Emerging markets (EM) are home to 85 per cent of the world’s population — roughly six billion people. These are people that deserve and demand the same welfare and comforts of the developed world. Many developing economies do not lead with sustainable achievements today, yet they hold tremendous potential to contribute to a more sustainable future. Said another way, if the wealthy countries succeed in ‘net zero’ but we starve the poorer countries of required capital, the world will have made little progress.
Emerging market debt (EMD) provides some of the most interesting opportunities to investors, but ESG scoring methodologies have been constructed such that emerging economies are at an automatic disadvantage, making it harder to deliver the dual outcomes of saving the world and generating excess returns. Nearly all responsible investors deploying capital in responsibly focused strategies, expect their investment will make a positive difference. This is especially true when investing in emerging markets debt.”
But there are four key challenges keeping investors from realising their targeted outcomes when investing responsibly in EMD.”
Challenge #1: Data providers rank issuers on how the world affects issuers instead of how issuers affect the world
Like traditional credit risk evaluation, most popular ESG scoring metrics are designed to reward an issuer by the degree to which it is immunised from the risks of operating and engaging with the world around it. Unfortunately, little emphasis is placed on evaluating how an issuer degrades the world, much less how to use this knowledge to create products and strategies designed to oppose these dominant trends.”
Challenge #2: ESG scoring methodologies are highly correlated with per capita wealth, penalising the poor and rewarding the wealthy
Research indicates nearly 90 per cent of a country’s ESG evaluation is tied to the country’s wealth. The World Bank goes further, stating, “A country’s national income permeates all sustainability-linked measures, used by the market.”
Average ESG scores across providers, are highly correlated with gross national income per capita, and by eliminating the income bias, results differ significantly.
I agree with the World Bank’s statement that current ESG approaches are likely to divert necessary development dollars from poorer countries to the wealthier and ultimately fail the overall responsible investing movement.
A country’s wealth and governance are also considered as a part of traditional rating agencies’ evaluation of an issuer. It compounds the weighting of this factor and explains the high degree of correlation between ESG scores and traditional credit ratings.
Challenge #3: There is no free lunch – investors are reducing the likelihood of favourable financial outcomes
Generally speaking, the dominant academic conclusion is that expected excess returns typically fall when using any investment strategy that restricts. While ESG restrictions have the potential to reduce downside risk through credit enhancement, they will also likely lower upside potential.
Further, issuers with better ESG scores typically are higher-rated credits, have lower cost of capital, and commensurate lower ex-ante asset returns. However, skilful forecasting of ESG can improve excess returns, particularly within the poorer, weaker countries.
Until asset managers adjust ESG scoring methodologies or portfolio weightings to neutralise the wealth and credit effects of conventional ESG approaches for EMD issuers and portfolios, they must prepare to structurally underperform traditional benchmarks as a consequence of this ESG approach.
Challenge #4: Divestment rather than engagement often results in worse societal outcomes
There are times when an issuer is simply so abhorrent or reckless that you cannot face the mirror knowing you are doing business with them. However, we believe speaking with and encouraging issuers to do better, by the world, can often be a successful strategy.
In xonclusion, dor investors looking to advance positive change while pursuing competitive returns, emerging markets provide intriguing opportunities to accelerate the shift to a sustainable and inclusive global economy.
Relative to developed markets, that seemingly have abundant resources to meet a sustainable trajectory, EM companies and countries are often early in their journey. The improvement potential offers opportunities to utilise capital to accelerate positive change.
Investing in emerging market issuers, that are interested in contributing to a more sustainable world, can create value over time, by aligning investments with issuers committed to improving their stakeholders’ welfare and credit profile. Examples include:
- Investing in sovereigns, quasi-sovereigns and corporates that are underpinned by strong governance with clear objectives in improving human welfare standards in a sustainable manner
- Pursuing long-term value creation by combining traditional credit-based investing with long-term improvements in human capital
- Measuring a commitment to sustainable change with a focus on governance, health, wealth, climate change, resource efficiency and economic/social rights
- Relying on a research-intensive process and proprietary, country wealth-agnostic assessment framework to help understand how issuers might affect the world
- Advancing positive outcomes by proactively engaging with issuers when possible
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