Introduction
The demand for environmental, social, and governance (ESG) or responsible investing (RI) is growing at a rapid pace with nearly USD 23 trillion of assets being professionally managed under RI as of 2016, an increase of 72% since 2012.1 Despite increased investor interest and relatively higher risk exposure to ESG issues, the lack of breadth and depth in corporate sustainability disclosures has led to exaggeratedly low ESG scores and hitherto restricted rigorous application of ESG integration strategies to emerging market (EM) portfolios. With regulatory momentum moving toward more transparent, relevant, and accurate corporate disclosures, and the increased use of technology to capture and analyze data, this sustainability information gap is quickly reducing in many EM countries.
In Part 1 of this paper, we make the case that this cannot come too soon for EM investing as these countries are generally both more vulnerable to ESG issues and less prepared to deal with them. From an active manager’s perspective, the ESG scores in emerging markets encompass a wide spectrum, thereby offering another avenue to add value. In Part 2 we establish that both macro and micro ESG issues can substantially impact the earnings potential of corporations. We also highlight the benefits of developing a proprietary ESG assessment framework over a reliance on off-the-shelf ESG scores from vendors. We also demonstrate, using a case study, how one can integrate ESG risks and opportunities with traditional financial analysis to enhance the overall investment process. We conclude by underlining our conviction that although ESG signals are worth integrating in all strategies, there are some strategies in which these signals have a greater impact.
Part 1: Why ESG?
Environmental, social, and governance or responsible investing discussions are often accompanied by a degree of confusion because participants cannot agree on what it involves: whether it improves returns, lowers the risk profile, or is just aimed at having a positive impact on all stakeholders. In its early days, RI started off as socially responsible investing (SRI) and had a primary focus of screening out companies or, in some cases, entire industries (e.g., tobacco) based on ethical or religious beliefs. It has now evolved into a practice of integrating material ESG data with traditional financial analysis to better manage risk and strengthen the investment decision-making process. Globally, seven ESG strategies, as defined by the Global Sustainable Investment Alliance (GSIA), are typically applied. These include screening based on negative, norms-based, or positive criteria; thematic and impact investing; active ownership; and ESG integration. Depending on the asset owner’s motivation, ESG investing could mean investing in businesses that generate positive social or environmental impacts (impact investing); screening out controversial businesses such as tobacco, weapons, alcohol, etc., from the investment universe (values-based investing); or employing ESG signals at the security and portfolio level with a goal of improving risk-adjusted returns (ESG integration).
As shown in Exhibit 1, RI is growing at a rapid pace, with nearly USD 23 trillion of assets being professionally managed as of 2016, an increase of 72% since 2012. This growth has been driven largely by institutional investors, as evidenced by more than 1,900 signatories to the United Nations supported Principles for Responsible Investing (PRI).2 These investors have committed to incorporating ESG issues into investment analysis and the decision-making process. Investor interest in ESG is driven by two key global trends. First, mismanagement of sustainability issues such as climate change, product safety, data security, and resource scarcity are having increasingly substantial financial impacts on a company’s fair value, thereby making assessment of ESG risks and opportunities a relevant enhancement to traditional financial analysis. Second, millennials, the generation born in the 1980s and 1990s, are strong believers in investing sustainably and are demanding that investment managers systematically evaluate ESG risks as well as negative environmental and societal impacts of their portfolio investments, be it for their inherited wealth or pension contributions.
EM countries are usually characterized by rapid population growth and urbanization, income inequality, and a lower quality of governance and regulatory enforcement. These characteristics make their economies more vulnerable to the ill effects of ESG issues such as extreme weather events (e.g., floods, droughts, cyclones), resource scarcity (e.g., water, food), social unrest, and corruption. Despite increased investor interest and a relatively higher investment risk exposure to ESG issues, the lack of breadth and depth in corporate sustainability disclosures has led to exaggeratedly low ESG scores and consequently restricted the rigorous application of ESG integration strategies to EM portfolios.
With a regulatory-driven momentum toward more transparent, relevant, and accurate corporate disclosures, and the increased use of technology to capture and analyze data, this sustainability information gap is quickly reducing in many emerging markets. Historically, EM companies have lagged their developed market (DM) counterparts in integrating sustainability in their day-to-day operations and therefore have, on average, ranked poorly on ESG performance. However, the performance range is quite broad. At one end of the spectrum, there are companies in the EM universe that demonstrate strong awareness and management of their ESG risks and opportunities and thus rank at par or better than many of their DM counterparts. On the other hand, there are many laggards with high levels of unmanaged ESG risks and, therefore, may expose a portfolio to black swan type events. A similar scenario exists when one looks at country-level ESG risks. This wide range of ESG performance in the EM basket makes it essential to establish robust criteria for assessing performance and integration of ESG data in an investor’s EM country and stock selection processes.
How relevant is ESG in EM?
As we will establish by using a number of examples in this section, EM economies are generally both more exposed and less prepared to manage the impact of ESG risks than DM. Therefore, it is of utmost importance that investment analysts factor in both country-level as well as issuer-level ESG risks when making EM investment decisions.
Environmental risks
The greater vulnerability to environmental impacts follows from the fact that agriculture constitutes 8% of GDP in EM versus only 1% in DM. The physical impacts of climate change, such as changing weather patterns, will be felt in all aspects of life, but we know the effects are particularly severe within activities that are highly dependent on environmental stability, such as agriculture. Unlike most developed markets, emerging economies do not have the luxury of buffers such as mass irrigation and crop insurance, leaving them vulnerable to floods or droughts. Another key environmental issue is air pollution, which comes from both consumer and industrial sources. Consumer sources include untreated waste and use of kerosene rather than piped natural gas in residential areas; industrial effects arise from a deficiency of public transportation, weak enforcement of laws capping factory emissions, and a larger prevalence of industries (e.g., ship dismantling, leather tanning, textile dyeing) with harmful by-products. Exhibit 2 illustrates the greater impact of weak environmental standards on emerging markets whether it is measured from a human or economic perspective.
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