Why Emerging Markets Will Miss The ESG Exploit

The exponential growth forecasted for sustainable investments risks being undermined by the structural gaps of the ESG ecosystem. Emerging markets will suffer a greater slow down due to their inner instability which has pushed western investors to limit their capital exposure.

An overview of ESG and supply issues

A recent study by PwC Ireland shows that the demand for ESG investments is largely overtaking supply. Clients’ willingness to put their money into projects that positively shape society and the environment is increasing, thanks to greater sensitivity towards these themes. ESG considerations are becoming more and more important in guiding the investment strategies of financial players, both for ethical reasons and for the greater profitability that impact investments can bring.

For assets under ESG mutual fund management, PwC forecasts a compound annual growth rate of 12,2% for active strategies and 17% for passive ones, between 2021 and 2026. These figures are much higher than the growth estimates for the industry. According to the consulting firm, the total amount of ESG assets under management will increase to 33,9 trillion USD by 2026. The share of ESG assets over the total market will rise from 14.4% in 2021 to 21.5% in 2026.

As ESG demand grows, corporate institutions are looking to amplify their offerings. HSBC is enlarging its Exchange Traded Funds (ETFs) with the launch of four new products related to ESG investments, focusing on Small Cap companies and emerging markets. The indexes related to these ETFs will apply standard restrictions to ensure a robust ESG investment profile for their clients. For example, only a maximum of 2,5% of revenues can come from thermal coal.

Recent developments might lead one to think that new days are coming. It seems that ESG investments are having a tangible impact on the world and are making actionable steps towards unlocking sustainable development. Unfortunately, things are not going exactly in this way. Several obstacles are slowing down the ESG investments supply. Some of these issues are well-known and have led many investors and institutions to express their concerns:

  1. the lack of common standards to evaluate green impact
  2. the lack of common standards for sustainability ratings
  3. the difficulty in carrying out fiduciary duties due to higher risk. Big funds such as Blackstone and Vanguard have faced serious legal consequences and multi-million-dollar fines.
  4. the higher compliance costs and the risk to underperform relative to the competition.

Without a major legislative intervention and the development of appropriate frameworks, ESG cannot express its full potential and experience the growth that it deserves. In developing countries, the difficulties are heightened due to inherent risks. This is a regrettable fact given that they are most dependent on ESG flows to convert their economy into a clean and sustainable one.

The heightened difficulties of ESG in emerging markets

Uncertainty is amplified in emerging markets due to geopolitical instability, heterogeneous industrial culture, and weak macroeconomic credibility. Western investors point to corruption and poor governance as structural issues that prevent them from investing.

Another frequently cited barrier to ESG investing in emerging markets is the lack of reliable data. In most of African and Asian countries it is difficult to collect and analyze reliable data, despite this being necessary to pursue a responsible investment approach. There is often a mismatch between the data required by ESG screens and the information available on emerging markets companies, even if more and more of them are working to meet the international benchmarks that ESG investors require.

According to the financial consulting firm ESG Africa, the social and environmental impact assessment prescribed by local laws are often of poor quality compared to international standards: this suggests that a legislative action by the government is required to raise reporting quality. Moreover, in some cases impact companies lack the tools and knowledge to evaluate themselves, losing international credibility. Or they disclose their own business-relevant information in a wrong format, which prevents their inclusion in data-driven ESG screening.

The low standards of ESG corporate disclosure are a big structural problem for emerging markets that can lead them to miss out on significant investment flows. The perception of risk prevents funds and financial players from investing in the countries that need the most help to achieve sustainable development thus also robbing them of the compelling opportunities that an imminent transformation of their economies can bring.

Figure 1. Risks in Emerging Markets.

An Intillidex report shows an increasing reluctance among investors to expose themselves to emerging and frontier markets. Examples of this excessively prudent approach is evident across the asset management world.

The Norges Bank Investment Management, one of the biggest sovereign funds worldwide, is one of the most proactive investors in the impact investment sector: it has declared that it will require a carbon neutral commitment by 2050 from all prospective investments and that it is pushing its portfolio companies towards the same target by 2040. Nevertheless, the Norwegian Finance Minister has recently declared that the fund will not add any emerging market companies to the portfolio. Weak institutions and the absence of strong protections for minority shareholders were deemed as a strong enough reasons to prevent the Norwegian sovereign fund from adopting responsible investment strategies in developing countries.

Therefore, we can say that ESG investors are put in front of a crucial dilemma:

 a) To take more risk by investing in impact opportunities in emerging markets and stay coherent with their sustainable development commitments?

Or

b) Leave emerging markets and redirect their investments?

Right now, it seems that the big players are choosing the second option. They would rather comply with their fiduciary duties and forego the risk of underperformance by not including emerging markets in their portfolios.

Concluding thoughts

The outstanding growth that analysts predict for ESG investments has not been seen in the regions that need it most. The structural uncertainties of the economic and legal systems in emerging countries, combined with the lack of common standards and regulations in the ESG sector, trouble investors and will push them to waive their commitments. A withdrawal in supply from emerging markets will remove an important changing force that is crucial to achieve a sustainable world.

As COP27 takes place in Egypt, several leaders of developing countries are complaining about the scarce aid given by the more affluent private sector in recent years. The commitments promised in past conferences have only been partially fulfilled, leading to a dangerous delay in the sustainable turnaround of emerging markets.

For these reasons, developing countries are going to ask for more funds from public investors and international institutions. A preferred interlocutor is the World Bank, that is receiving huge pressures from stakeholders, like the US government, to widely enlarge its green loans. The hope of developing countries is that a major involvement by multilateral development banks and public institutions could overcome the reluctance of the private sector and attract more capital towards ESG projects. Without this greater effort, reaching the climate goals that the world needs will be dramatically difficult.

Author: Giuseppe Turturici

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