In recent years, the integration of ESG principles has spread across a growing number of asset classes, and now emerging markets, which have traditionally been slow on the uptake, are no longer immune.
During the past three years, there has been a significant increase in ESG emerging market funds available to European investors, with Morningstar figures showing the number of European-domiciled strategies has risen by 89% since 2017, more than double the 40% growth for the wider European sustainable fund universe over the same time period.
Elizabeth Stuart, an analyst of sustainability research at Morningstar, says: “Investors committed to sustainability are not satisfied with only their developed market exposure having an ESG focus. These funds offer a more holistic approach to sustainable portfolio construction.
“We have [also] seen the ESG market growing within emerging markets. This has spurred more disclosure from corporates and other issuers. With better data coming to market it is possible to create and market these products in Europe with confidence.”
It is unsurprising that ESG and emerging markets are finally on a collision path. A recent report by Pictet Asset Management and the Oxford Smith School of Enterprise & the Environment finds that emerging markets are facing the highest risks from climate change, with Brazil and India standing to lose up to 60% of their GDP per capita by the end of the century.
“Another report by Moody’s reveals ESG credit risks are more prevalent in emerging markets than in developed ones, with 36% of all of its rating actions on debt issues in emerging markets in 2019 involving material ESG considerations, especially related to governance.
Louis Tambe (pictured), fund analyst at FE Investments, says given the governance and transparency issues in the region, “emerging market fund managers have had to work harder to be comfortable with the governance structures” of the companies in their investment universe, while also having to “consider the level of values they hold these companies to”.
“This can get complicated when certain governments’ policies, such as China, conflict with the standards of more developed and liberal economies,” he says.
China’s pledge
However, there is some positive momentum in this area. China, traditionally one of the biggest concerns from an ESG standpoint, recently made a commitment to become net zero by 2060, which could help lower global warming by around 0.2- 0.3°C, Pictet AM’s study estimates.
Charlie Carnegie, research director, sustainability at Arisaig Partners, says China’s commitment to net zero “will likely be a big growth driver for new industries and innovation, which could see the country become the leading global player in green technology”.
The country already has the world’s largest renewable energy capacity, with more than 184 gigawatts wind and 175 gigawatts solar installed, while 60% of solar panels are produced in China.
However, Ali Hussain, head of research at FIM Partners, warns China will remain the most challenged of the large emerging markets from an ESG perspective unless the government shows support for corporate disclosures.
“China does not allow details of audits to be disclosed and this has come from the government level. So how can you trust a country where you don’t know if the numbers are even real?” he asks.
Missed opportunity
Professor Hepburn also believes there is “a bit of a missed opportunity” across emerging markets when it comes to green recovery policies following the pandemic, with stimulus measures announced by many countries in the region, especially South American nations and Mexico, described as “not particularly green”.
Carnegie adds while a few countries assessed by the Climate Action Tracker are aligned with the 2°C development pathway, including India and the Philippines, “most of the others have insufficient policy to meet with the Paris Agreement aligned requirement”.
However, Patricia Ribeiro, co-manager of the American Century Emerging Markets Sustainable Impact Equity Fund, says it is even more important to invest in those countries where the governments are showing little interest in the ESG agenda, such as Brazil.
“It has been very challenging to invest in Brazil because of where the president stands on issues such as the Amazon, but there are so many areas that need focus and investment, and we know either the government is not going to do it as they don’t believe in it or they can’t afford it,” she says
Education Group, a leading operator of private higher education and vocational schools in China; water and sewage treatment companies, an area that requires high amounts of additional investment in emerging markets; and some smaller banks that focus on customers that don’t have access to traditional banking.
Ribeiro notes that getting hold of the right data to quantify the positive impact of investments in the region is still a challenge but, according to Hussain, there are many emerging market businesses that have been following sustainable principles for some time but are not yet disclosing this.
The good news, he says, is that disclosures are improving: “Five years ago, just 5% of businesses in our investment universe were doing sustainability disclosures and now it’s closer to 20%.”
A tough job
Yet finding stocks that fit sustainability principles while also delivering a strong financial return in emerging markets is still no mean feat.
Ashish Swarup, portfolio manager at emerging market specialist Aikya Investment Management, says: “If you can find companies that are good on the G and serve a strong social purpose (S), while also not damaging the E – that’s the holy grail.”
For Swarup, the first step is to avoid companies that are controlled by the government, which means staying away from resources, industrials, oil, and often even real estate and banks. Instead, he invests in companies that have a large shareholder or family behind them whose interests can align with the values of minority shareholders. As a result, the portfolio tends to be tilted towards consumer-oriented sectors.
However, even in these sectors not all companies fit the bill. For example, Carnegie says his team has taken “an increasingly sceptical view on environmentally intensive consumer goods sectors such as dairy”, as he believes the falling demand coupled with policy pressures “could lead to poor shareholder returns in the coming years”.
Meanwhile, Tambe adds that emerging market equity managers must be mindful of the impact that excluding some large players, such as Chinese tech names, from their portfolios on ESG grounds could have on performance.
He says: “We can see this with many sustainable emerging markets funds underperforming their non-sustainable counterparts, where the reverse is often true within developed markets in recent years.”
This article first appeared in the January issue of Portfolio Adviser‘s sister title ESG Clarity. Read more here.
