The gap in the emerging market

There is still a huge need for ESG investment in emerging markets, but companies there are responding to various sustainability and social needs. What’s more, reporting is improving too, finds Piyasi Mitra.

A conversation around environmental, social and governance (ESG) investing in emerging markets versus that in developed markets would be like comparing apples with oranges because ESG appears much more embedded in developed market companies.

While International Monetary Fund data shows that emerging markets account for two-thirds of global greenhouse gas emissions, other data shows that a higher percentage of companies in developed markets have strong levels of ESG risk management, according to Nicolo Bragazza, associate portfolio manager at Morningstar Investment Management. The figure – revealed by comparing the developed market Morningstar DM TME Index with the emerging market Morningstar EM TME Index – is 64%, compared with 32% in emerging markets.

Corporate governance is a challenge within emerging markets because many notable companies are owned by, or have links to, governments. This may lead to decisions that prioritise political goals rather than shareholder interests.

“A static approach to ESG issues may penalise companies on their path to business improvement,” says Bragazza.

According to Claude Brown, a partner at law firm Reed Smith, corruption and political instability also continue to pose challenges for investors in emerging markets: “Each potentially exposes asset managers to reputational and financial risk. Additionally, interaction and possible tension between E, S and G make impact investing a challenge due to the collateral risks involved.”

For investors with insufficient data and disclosures, there is an underlying fear that data scarcity or opacity may mask significant problems, adds Brown.

Also, good governance doesn’t always gain wide traction. This is because of cultural differences between emerging countries and ESG investors.

“If the investing policy intends to be uniform across the portfolio, cultural differences can reduce the pool of investable countries, increasing the portfolio’s concentration risk.”

“If the investing policy intends to be uniform across the portfolio, cultural differences can reduce the pool of investable countries, increasing the portfolio’s concentration risk,” says Brown.

Catriona Macnair, an emerging markets investment director at abrdn and lead portfolio manager for the asset manager’s Article 9 emerging markets SDG [sustainable development goals] equities strategy, says investors need to research emerging market companies for visibility about who is behind the business. Investors need to know the extent of the backers’ voting powers and understand the alignment of management incentives with minority shareholders and the degree of independent oversight.

Relying on third-party external data providers is not enough in emerging markets, says Macnair. Data can be “backwards-looking” with narrower coverage for small-cap names.

According to Macnair, almost 15% of the holdings in abrdn’s Article 9 emerging markets SDG strategy are not covered by MSCI, a major provider of ESG data.

But given the boom in passive money flows, many of which will use quantitative screens based on MSCI scores, there are lots of opportunities for active ESG or UN SDG-aligned investors willing to undertake due diligence and legwork themselves in a bid to unearth less well-known names where sustainability disclosures are patchy or where there is no MSCI coverage.

“A key consideration is the proximity of emerging market corporates to pressing fundamental global problems such as deforestation, poverty and climate change,” says Macnair. “Disruptive technologies, deployed cost-effectively, have the potential to solve these problems profitably and transform lives.”

Just transition

Juliana Hansveden, emerging market sustainable equities portfolio manager at Ninety One, thinks there are more sustainability-driven growth opportunities in emerging markets than in developed markets. Some of the thematic opportunities are financial and digital inclusion, decarbonisation and healthcare.

She says also that clients in emerging markets look for the same opportunities as clients in developed markets, especially as growth opportunities and sustainability are linked to emerging markets.

However, some emerging market companies will also have more exposure to social issues than to governance or environment. For instance, manufacturing, materials or mining involve disruptive work that impacts local communities, explains Hansveden. The lives of local farmers may change when a company sets up new facilities near agricultural fields, and there is a risk that the water supply gets polluted. Yet importantly, companies that run themselves sustainably – which implies sustainability risk management – should be less exposed to regulatory sanctions, reputational damage, consumer opposition, talent loss and other threats to long-term success, says Hansveden.

One of the strongest features of ESG in emerging markets is falling renewable energy infrastructure costs. These make it easier for a large section of emerging markets to bypass the building of electricity infrastructure based on fossil fuels and allow them instead to meet energy demand through clean energy generated by wind and sun, points out Andrew Ness, co-manager, Franklin Templeton Emerging Markets Sustainability Fund.

The International Energy Agency’s projection is that global solar power spending will hit over $1 billion a day or $382 billion a year, while investment in oil production will stand at $371 billion.

“A key consideration is the proximity of emerging market corporates to pressing fundamental global problems such as deforestation, poverty and climate change,” says Macnair. “Disruptive technologies, deployed cost-effectively, have the potential to solve these problems profitably and transform lives.”

China, India and Brazil have announced climate-aware ambitions, including legislation to limit emissions, says Ness. “Emerging markets are home to many companies providing solutions that address environmental problems,” he adds. The solar supply chain, battery electrolyte production, EV supply chain and semiconductors are all investments in the Franklin Templeton GEM Sustainability Fund.

However, challenges for power are not just about power generation, but also distribution, says Brown at law firm Reed Smith. Despite abundant sources of renewable energy in emerging countries, the essential infrastructure is frequently lacking.

“The population is often sparsely distributed with poor transport infrastructure, making construction and installation of a decentralised power grid hard. In others, there are highly concentrated population nodes which are not only at significant distances from the renewable sources but make safe, localised energy distribution within high-density urban areas costly and time taking,” says Brown.

As ESG inflows increase, there is more pressure on investors to find opportunities. “This, in turn, is producing more sophisticated impact modelling. However, the data issue remains, hindering the transition from exclusionist strategies to activist ones,” adds Brown.

But setting up alternative power sources cannot be carried out in isolation. “Those engaged in fossil fuel-based power generation in emerging markets need to be redeployed if investment in sustainable energy aims to avoid adverse social consequences.”

Renewables rule

ESG investments in India have primarily been into the renewable energy sector, with green shoots in low-carbon sectors, such as green hydrogen, across listed and unlisted spaces, points out Shantanu Srivastava, sustainable finance and climate risk lead (South Asia), at the Institute for Energy Economics and Financial Analysis (IEEFA).

“A major tailwind for ESG investors in India includes the government’s clean energy ambitions providing opportunities in a sector ranking high on ESG credentials,” he says. The capital market regulator, the Securities and Exchange Board of India (Sebi), has also rolled out a mandatory regime – the Business Responsibility and Sustainability Reporting Standards (BRSR) – for the top 1,000 listed companies in the country.

Sebi has issued guidelines for green debt securities for domestic issuers to wade off any greenwashing risks. India’s central bank, the Reserve Bank of India, has also recommended disclosure by banks in line with the Task Force on Climate-Related Financial Disclosure, says Srivastava.

He adds: “To address mis-selling and greenwashing in ESG schemes introduced by Indian asset managers, Sebi has introduced measures such as mandating ESG schemes to invest at least 65% of assets under management in listed entities where the assurance on core BRSR and third-party assurance and certification by the board of assets managers on compliance with the objective of ESG schemes are undertaken, among others.”

An official green taxonomy is much needed. “Compliance is largely in the purview of the reporting entity, and the BRSR also doesn’t require disclosure of detailed transition strategies by currently high carbon-emitting companies,” says Srivastava.

“Emerging markets are home to many companies providing solutions that address environmental problems.”

“Also, government policies have historically focused on decarbonising the power sector, and new policies are only now emerging for other hard-to-abate sectors. For some of the larger institutional investors, such as the insurance and pension sector, the investment regulations are prohibitive of investment in clean energy technologies.”

Saurabh Trivedi, research analyst at IEEFA, recommends that Sebi continues strengthening its ESG frameworks to address greenwashing and increases the ESG-labelled bond issuances in local currency. “An Indian green taxonomy should introduce investment guidelines for the wider green sector like green hydrogen, battery storage, energy efficiency and other sustainability projects,” he adds.

There will be pressure on corporate boards to showcase their ability to effectively manage ESG issues, including but not limited to climate change, human rights and social issues. Biodiversity and natural capital sectors are likely to attract the interest of the Indian investor community in times ahead, Trivedi says.

Currently, Federal Bank Limited is the only bank in India to discontinue financing new coal projects. Still, Trivedi is hopeful that more banks will start establishing divestment policies against climate-risky sectors.

“A major tailwind for ESG investors in India includes the government’s clean energy ambitions providing opportunities in a sector ranking high on ESG credentials.”

Brown points out that social investing, particularly impact investing, fares better in emerging markets than governance, as health and education tend to be more neutral objectives. However, impediments to virtuous investment strategies are genuine.

“One only has to look at reproductive rights, non-gender-oriented education or underage-related employment to see some of the pitfalls,” says Brown.

Environmental-led investing is less complex because international financial institutions, development finance institutions and multilateral development banks apply rigorous environmental standards on their investment and aid, says Brown, which exposes emerging markets to environmental criteria, monitoring and reporting in a manner that “dwarfs” comparable requirements for S and G projects.

“This makes them better placed to respond to private investment in the environmental space because the infrastructure is there and understood.”

Power access struggle

Parts of many developing nations struggle with power access – a factor prioritised over investing in green alternatives. Abrdn invests in both themes. “We invest in Energuate, the providers of electricity in rural Guatemala, with dedicated capital expenditure towards increasing access to electricity from the current 90% to 99% by 2032,” says Sam Bevan, investor director and portfolio manager of abrdn’s Article 9 EM SDG Corporate Bond Fund.

The fund also invests in CMI Energía, a renewable power operator across Central America, including Guatemala. Abrdn’s focus is on decarbonising grids within the electricity-generation space.

Bevan suggests “storytelling” around sustainable investment be more acute in emerging markets, given these markets’ focus on reducing inequalities.

“The shift is now away from a corporate social responsibility perspective, to demonstrating the positive or negative impact of products and services.”

Opportunities lie in investing in companies providing healthcare access for 50% of the global population still waiting for it, financial services to the 1.7 billion unbanked population, or upping telecommunications’ 30% penetration in the sub-Saharan region, for instance.

Working in the realm of fixed income, Bevan argues first-mover advantage can drive alpha. Barclays data shows only 6% of emerging market debt corporate bonds is ESG-aligned, compared to 30% in euro corporate bonds. Demonstrating how improved ESG and sustainability perceptions can lead to bond outperformance, Bevan cites the improvement in Tower Bersama’s rating, from a B to an A, in abrdn’s two-and-a-half years of engagement with the company. This move led to the compression of spreads in Tower Bersama bonds.

Nascent market

Macnair points out that of more than 700 emerging market equities funds, only about 20 fall under Article 9 – illustrating that the ESG asset class in emerging markets is still nascent in comparison with developed markets.

But disclosure among emerging market companies is improving, Macnair acknowledges – ranging from supply chain audits to avoided emissions and to the number of new pharmacies opened within South Africa’s townships.

Technology, media and entertainment and telecommunications companies have been at the forefront, says Bevan. Citing Helios Towers – a pan-African telecom tower infrastructure company which provides in-depth reporting on connecting rural areas – he adds: “The shift is now away from a corporate social responsibility perspective to demonstrating the positive or negative impact of products and services.”

© 2023 funds europe

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