Unlocking the ESG investment potential in emerging markets

Sustainable investing is more than about seeking companies with impeccable environmental, social and governance (ESG) profiles. It is also about uncovering companies that are improving their ESG footprints - and their disclosures go a long way towards signalling and evidencing such progress. Yet, across emerging markets (EMs), corporate ESG disclosures are uneven and broadly lag those in developed markets.

Individual EMs are developing at different speeds, both in terms of stages of economic development as well as regulation. There are unique ecosystems and different drivers in each individual EM, as compared to developed markets.

Investors relying solely on published information to assess EM companies’ sustainability plans risk missing the incremental change in trends. Therein lies the opportunity for investors who can look beyond the surface.

Varied disclosure landscape

Sustainable investing is too often associated with the search for companies with best-in-class ESG credentials, but that focus can overshadow the investment opportunities in companies incrementally improving their approach. This pitfall deserves particular attention in emerging markets, where the perceived ESG gap relative to developed markets has kept many companies off some sustainable investors’ radars.

That caution has persisted despite EMs’ improving ESG-disclosure trends over the years. We looked at data compiled by Bloomberg, where various markets were scored on their ESG disclosures; using these ESG disclosure scores as a proxy, we found that ESG disclosure scores in selected EMs were higher than those in developed markets.

The data showed that levels of corporate ESG disclosure varied widely across emerging markets, with select markets such as Brazil and South Africa scoring better than the US. Markets such as India and Malaysia also scored comparably well. Taking a broad-brush view of EM companies’ disclosure deficit would discount the pockets of strong reporting practices that exist.

What we also find promising is the growing transparency that most EM companies have displayed in recent years. The faster pace of advance for EMs could partly reflect the lower base that they started from, and we think they have room to progress further.

Paving the way forward

Market-wide sustainability and governance policies and initiatives are gaining ground in the developing world. We expect this trend to encourage companies to improve their disclosures and public accountability.

As EMs grow and evolve, we believe engaged active owners partnering with policymakers, regulators and stock exchanges can improve corporate governance and help raise awareness of sustainability factors. Our engagements go beyond the corporate level, and we have been heavily involved in driving the agenda around policy advocacy to foster positive outcomes.

In Singapore, for instance, we provided guidance to the Singapore Exchange on 2 consultations – one on a common set of Core ESG metrics and one on Climate and Diversity. We also provided feedback to policymakers in Singapore advocating for a materiality-based approach, including reference to the Sustainability Accountings Standards Board to give investors industry-specific insights, among others.

We believe that some of the most overlooked sustainable investment opportunities in EMs lie in companies making incremental improvements on these ESG factors. Evolving ESG disclosures - and their impact on investors’ ability to perceive and position for these transitions - will be key to watch.

Opportunities in net-zero race

The Paris Agreement, which has been signed by all country constituents of the MSCI Emerging Markets Index, focuses on the decarbonisation of economies.

Individual EMs have announced climate-change policies to limit and reduce emissions, as well as plans to tackle major environmental concerns. Examples include China, which has committed to peak carbon emissions by 2030 and to reach net-zero by 2060, and India which has committed to net-zero emissions by 2070.

Current commitments by some of the largest EMs fall short of the global ambition to meet net-zero commitments. However, one of the advantages that emerging markets have over their developed peers is their ability to leapfrog technologies. Clean energy stands out as one such opportunity.

As the demand for electricity rises, governments could build capacity in renewable energy sources as opposed to relying exclusively on carbon-intensive technologies for electricity generation. By contrast, developed markets potentially have a surfeit of fossil fuel “stranded assets” requiring decommissioning.

Furthermore, the transition to clean energy in EMs should boost demand for materials produced in Asia, particularly in the solar industry where China is a leader, producing almost 75 per cent of solar modules globally. Both emerging and developed markets are expected to significantly increase installation of solar photovoltaic (PV) systems, with the annual market size expected to grow 5-fold as the industry matures.

Polysilicon is a key material in the solar PV industry, and the Asia-Pacific is expected to be the dominant producer globally. The region is also forecast to be the fastest-growing market for polysilicon between 2020 and 2025, led by increasing demand in China and India.

Research, engagement and partnership

Seeking companies with incremental improvements in ESG scores is challenging for investors without the resources and relationships to make well-informed assessments. While third-party ESG ratings are available, research agencies differ in the scope and focus of company coverage.

Data gaps and subjectivity can also lead to inconsistent ratings. A CFA Institute paper, “ESG Ratings: Navigating Through the Haze”, showed that ESG scores amongst third-party research providers have a very low level of correlation. This puts investors without an on-the-ground presence in a challenging position.

We use published information as a starting point for research and incorporate our own findings to form forward-looking views on companies’ ESG prospects. The additional work requires in-depth local studies of individual markets and companies, as well as first-hand access to managements and other stakeholders.

Active, bottom-up sustainable investing is a journey, as opposed to a destination, and meaningful ESG improvements take time. This makes sustainable investing about identifying companies seeking or making progress on their ESG transition, just as it is important to spot existing ESG leaders. However, varying levels of ESG disclosures in EMs are likely to keep investors from getting a full view of companies’ ESG direction.

Even amid growing transparency, we still find proprietary on-the-ground research and long-term engagement with companies, regulators and policymakers using a long-term partnership approach to be the best way to bring about sustainable growth and development.

Our experience investing in EMs has shown us the difference that deep relationships with companies can make. Mutual trust and two-way communications often pave the way for us to partner with investee companies in exploring and shaping improvements in ESG disclosures and other areas.

All this work, if done well, could add up to a competitive advantage in spotting ESG advancers before the rest of the market has adequately priced in their prospects.

The writer is portfolio manager at Franklin Templeton Emerging Markets Equity.