S&G Later in Alphabet Saps Screening Order

ESG has become one of the trendiest topics for investors in the wake of the Covid-19 pandemic which highlighted global social and governance disparities as many countries battled “once in a century” climate events like droughts and floods. While green bonds have been issued by emerging markets corporates and sovereigns, many have been called out by investors for “greenwashing.”  Poland, for example, issued a green bond but many investors noted that it is the only EU country that has refused to sign onto the bloc’s 2050 climate neutrality goal, while some have dumped Indonesia’s due to deforestation risks.

Absent global benchmark metrics for measuring ESG, some dedicated emerging markets investors have embraced the MSCI EM ESG Leaders Index. Annualized returns of the ESG Index at 14.5% the past decade have outpaced the broader MSCI Emerging Markets Index.  Morningstar estimates that actively managed ESG funds globally total over USD 2 trillion, of which emerging markets funds account for only USD 194 billion. 

Traditionally, the argument for investing in emerging and frontier markets has been faster economic growth, a growing middle class, and a younger population.  Post-pandemic as debt and deficits weigh and US Treasury yields rise, some are questioning the attractiveness of the overall emerging market asset class.  However, the IMF, in its just-updated World Economic Outlook, projects that despite country/regional disparities that emerging market growth will continue to outpace advanced counterparts the next two years with the former expanding at 6.7% and 5.0% against 5.1% and 3.6%.  With China as an exception, EMs have vastly younger populations than advanced economies, with millennials and “Generation Z” who are actively embracing sustainability.

Assessing ESG is arguably more difficult in emerging markets. There are clear quantitative environmental targets that can be measured including waste production, water consumption and carbon emissions However, there are a scarcity of data on social and governance issues, particularly in smaller markets.  While some sectors are deemed “safe” from the environmental perspective, including tech and finance which make up the biggest weightings in ESG indices, the social and governance issues are more difficult to discern due to confusing and incomplete reporting and in smaller markets less experience dealing with minority investors. 

The heavy weighting of fast-growing technology companies in emerging Asian markets has sent ESG funds pouring into the region.  Last year emerging Asia attracted 75 cents out of each dollar of ESG-dedicated capital invested across all emerging economies, according to EPFR Global data, a trend that is accelerating this year. While Asian growth outpaced other regions last year on virus containment, many ESG investors also cite China’s pledge to achieve carbon neutrality by 2060 and South Korea’s ten years earlier goal as rationale for Asia’s heavy weighting. However, China, which accounts for nearly half of EM indices, is still building new coal plants, relies on it for nearly 60% of its energy needs, and consumes half of the world’s supply. It also cut subsidies for electric vehicles without warning in 2019, leading to questions if the plan for carbon neutrality is an empty public relations promise. Other regions in the emerging market universe face different challenges.  A recent study from London’s Imperial College of large asset managers and global banks found many commodity and energy producers in other EM regions are unable to raise green finance.  The report argued that polluting countries and industries in EM could first issue “transition bonds” which could tie the issuer’s borrowing rate to specific incremental environmental targets. 

The ESG focus is still largely on the “E,” as the most visible and quantifiable acronym slice in macroeconomic terms.  The Jubilee Debt Campaign found that in some African countries up to 10% of GDP has been diverted in recent years to address the growing costs of climate change due to unprecedented droughts and flooding, while a recent Morgan Stanley global poll found more than two-thirds of respondents expect climate change to be the biggest driver of share prices this year.  However, the social and governance issues, while difficult to measure, are equally as important as emerging economies begin to bounce back from the pandemic’s economic and social destruction, and broader inclusion and sustainability instruments proliferate to forge their own asset classes and performance metrics that could gain earlier universal acceptance.   

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