[Divyanshu Sharma is a 3rd Year BALLB (Hons) Student at National Law University, Delhi]
Corporate social responsibility (‘CSR’) and environmental, social and governance (‘ESG’) investment criteria are two concepts which predominantly affect the investment decisions of a socially oriented investor. According to the UNIDO, CSR is a management concept wherein companies integrate social and environmental concerns in their business operations and relations with their stakeholders. CSR became a part of the Indian corporate setup with the introduction of Companies Act, 2013 under section 135. The mandatory nature of CSR under the Indian regime has witnessed significant activity, with companies allocating their resources for socially sensitive projects, essentially due to the strict nature of the CSR obligations under section 135.
Against this, ESG is a relatively new idea which has seen its rise in the Indian corporate world in the last couple of years. ESG is an investment strategy which aims to focus on companies whose environmental, social and governance policies are scored high by independent analysts. A crucial link between CSR policy and ESG principles is that both aim for the achievement of sustainable development goals (‘SDG’) in the Indian society through corporate activities.
In the recent past, the Indian corporate sector has witnessed a drop in CSR expenditure, which is one of the primary tests for assessing CSR compliance in India. Concurrently, there has been a sharp rise in quantum of ESG funds in India, with a growing number of investors becoming socially responsible. Through this post, the author intends to answer the following question: can this trend (of ESG’s rise and CSR’s decline) result in a situation where the CSR regime would have to give way to ESG policies?
Rationalising the Advent of ESG in India
On 1 April 2014, India introduced a requirement that companies incur a minimum CSR expenditure of 2% of the average net profits, which applies to all companies meeting a particular threshold of turnover, net worth and net profit. Through several legislative amendments, CSR compliance became an important factor in making investment decisions, wherein investors started taking into consideration the CSR activities, compliance and reporting by companies.
However, the seven-year lifespan of CSR in India has brought to light some of its major flaws. The outlook towards the CSR policy has shifted from its intended objective of social responsibility to a mere tick-in-the-box regulation. In the name of CSR, business organizations are seen as merely spending the 2% amount, irrespective of the actual impact on social welfare. This is evident from the fact that CSR funding is restricted to the tangible aspects of social welfare, so that companies have palpable evidence of CSR activities. Furthermore, several cases have come to light wherein companies have been caught evading CSR regulations, coupled with the decriminalization of CSR offences. Thus, the unwillingness of corporates, and a lax attitude of regulators led to the downfall of the CSR regime in India. This left a lacuna in the space of social responsibility of corporates, which was filled by ESG policy.
Unlike the CSR policy, ESG policy entered Indian corporate landscape due to a ‘sustainability revolution’ led by institutional investors. Similar to the global trend, institutional investors began demanding ESG friendly operations and practices from Indian corporates. Investors actively analyzed the outlook of companies towards ESG goals, and accordingly either rewarded or punished companies, as occurred in the case of PC Jewellers and Manpasand. Investor vigilance for ESG compliance coerced companies to adopt ESG compliant policies. Furthermore, Securities and Exchange Board of India (SEBI) validated the investors’ sentiment towards ESG and, mandated detailed ESG-specific disclosures by top 1000 listed companies, to support their cause. Thus, the corporate players, financial institutions and regulators have responded well to the introduction of ESG and have sought to assimilate it into the Indian corporate setup.
Differentiating ESG & CSR
While the ESG policy has been accepted by the corporate world and the regulators, the CSR regime continues to be in operation. This co-extensive nature of the policies has raised doubts regarding their areas of operation, and their relative position in the corporate governance setup. In order to assuage these concerns, it is imperative to understand the differences between the two policies.
The difference between the two concepts can be understood from their varied scope of applicability. CSR is a concept that was introduced by Companies Act, 2013 in order to motivate or compel (in the case of India) business organizations to contribute a portion of the profits earned towards a social cause, so as to give something back to the society. This policy requires the specified companies to spend at least the 2% amount towards the charitable activities listed under Schedule VII of the Companies Act.
Contrary to this is the scope of ESG. The nature of ESG is such that no organization can claim compliance with the ESG requirements by merely engaging in some philanthropic activity. Rather, business organizations need to show that their overall day-to-day policies and operations are actively promoting environmental, social and corporate welfare concerns, which is in the interest of all its stakeholders.
This difference can be better understood through an example. CSR demands that a company fulfilling the criteria of section 135 of the Companies Act, 2013 spend at least 2% amount of company profits towards an organization supporting women empowerment. On the other hand, ESG requires the companies to frame such employment policies which lead to equal employment opportunities without any gender-based discrimination, across all the levels of management.
Another difference, emanating from the scope of these two policies, is regarding the manner of internal governance mechanism for assessing the compliance with these policies. For the CSR regime, rule 5 of the Companies (Corporate Social Responsibility Policy) Rules, 2014 mandates the creation of a CSR Committee, whose job is to formulate the annual CSR policy of the company and design an action plan to implement the same. As against this, ESG policy requires active participation of all managerial personnel and board members in the development and implementation of ESG friendly policies. That is why ESG-conscious investors demand recruitment of ESG-informed personnel, especially for directorial positions. They believe that until the time the directors of a company are not ESG-oriented, development and enforcement of ESG policies would not be possible. Thus, due to its vast scope, covering the entire operations of a company, ESG requires the participation of all the company’s members as compared to a mere two-member committee.
The last basis of difference between CSR and ESG relates to their measurability. A major concern with the CSR regime is that there is no specific manner of measuring the CSR score of a company. This is mainly attributable to the fact that CSR involves such wide range of projects that creating a common measurement standard is difficult, given the varied scope of the Schedule VII activities. Until now, CSR compliance is verified only by ensuring that the companies have spent at least the 2% amount as prescribed. While the 2021 amendment to CSR Rules, 2014 mandate an independent compliance report, as a part of annual board report for specific companies, past experience has shown that such reports would not be able to bring in the desired transparency. This is because the disclosure format (which has not changed after the amendment) does not require the profile of the beneficiaries, making it difficult to make a holistic impact-based analysis of the CSR policy.
However, this problem of measurability does not apply to ESG. Since the introduction of ESG in India, several private and government indices have been launched to inform the investors about ESG compliance of different listed companies. The National Stock Exchange India has launched several indices to rank companies based on their ESG score and potential risk. In fact, the NSE recently launched a sector-wise ESG ranking index. Such indices have enhanced transparency in the ESG compliance of companies and have equipped investors to make informed decisions. Furthermore, the ESG scores of companies (given by intendent proxy advisory firms like ISS and Refinitiv) take into consideration the SDG impact of the company’s operations.
Predicting the Future
The discussion thus far has revealed that there are some major differences between CSR and ESG, regarding their scope, governance mechanism and measurability. But, according to the author, these glaring differences lead to the conclusion that the rising success of ESG and the consequent fall in CSR compliance does not mean the end for the CSR policy in the near future.
This is because ESG is based on the stakeholder theory of corporate governance, which aims at creating value for all the stakeholders associated with a company. Stakeholders include shareholders, employees, customers, society, and government. Against this broad aim of benefitting several entities, CSR benefits only one specific stakeholder i.e., society, by mandating contribution of corporate resources to socially important issues. This is the reason, rule 2(d) of the CSR Rules, 2014 explicitly bars the business operations of a company from the scope of CSR activities and restricts it to areas mentioned under Schedule VII. Furthermore, the proviso I to section 135(5) postulates giving preference in a company’s CSR policies to local areas surrounding its place of operations. Against this, ESG policies generate values for all the stakeholders, and not specifically for society. Furthermore, the profits generated from ESG policy directly benefit the entities associated with the company (employees through more optimal remuneration policies and inclusive work environment; investors through safety of investment and greater returns; and customers through quality products) and broadly benefit the society. But CSR ensures that a part of the profits earned by the company directly benefit the society, thereby making it practically feasible to generate value for the society at large.
Furthermore, it cannot be said that the rise of ESG compliance, with the consequent fall in CSR contributions points towards the end of the CSR regime. As has been previously mentioned, ESG’s success in India is attributable to an investor-driven revolution. This revolution, coupled with the deleterious consequences of Covid-19, has seen investors rushing towards ESG-compliant companies. Due to this, non-compliant companies have been obliged to change their outlook towards ESG policies, so as to attract funds for growth and development. Furthermore, due to a severe resource crunch during Covid-19, the inflow of investment hit a stumbling block. Due to this, investors became even more selective and laid greater emphasis on ESG scores while making investment decisions. This accelerated the pace of the transition towards ESG policies, for companies which were in dire need of funds. However, Covid-19 also saw a fall in the profit margins of companies, due to which several companies did not qualify for the mandatory CSR compliance rules, giving them the freedom from the mandatory CSR obligations. This led to the fall in the CSR activities in the past two years.
Lastly, there is also a policy angle which requires the Indian corporate sector to continue with the CSR policies despite the successful introduction of ESG in India. Since ESG is at a nascent stage in India, the regulatory system for effective implementation of ESG is still not in a state of readiness. Several concerns need to be dealt with before completely relying on ESG policy. These include the issue regarding the unquantifiable nature of ESG policies’ effect on the financial markets which can better equip investors to make decisions; a detailed and successful ESG accounting mechanism; and the lack of market agreement on which specific elements of ESG have drawn focus. Due to this, the ESG scores given by different entities are not uniform. Until the time these issues are resolved, CSR is well-regulated enough to handle the interaction between corporations and society.
The above discussion leads to the conclusion that the scope of ESG is wide enough to include the CSR policies of companies within it. But this does not mean that one can dispense with CSR rules in the wake of the traction that ESG has been gaining. This is because CSR deals with one specific element of ESG’s goal of stakeholder welfare and ensures that the remotest stakeholders receive the benefits in a direct way. Dispensation of CSR cannot be even considered till until time the ESG regime is fully well-regulated, which is a long way ahead.
– Divyanshu Sharma