ESG Indices: Methodology and Importance

Introduction

A stock market index is a statistical measure to judge and evaluate the market. One of the benchmarks for investors is indices, which means that the investors, whether institutional or individual, look for the index of a particular stock exchange to monitor their portfolio. Stock Exchanges have indices such as the Nifty 50 on the National Stock Exchange, and the BSE Sensex. The investors have to make decisions regarding their portfolios such as buy, sell, or hold, depending upon the information regarding individual stocks. The decision making requires a lot of information and analysis. One of the basic parameters is the index. Index is important as it is a benchmark for measuring the performance of the shares as well as for a portfolio. Stock market indices are important parameters due to their interlinkages with other macro-economic factors. (Moussa & Delhoumi, 2021). There are different types of indices such as thematic, sectoral, and broad based. Examples of broad-based stocks are the Nifty 50, and the Nifty 100. The sectoral index consists of the Nifty Auto and the Nifty Bank. Examples of thematic indexes include the Nifty Energy and the Nifty 100 ESG. Each index is calculated using a methodology. Most of prescription use the free float market capitalization method, and the index is displayed to the investors in a real-time mode.

ESG means the Environmental, Social, and Governance aspects of a company. ESG risk scores of different companies are calculated using different methodologies. Over the period, ESG indices have gained significance from the investor\'s point of view, apart from other indices. Stock exchanges display ESG indices for the benefit of the customers. Companies that are ESG sensitive face fewer financial issues. (Singh, 2023). ESG indices have risk hedging properties. (Piserà & Chiappini, 2022). They fall under the thematic indices.

The three indices of Nifty related to ESG are analyzed. These three indices are the Nifty 100 Enhanced ESG Index, the Nifty 100 ESG, and the Nifty 100 ESG Sector Leaders Index. The investors are interested in returns from environmentally responsible, socially aware, and ethical firms. The three Nifty ESG Indices are created to reflect the performance of the Nifty 100 index\'s constituent companies based on their ESG scores; ESG indices outperform other conventional indices. (Deshmukh et al., 2022). It has become imperative to study the performance of the ESG indices since inception, the methodology of calculation, and the importance of the ESG indices from the point of view of the investor as well as the company.

Objectives

1. The indices are essential benchmarks for analyzing stock markets and are based on the ESG scores, hence it is important to study and analyze the three ESG indices i.e., the Nifty 100 Enhanced ESG Index, the Nifty 100 ESG, and the Nifty 100 ESG Sector Leaders Index.
2. The ESG Indices follow a different methodology as compared to other indices, hence it is essential to understand the methodology followed for the calculation of the three indices as the indices are based on ESG risk factors.
3. ESG is one of the recent concepts in the financial world, therefore it is essential to understand the importance of the ESG indices, from the investor\'s and companies\' perspectives.

Methodology

For the purpose of the study, three indices related to ESG are selected. The three indices are thematic indices of the National Stock Exchange i.e., the Nifty 100 Enhanced ESG Index, the Nifty 100 ESG, and the Nifty 100 ESG Sector Leaders Index. The data was sourced from the website of Nifty indices. The data for the Nifty 100 Enhanced ESG index and the Nifty 100 ESG index is for the period 27th March 2018 to 16th February 2024. The Nifty 100 ESG Sector Leaders\' data is from 15th June 2020 to 16th February 2024. The closing index of the three indices was selected for the study. For all three indices, graphs were also prepared for sector representation, weight percentage, and top constituents by weightage from the fact sheet available on the Nifty Indices website. The date of the factsheet is 31st January 2024 and was accessed on 16th February 2024.

Nifty100 Enhanced ESG Index

The purpose of the Nifty 100 Enhanced ESG Index is to represent the performance of the Nifty 100 index firms according to their Environmental, Social, and Governance (ESG) risk scores. Businesses that have a high category risk are not included in the index. Each member\'s weight in the index is skewed according to the ESG risk score the firm has been allocated i.e., the weight of each constituent is determined by taking the company\'s modified ESG risk score and free-float market capitalization.

Nifty100 ESG

The Nifty 100 ESG Index is intended to show how well-performing Nifty 100 index companies have done in relation to ESG risk scores. Each component\'s weight in the index is skewed according to the ESG risk score that the firm has been allocated i.e., the component weight is determined by taking the company\'s modified ESG risk score and free-float market capitalization.

Nifty 100 ESG Sector Leaders

The goal of the Nifty 100 ESG Sector Leaders Index is to monitor the performance of a few chosen companies from each Nifty 100 sector that have demonstrated strong ESG risk management and are not associated with any significant scandals. About 75% of the eligible stocks\' Free Float Market capitalization within each Nifty 100 sector is covered by the index. Subject to a 10% stock cap, the stocks\' weights are determined by their free-float market capitalization.

ESG Index Methodology for Nifty 100 ESG Index and Nifty 100 Enhanced ESG Index

When compared to the Nifty 100 (parent index), the Nifty ESG indices (the Nifty 100 ESG index and the Nifty 100 Enhanced ESG index) produce a portfolio with a similar sector exposure but with a stock level ESG bias. As a result, companies with stronger ESG performance are given a higher weightage in the portfolio. The methodology followed for the Nifty 100 Enhanced ESG Index and Nifty 100 Index is tilt weighted, with the number of constituents being 94 and 95 respectively. The launch date was 27th March 2018, the base date was 01st April 2011, the base value was 1000, the calculation frequency is end of day, and the index is rebalanced semi-annually.

Designed to reflect the performance of the Nifty 100 index\'s constituent companies based on their ESG scores, companies involved in significant environmental, social, or governance scandals will not be considered for inclusion in the index. The index\'s constituents\' weight is determined by combining their ESG scores with free-float market capitalization. The indices\' base date is 01st April 2011 and their base value is 1000. For stocks to be included in the Nifty 100 ESG Index and the Nifty 100 Enhanced ESG Index, they must meet the specified eligibility requirements. Stakeholder Empowerment Services (SES) provides ESG and controversial research. Stocks ought to be included in the Nifty 100 during the index review period. There will only be consideration for common equity shares.

Companies\' performance on the fronts of environmental, social, and governance is gauged by their ESG score. Three key factors-environmental, social, and governance-as well as policy declarations are used to evaluate the companies. The scores are categorized into eight grades: A+ 90 to 100 score; A - 80 to 89.99 score; B+ 70 to 79.99 score; B 60 to 69.99 score; B- 50 to 59.99 score; C+ 40 to 49.99 score; C- 20 to 39.99 score; D - 0 to 19.99 score.

Each year, SES evaluates the organizations based on Business Responsibility & Sustainability Reports, as well as critical disclosure requirements from Integrated Reports (GRI/IIRC), TCFD, and other reports. Furthermore, corporations are continuously checked for any ESG-related controversy. Subject to the following criteria, stocks that currently comprise or will soon comprise the Nifty 100 index may be included in the index:

• When a company is being reviewed, it should have an ESG score.
• Index firms with an \"ESG score\" of less than 60, or B-, C+, C, and D grades, will not be included in the Nifty 100 Enhanced ESG Index. Businesses having a controversy score below 70 will not be allowed. Businesses involved in the sale of alcohol, cigarettes, illicit weapons, and gambling are not allowed. Chemical and biological weapons, anti-personnel mines, and cluster bombs are examples of controversial weaponry.

ESG Index Methodology for Nifty 100 ESG Sector Leaders Index

The Nifty 100 ESG Sector Leaders Index attempts to monitor the performance of a few chosen companies from each Nifty 100 sector that have performed well on the ESG front and are not associated with any significant scandals. The index monitors the performance of the Nifty 100 index stocks that have achieved high scores in the areas of environmental, social, and governance. Businesses engaged in significant environmental, social, or governance provide approximately 75% coverage of the Free Float Market Cap of eligible stocks within each sector of the Nifty 100; companies involved in the business of tobacco, alcohol, controversial weapons, and gambling operations shall not be considered for selection in the index. The stock\'s weight is determined by its free-float market capitalization, with a 10% maximum stock cap. The index\'s base value is 100, and its base date is January 1, 2014.

For stocks to be included in the Nifty 100 ESG Sector Leaders index, they must meet the following eligibility requirements. All stocks that were included in the Nifty 100 at the time of evaluation are qualified to be included in the June and December indices. Companies with controversy scores below 70 will be disqualified; Only ordinary equity shares will be considered. Companies with ESG scores below 60, classified as B-, C+, C, and D grades, will be excluded.

Businesses that receive at least 25% of their revenue from nuclear power, gambling, cigarettes, breweries, weapons, and/or any money from \"controversial weapons\" (as defined by the firm disclosures given under the segment revenue breakup in its annual report) will not be allowed to participate.

Importance of ESG Indices

Various studies are available to understand the importance of ESG indices. Investing in ESG indices can improve portfolio diversity and risk-adjusted returns. (Alvarez-Perez et al., 2024). ESG disclosures have gained momentum during the last few years. (Del Gesso & Lodhi, 2024).

Studies reveal that the stock market reacts positively to the disclosure. There is a positive association between stock market returns and ESG disclosure (Desai, 2023; Naseer et al., 2023). The majority of investors felt that ESG problems are important when making investments and indicated a readiness to make socially responsible investments, despite a low degree of understanding of SRIs. Investors\' awareness of SR/ESG funds, SR/ESG indices, and the desire to engage in SRI channels have a substantial impact. Retail investors\' money is invested by institutional investors, thus ESG fund managers must comprehend their social investment inclinations. (Jonwall et al., 2022). More ESG-compliant businesses might be included by fund managers in their portfolios, and financial incentives from the government can be a powerful tool for motivating investors. Businesses seeking long-term, sustainable capital investment should also strategically implement green production methods. (Raut et al., 2023).

Investors look for different parameters, both financial and non-financial, before investing in a company\'s shares. Financial parameters such as returns on the stock markets, the earnings per share, and profitability is also studied and analyzed. ESG falls under non-financial parameters, and the impact on the environment, society and governance are assessed, as investors do not want to risk exposure to the issues under ESG aspects, for example, pollution caused by industries is an environmental issue, employee dissatisfaction can be a social issue and unethical practices followed by the board can be a governance issue. Therefore, a company that is environmentally compliant, follows ethical and correct governance practices is preferred by the investors. On the other hand, if companies are a part of the ESG index, then they will be assumed to be following the right approach towards ESG related practices. Not only the retail, but also institutional investors rely upon ESG related index. Businesses that are environmentally aware, socially responsible, and follow ethical practices in governance are desirable investment destinations. ESG risk ratings, ESG disclosures by businesses, and ESG index will play an important role in the decision making for investors, especially in long-term investments as both profits and ESG responsible companies will sustain in the market in the long run. In fact, products and services of ESG responsible companies will be in more demand.

Conclusion

All three indices are based on the risk score associated with ESG. These indices are therefore different from the indices such as the NIFTY 50, as they do not incorporate the risk factors related to the ESG factors, making the ESG indices more robust. It can be observed that the investors will rely on ESG indices more in the coming future. There are many ESG rating agencies that provide risk scores on which the investors rely. It can be concluded that investors will be able to assess the risk exposure of companies with the help of the ESG indices and will therefore be able to build a robust portfolio.