INVESTMENT MANAGEMENT

APRIL 2016

Connecting the Dots ESG: A New Dimension to Investing

In the past few months there is a sudden awakening of mainstream interest in India around pollution issues. The newfound interest can be traced back to the widely debated measures taken by Delhi Government to curb pollution, the Agreement on Climate Change in Paris (COP21) and even World Health Organization (WHO) reports on the alarming levels of air pollution in Indian cities. Some of the statistics are damning – per WHO, 13 out of the 20 most polluted cities in the world are in India, pollution levels in the most polluted city of Delhi as measured by particulate matter most harmful to respiration (PM2.51) are almost thrice that of Beijing and nearly fifteen times more than that prescribed by WHO (Display 1). The implications have been severe, such as a reported fourfold increase between 2008 and 2015 in the number of patients with respiratory ailments at the All India Institute of Medical Science in Delhi2. A Deutsche Bank report3 quotes a study by the Royal College of London that found an increase in PM2.5 by one microgram per cubic metre reduces life expectancy by 3 weeks which implies that such alarming levels could chop off a significant portion of one’s healthy years.

AUTHORS

AMAY HATTANGADIManaging DirectorMorgan Stanley Investment Management

SWANAND KELKARExecutive DirectorMorgan Stanley Investment Management

1 Particulate matter smaller than 2.5 micrometers2 Leave Delhi (April 2, 2015). The Indian Express. Retrieved on April 1, 2016 http://indianexpress.com/

article/india/india-others/leave-delhi/ 3 Jun Ma (March 2013). China: Big bang measures to fight air pollution. Deutsche Bank

2

CONNECTING THE DOTS

Display 2: Key Regulatory Measures

Auto Draft regulations to advance the implementation of BS V and BS VI fuel emissions standards by three years versus the original schedule (2019 and 2022 respectively). Also intends to make BS IV (equivalent to Euro-IV) applicable across India by April 2017

Energy Mandatory supply of crushed coal to all thermal power plants from April 1 , 2016

Coal above grade G-10 to be transported only after being washed from Oct 01, 2017

Preferential allotment of cheaper gas for city gas and piped gas applications

Introduction of clean energy cess on imported coal and production of coal, lignite and peat to fund clean energy projects in the gas and renewable space

Power Stringent norms for emission from thermal plants regarding (1) the height of chimney (2) specific emission limits to be achieved (3) Monitoring of Water usage effluent disposal. (4)mandatory installation of flue-gas de-sulfurization (FGD) units, in certain cases

Measures taken in Delhi

To permit only odd/even numbered vehicles on alternate days for a fortnight from Jan 1, 2016

Temporary ban on registration of diesel luxury cars/SUVs (>2000cc)

A scheme to ensure compulsory scrapping of diesel vehicles that are over 10 years, under consideration

Source: Kotak Institutional Securities, Nomura Research, IDFC

While getting timely data should be a priority, equally important is coordinated action on the issue. Public policy will have a big role to play here and the states and Union have to work in tandem for this. What we see currently is disjointed and localized action treating the symptoms rather than the disease. Certain policy actions have unintended consequences especially when viewed through the lens of their impact on pollution. In 2014-15, Indian Railways significantly hiked haulage charges for freight transport which co-incided with a large reduction in diesel prices that makes road transport for freight more economical. This meant that transporters aggressively shifted their preferred mode of transportation from rail to road. This is evident in near zero growth in rail freight traffic and a heady 20% growth in sales of commercial vehicles (Display 3). What this has effectively done is shifted freight movement in the country to a much more polluting form of transport.

Display 1: Top Polluting Cities

Igdi

r

WH

O

Beijin

g

Khan

na

Agra

Alla

haba

d

Nar

ayon

ganj

Ludh

iana

Amrit

sar

Kanp

ur

Doh

a

Firo

zaba

d

Luck

now

Ahm

edab

ad

Khor

amab

ad

Raw

alpi

ndi

Pesh

war

Kara

chi

Raip

ur

Gw

alio

r

Patn

a

Del

hi

0

20

40

60

80

100

120

140

160

PM 2.5 level, Annual mean, microgram/m3

180

Source: WHO’s Ambient Air Pollution Database, 2014.

WHO Guideline values for PM2.5: 10 microgram/m3 annual mean, 25 microgram/m3 24-hour mean

We have seen a similar spike in interest about the issue in China before. In January 2013, Beijing experienced a prolonged bout of smog, so severe that residents termed it “Airpocalypse”. PM2.5 levels reached 40 times4 the WHO standard prompting the Chinese Government to swing into action. In December 2013, the National Development and Reform Commission (NDRC) issued the first nationwide blueprint5 for climate change, outlining an extensive list of environmental objectives for 2020. Crackdown on polluting factories and mandatory real time disclosures of air emissions and water discharges followed with Premier Li Keqiang declaring a war on pollution6 in March 2014.

Even in India, the Union and state Governments are aware of the problem and instituted a series of measures to control this menace (Display 2). While the jury is still out on how successful or achievable some of them are, what is certain is that we have barely scratched the surface in tackling the issue. If the first step in solving a problem is acknowledging that you have one, we have crossed that hurdle. The second important step is trying to correctly frame the problem which would mean getting good, timely information on the sources of pollution. Nationwide data on the sources of pollution is hard to come by. Also it is difficult to extrapolate global data as sources of pollution are not comparable across the world. Burning firewood as cooking fuel, for instance, is a major source of pollution in India unlike most parts of the world.

4 Something in the air? (Jan 19, 2013). The Economist. Retrieved on April 11, 2016 from http://www.economist.com/news/china/21569743-measures-air-pollution-go-scale-public-impatience-rises-something-air

5 China’s Policies and Actions for Addressing Climate Change (2013). Retrieved on April 11, 2016 from http://en.ndrc.gov.cn/newsrelease/201311/P020131108611533042884.pdf

6 China to ‘declare war’ on pollution (March 4, 2014). Reuters. Retrieved on April 11, 2016 from http://www.reuters.com/article/us-china-parliament-pollution-idUSBREA2405W20140305

3

ESG: A NEW DIMENSION TO INVESTING

Display 3: Trends in Freight Movement

Feb-12 Feb-13 Feb-14 Feb-15 Feb-16Aug-12 Aug-13 Aug-14 Aug-15

-20

-30

-10

0

10

30

20 Commercial Vehicle growth (yoy %)

Feb-12 Feb-13 Feb-14 Feb-15 Feb-16Aug-12 Aug-13 Aug-14 Aug-15-5

0

5

15

10

Railway Freight growth (yoy %)

Source: SIAM, CMIE, Jefferies. Data as Feb 2016.

A similar unintended consequence was the large growth in the sale of diesel vehicles in the country between 2011 and 2013, when diesel was subsidized and petrol and natural gas were not and consumers preferred to buy diesel vehicles due to this incentive structure (Display 4). Or take the case of industrial fuels like furnace oil and naphtha compared to use of natural gas for industrial purposes. These fuels are infinitely more polluting than a gas based solution and yet in the state of Gujarat fuel oil attracts only 5% sales tax while natural gas for industrial use is taxed at 15%7. Ideally, a solution which is more environment friendly should be incentivized but priorities have clearly been elsewhere in these cases. Such consequences have to be acknowledged and studied at the design level itself with environmental considerations embedded in all facets of policy making.

Display 4: Growth in Diesel Car Sales

-20%

-10%

0%

10%

20%

30%

40%

50%

0

2

4

6

8

10

12

14INR

Diesel Car yoy Non Diesel Car yoy Diesel Subsidy Per litre (RHS)

Source: SIAM, CRISIL, Morgan Stanley Research. Data as of March 31, 2013

7 Source: Nomura Research

In case you are wondering if we have switched professions from being institutional money managers to being green activists, we haven’t. Institutional investors and our clients have become increasingly focused on Environmental, Social and Governance (ESG) related matters of companies that we invest in. The number of asset manager signatories to the United Nations Principles for Responsible Investing (UN PRI) is growing rapidly (Display 5) and this means that there will be increasing and more wide-spread pressure on Governments and corporates to make ESG a center-piece of their policies and strategies respectively.

Display 5: UN PRI Signatories– Gathering Momentum

Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-150

10

20

30

40

50

60

70

0

200

400

600

800

1000

1200

1400

1600

Assets under management (US$ trillion, LHS) Number of Signatories

Source: UN PRI, http://www.unpri.org/news/pri-fact-sheet/

As investors, we are spending considerable amount of time trawling through Business Responsibility Reports that form part of Annual Reports of corporates, a section that honestly speaking, we flipped over a few years ago. It is a given that more money is going to chase companies that score highly on ESG and that will result in premium valuations. From an investing standpoint, this will be an enduring theme in the markets and companies that help provide environment friendly alternatives to existing methods will be huge beneficiaries. In the Indian context, these could be providers of city gas, technology companies that help reduce emission, those engaged in production of clean power or facilitating it as financiers or contractors. Corporates and investors will do well to sit up and take notice of this new trend.

© 2016 Morgan Stanley CRC 1477373 exp 04/20/2017 8561875_CH_0416 LIt-LInk: INVVIEWCNTDOT0416

This material is for Professional Clients only, except in the U.S. where the material may be redistributed or used with the general public.The views and opinions are those of the author as of the date of publication and are subject to change at any time and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.All information provided has been prepared solely for information purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.Investing involves risks including the possible loss of principal.Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.Morgan Stanley Research reports are created, in their entirety, by the Morgan Stanley Research Department which is a separate entity from MSIM. MSIM does not create research reports in any form and the views

expressed in the Morgan Stanley Research reports may not necessarily reflect the views of MSIM. Morgan Stanley Research does not undertake to advise you of changes in the opinions or information set forth in these materials. You should note the date on each report. In addition, analysts and regulatory disclosures are available in the research reports.This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.EMEA:Issued and approved in the United Kingdom by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authority’s rules).U.S.:NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSITHong Kong:This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong.Singapore:This document may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than to (i) an accredited investor (ii) an expert investor or (iii) an institutional investor as defined in Section 4A of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); or (iv) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA.Australia:This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.Morgan Stanley Investment Management is the asset management division of Morgan Stanley.All information contained herein is proprietary and is protected under copyright law.