Proxy advisory and ESG ratings are two related services for large investors. A proxy adviser tells investors how to vote on each decision at a company's shareholder meetings. An ESG rating grades how a company treats the environment, society and its shareholders. ESG stands for environmental, social and governance. Governance means how a company is run and controlled, for example how independent its board of directors is.
Why do investors need a proxy adviser? A large mutual fund may own shares in hundreds of companies. Each company holds at least one shareholder meeting a year, with several resolutions to vote on. A resolution is a formal proposal, such as appointing a director or approving the managing director's pay. In India, SEBI requires mutual funds to vote on these resolutions and to publish how they voted. A fund cannot study thousands of resolutions by itself. So it buys research from a proxy adviser. In India, proxy advisers must be registered with SEBI.
Take, for example, a listed company that proposes to raise its managing director's pay by 60%, although its profit fell last year. The proxy adviser reads the notice of the meeting and the annual report. It compares the pay with that of similar companies. It then publishes a report that recommends voting against the resolution. Large funds read the report before they vote, but each fund makes its own decision. The votes themselves are cast electronically through proxy voting systems.
ESG ratings work differently. The rating firm collects data on each company: its emissions, its safety record, how it treats its staff, and how independent its board is. Large listed companies in India report much of this every year in a business responsibility and sustainability report. The firm turns the data into a score or a grade. Funds use ESG ratings to choose which companies to hold. An index provider uses them to build ESG indices, which include only companies with good ratings.
A fund's investment management system stores both the ratings and the voting advice next to each holding. An ESG rating is different from a credit rating. A credit rating grades whether a company will repay its debt. An ESG rating grades how the company behaves.