This is the basis of the EU's reporting rules (CSRD and its standards, the ESRS).

The Indian rulebook in brief

• BRSR: annual ESG report for the top 1,000 listed companies, built on nine principles (the NGRBC)
• BRSR Core: a smaller set of key indicators that must be independently assessed or assured, reaching the top 1,000 from FY 2026-27
• ESG Rating Providers: regulated by SEBI under the Credit Rating Agencies Regulations since July 2023
• Governance rules: the Companies Act 2013 and SEBI's LODR Regulations

ESG in valuation

ESG issues affect value through three channels: revenue and costs (a carbon price, a lost customer, a fine), the discount rate (higher risk means a higher cost of capital), and the long-term growth and returns built into terminal value. The ESG-Integrated Valuation guide covers this in detail.

How to evaluate a company's ESG, step by step

1. Start with materiality. Pick the few issues that matter for the industry, such as water for a beverage maker or carbon for steel and cement, before looking at any score.
2. Read the disclosures. Use the company's BRSR, and give most weight to the BRSR Core indicators, which must be independently assessed or assured.
3. Check governance first. Look at board independence, promoter holding and pledged shares, related-party transactions, and audit quality. In India, governance failures have often destroyed the most value.
4. Test the data. Check the assurance or assessment statements, compare figures across years and against peers, and test numbers against each other, such as emissions against energy use.
5. Treat ratings as one opinion. Read the provider's methodology, and expect two providers to disagree.
6. Link it to value. Decide whether each material issue changes revenue and costs, the discount rate, or the growth and returns in the terminal value.