Emerging markets (EM) have historically suffered from what the Financial Times, in 2017, referred to as the “perception deficit”. This means that, although there are of course risks associated with EM investment, the perceived risks are often higher than the evidence shows.
This disparity between fact and fiction has been especially pronounced in emerging market debt (EMD). Far from being an obscure and risky outpost of fixed income, a close assessment of risk factors in EMD shows that it has many qualities similar to, or even better than, other asset classes treated as core allocations. Despite this, investors still have not embraced EMD to the extent that could be justified by its risk and return profile.
The perception deficit has appeared most recently in the rise of environmental, social and governance (ESG) factors. There are skeptics in the market who believe ESG analysis has no place in EMD. We think this view is misplaced. Here, we pick out some of the most common myths to bust.
Myth: ESG doesn’t work for sovereign bonds
There has historically been less focus on using ESG factors to evaluate sovereign debt than corporate debt. Most investors consider country-scale risks and opportunities when allocating capital, but there is limited integration of longer-term sustainability issues in traditional macro-economic analysis.
Even so, the importance of sustainability factors to sovereign performance is growing hand-in-hand with concerns around a future climate change “tipping-point”. But how do you do it?
We think that the traditional approach to sustainability using the ‘E’, ‘S’ and ‘G’ pillars doesn’t meaningfully convey how underlying country economics and asset prices are affected.
Our approach to quantifying the ESG risks in EM sovereign debt starts with an established economic model known as “Solow Growth”, which models the per capita productivity in an economy. We then assess the sustainability of that productivity using a range of metrics, such as access to healthcare or electricity, or the level of social equality, to name just a few. These factors ultimately form a view of risks to, and opportunities for, a country’s development and the value of sovereign assets.
Myth: ESG information isn’t available for EM corporates
Some investors take the view that transparency is an issue for EM companies and, in truth, information regarding company practices can be more challenging to source. However, this improves the opportunity set for active managers. This is especially true given the importance of the “human factor” – the aspects of sustainability which are difficult to quantify – in ESG assessments.
Indeed, the fact that it is more difficult to source ESG information makes research analysts’ work that much more valuable. Any information that is not well-known by the market can be used by analysts to generate alpha.
Ownership structures and governance standards vary significantly across different emerging market countries. Some represent weaker corporate governance, while others simply fit into different conventions and legal systems.
ESG analysis on EM corporates can potentially add a valuable additional layer of downside protection for portfolios, by distinguishing whether companies’ corporate governance reflects different conventions or actual governance risks. Anecdotally, any company that engages seriously with ESG issues raised by investors - in emerging markets or otherwise – also tends to be more disciplined and detail-oriented.
Myth: You don’t need in house ESG analysis
The complexities - described above - of gathering ESG information in EMD analysis make in-house research essential, in our opinion. There is even less consistency between the conclusions drawn by ESG rating agencies, when looking at the same company within emerging markets, than is the case in developed markets. This makes thoughtful analysis particularly impactful in EM.
Probability of ESG scores being in the same quintile - developed and emerging markets
Source: MSCI, Thomson Reuters, Sustainalytics
By way of example, we recently came to a very different ESG assessment of a Chilean electricity generating company compared to third-party ESG providers. This helped form the basis for a positive investment recommendation. The company was scored poorly by third party analysis because of its carbon-intensive energy generation mix. However, that assessment did not look at the whole picture.
The firm’s generation mix was due to a lack of existing renewable infrastructure in the areas of operation, and in fact, the company’s mix was on an improving trajectory. It has 642 megawatts – enough to power over 700 average US homes for a month – of renewable projects under construction, as well as the scheduled closure of coal fired plants in 2022 and 2024.
Our integrated ESG approach means that the analyst can balance ESG risks against what is being priced in by the market. If the analyst believes ESG risks are lower than the market is pricing into bond yields, it could produce an opportunity.