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ESG in emerging markets: Cleaning up

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13 Jun 2022

Emerging markets now emit most of the world’s greenhouse gases. But addressing the many ESG challenges is complex. Mark Dunne reports.

Emerging markets now emit most of the world’s greenhouse gases. But addressing the many ESG challenges is complex. Mark Dunne reports.

China’s influence over the world takes many forms. It is the globe’s second largest economy after its GDP expanded by an average of 10% a year in the decade to 2021. It controls the world’s largest army of 2 million soldiers and it emits more of the planet’s climate-destroying greenhouse gases than any other country.

China’s rapid industrialisation has lifted millions of people out of poverty, but that has come at a price. It has been largely fuelled by coal. Two-thirds of its energy emanates from those little black rocks, making it the world’s largest consumer, accounting for half of the coal burned globally.

Demand in China is expected to increase, as they have been building more coal-fired power stations since 2018. The figures already make difficult reading. China is responsible for a quarter of the world’s greenhouse gas emissions. When the rest of the developing world is included, the figure shoots up to 63%, the Centre for Global Development says.

This makes it difficult for some to invest in emerging market assets, with almost three quarters (74%) of UK pension schemes working to a net-zero target or planning to commit to one in the next two years, according to the Pensions and Lifetime Savings Association (PLSA). “Emerging markets face some of the biggest sustainability challenges in the world,” says Eric Nietsch, head of ESG, Asia at Manulife Investment Management. “Companies that are addressing these challenges could outperform.”

Keep it clean

When it comes to investing in the developing world while building net-zero portfolios, an obvious asset class stands out. For Nietsch, wind and solar power look likely to be the winners, as governments become increasingly concerned with energy security. “Renewables tend to be domestic sources of energy, so they can increase energy security,” he says.

Asia, predominantly China and South Korea, is where most materials for wind and solar power infrastructure are produced along with batteries for electric vehicles. “With the global energy transition there is a huge opportunity for emerging markets to meet that demand to help the world meet their energy targets,” Nietsch says.

But climate change is not the only issue investors are considering. Inflation is raging across emerging markets, so investors need to ensure that bond issuers can raise the capital needed to meet the interest payments on their debts. “In higher-rated emerging market sovereigns, the buffer to absorb higher food and fuel prices is greater than in weaker, single B-rated names.

This does not mean, however, that investment-grade credits are immune,” says Uday Patnaik, head of emerging market debt at Legal & General Investment Management (LGIM). “India is a case in point – in the light of higher international energy prices, the sovereign has temporarily suspended limiting the use of coal to ensure cheaper domestic energy supplies to help reduce inflationary pressures,” Patnaik adds.

For some, investing in a heavily emitting company that is moving in the right direction could be more important than one that just ticks all the boxes to be a green investment. “We are not trying to get the best-in-class, we want the companies and governments which are an improving story,” says Carl Shepherd, an emerging market fund manager at Newton Investment Management.

“What is happening in Ukraine will accelerate the move away from a dependence on fossil fuels, but it will create a backward step in the near term, as countries scramble to source energy from elsewhere as cheaply as possible in light of inflation. “Short term there is bad news, but it could accelerate a move to cleaner energies. So, it is not all doom and gloom,” he adds.

Take them with you

No matter what you invest in, you need to make sure that in trying to solve the carbon emissions problem that you do not cause a social problem. A just transition means that no one is left behind and that instead of decimating communities, investors are providing alternatives by, for example, funding education programmes. “It is important for investors in emerging markets to not just consider the energy transition, but a just transition,” Nietsch says.

However, fears that reducing carbon emissions in these markets could pull more people into poverty may be misplaced. “We believe that reducing carbon emissions in emerging markets will have a net positive social impact. It is expected to create more jobs than it would displace,” Nietsch says. “It would protect some jobs from the physical risk of climate change and reduce the death and illness associated with air pollution. So, there are pronounced social benefits from reducing carbon emissions,” he adds.

It is not just about the social benefits; it could lead to workers being moved into alternative roles. Nietsch uses the changing demand for natural resources as an example of how mass unemployment could be avoided while the world transitions to a low carbon economy. “A low carbon scenario has a higher demand for materials such as steel and copper. There could be a reduction in mining of thermal coal, but those jobs could potentially be repurposed to other parts of the mining sector,” he says.

Are you local?

Madeleine King, head of research and engagement at Legal & General Investment Management (LGIM), acknowledges that there are challenges when investing in emerging markets, such as difficulties with data and having to consider the sovereign element when assessing corporates.

But these challenges are not insurmountable. “Emerging markets and ESG can be compatible,” she says, adding that much of ESG analysis is based on basic data points, including assessing what a company does and if it is meeting sustainability standards. “For any bond we invest in, whether it is an emerging market corporate or a developed market blue chip, we want good information about the company’s operations and where its revenues come from,” she adds.

King says emerging market corporates are open to discussions around improving their operations. “It is a widespread conversation now. We are no longer a lone voice knocking on the door asking to talk about climate change. “They are willing to have these conversations in a way they were not five years ago. The big emerging market issuers understand that the rules have changed with investors looking for more than they once did.”

The issue is their ability to act on those discussions is difficult in certain countries. “They are not able to deliver on everything we want, but the tone has changed,” she adds. It appears that emerging market governments have worked on improving their dialogue with investors to build a vibrant market. “Communication has developed over the past 10 years,” Shepherd says.

“A lot of that is down to governments issuing more local debt. They have upped their game to develop a domestic funding market that is credible and also less volatile. “Dollar liquidity is a worsening picture, so you want to create a demand for local debt,” he adds.

Being realistic

The ESG development of emerging markets is a big part of the world’s net-zero ambitions. They have to decarbonise for the world to make a huge dent in climate pollution. Yet investors need to be realistic on what they can achieve. “You cannot set the same standards in emerging markets as you do in the developed world with respect to climate change,” King says. “You have to be realistic in that it takes longer. “While developed markets have had the benefit of industrialisation, many emerging markets are only just getting to that point,” she adds. “We cannot expect emerging market countries to decarbonise at the same rate as those in developed markets.”

LGIM wants its developed world portfolio companies to phase out coal by 2030, but emerging market companies have more time. “We cannot apply the same standards to a Dutch electricity company as we would to an Indian electricity company. They are in different stages of their life cycle,” King says. “With ESG, no one has the right answer,” Patnaik says. “A client sitting in Germany’s view of ESG will be different from that of a client sitting in Saudi Arabia.”

Being at different stages of their lifecycle might be why corporate data in emerging markets is less mature than that released in the developed world. “Investment decisions in emerging markets can often be more complex because of a lack of robust information to base decisions on,” Shepherd says.

Patnaik says that the issue with transparency is not always down to companies not wanting to release data, but in lacking the systems to do it. “Sometimes these corporates have grown so quickly because their economy has grown quickly, so the quality of their information has to catch up.” He adds that considering ESG factors is important to invest successfully in emerging markets. It is about assessing the owner of the company, determining if the directors are independent and ascertaining if the company changes auditors regularly. “These have always been issues and what ESG has done is put a framework around it,” he adds.

The long game

“Emerging markets are emerging for a reason,” Shepherd says. “Something has not gone right or there is an institutional weakness.” This could mean that some changes will take longer to implement than others and investors may need to be patient. “The results will not be immediate for something that is improving people’s lives,” Shepherd says. “If there is a need for improved sanitation, it will have a big impact on people, but the results will come through in 10 years’ time. “That shows me that they are committed to improving lives,” he adds. “It is the same with education, where positive results will not be evident for 10 to 15 years. They are not after quick wins and are serious about fixing these problems.”

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