Corporate governance standards are gradually improving in the emerging markets and increased focus on environmental, social and governance (ESG) factors is expected to drive corporate transparency further, says Insight Investment ESG analyst Joshua Kendall.
A signatory of the United Nations-backed Principles for Responsible Investment (PRI), Insight believes environmental, social and governance considerations are equally applicable for investing in the emerging markets as they are for developed ones. Joshua Kendall, ESG analyst, believes the focus on ESG in emerging markets (EM) is on evaluating long-term risk factors.
Insight sits on an industry committee that aims to improve the use of ESG research by credit rating agencies (CRAs). The committee believes ESG factors require greater prominence within credit assessments, which should encourage an improved link between ESG risk criteria within credit reports and credit ratings. CRAs play a crucial market role as they provide independent reviews of business strategy, financial performance and issuer idiosyncrasies. The momentum achieved so far should lead to more companies’ cost of capital being tied to ESG performance, says Kendall.
Increasing ESG information by more market participants beyond CRAs should have two significant effects, observes Kendall. First, companies will be expected to disclose more—essential where transparency is inadequate, as is often the case in emerging markets. Second, it may encourage improved corporate performance in ESG-related themes as companies become more cognizant that ESG performance links to investors’ evaluation of an issuer.
Insight acknowledges that corporate governance standards are already improving in the emerging markets, comments Kendall. As that improvement takes place, integrating ESG in investment processes may help identify companies lagging their peers or where there is an increasing possibility things can go wrong. In the past, credit investors have been particularly affected by the poor disclosure of financial statements and weak covenants. ESG can be seen as a risk variable alongside other salient factors, such as liquidity, leveraged buyouts or specific events and changes in regulation.
FILLING THE GAPS
More accurate and relevant information can translate into better investment decisions, says Kendall. However, for many smaller issuers, especially in the emerging markets, the availability of relevant non-financial data often lags behind that for larger issuers. While ESG research from independent third-party providers of investment-grade issuers is around 95% (by market weight of popular corporate indices), emerging market issuers have lower coverage in popular corporate indices, he notes.
In those instances, where independent ESG analysis cannot be sourced from market data providers, an alternative approach is to ask company management directly to conduct a self-assessment survey on ESG factors. A refusal to comply can be taken into account in the credit assessment of the issue, comments Kendall. This selfassessment can also be used to generate an ESG scorecard. As bonds are often held to maturity, investors need to be confident in the management and the financial position of the companies in which they invest.
As it stands, there is also an argument that CRAs do not always assess ESG risks in a consistent or fully transparent manner, failing to capture the relevant key indicators and leaving them hidden behind other information, says Kendall. The impact environmental risks can have is particularly illustrative.
For example, a Singaporean commodities trader has been affected by a number of reputational concerns. Among these, the company was implicated as possibly contributing towards deforestation in Indonesia, which the firm strongly denied. Governance concerns were well-documented, especially those related to the board of directors. These problems became apparent in a series of related party transaction risks, a boardroom power struggle, executive turnover and accounting problems. These have been a distraction for the business and its strategy, causing financial conditions to worsen, Kendall says. Credit default swap spreads subsequently ballooned and CRAs effectively considered the company in default of its debt.
There may well be concerns surrounding governance in the banking sector across emerging markets given complex ownership structures and interference from large shareholders and/or governments. There is also the potential for money laundering and corruption, particularly given sprawling networks across vast terrain. Kendall says accounting practices can be opaque, while the transition towards and implementation of international financial reporting standards can be a complicating factor. Another element that adds complexity is that there is often the partial ownership of banks by industrial groups and the politicization of lending and regulatory decisions. Engagement and evaluating ESG ratings can help determine whether there are financial risks to price.
SCREEN TEST: ESG IN ACTION
The growth in interest in emerging markets as an asset class over the past two decades has converged with the increased desire to incorporate ESG into investment policies generally, according to William Cazalet, head of systematic equity portfolio management at BNY Mellon Asset Management North America (AMNA).
While ESG data has long been established in developed markets, coverage of emerging market companies has only become more broadly available relatively recently (i.e., in the past few years). It is now possible to tilt portfolios towards companies that score more positively in terms of ESG in the emerging markets, he observes.
Cazalet says the ESG information available in emerging markets is also now on a more granular level: it is feasible to drill down not only to “Environmental,” “Social” and “Governance” levels but to focus on specifics, such as water stress or supply-chain labor standards.
This more granular approach can help to identify companies that may have an adverse environmental impact, such as petroleum companies or utilities. With manufacturers in countries such as Taiwan, there can be concerns around employment practices and employee welfare, he observes.
Good examples of information providers are MSCI ESG Research and Sustainalytics, which lend themselves to both negative and positive screens, he adds.
Cazalet sees raised standards as evidence of greater adherence by emerging market exchanges and, by extension, the companies listed on them, to reporting criteria such as Generally Accepted Accounting Principles and International Financial Reporting Standards. The Global Reporting Initiative’s (GRI’s) Sustainability Standards are also making inroads in the emerging markets. (GRI is an independent international organization that has promoted sustainability reporting since the late 1990s.)
For Cazalet, in trying to evaluate the long-term benefits of incorporating ESG into an investment process, it is also important to have as long a historical set of data as possible in order to understand how stocks perform in terms of ESG criteria over an extended time frame.
According to Karen Q. Wong, head of equity portfolio management at BNY Mellon AMNA, this trend—mostly driven by investor demand—gathered momentum, particularly after the global financial crisis. In Wong’s view, the lack of focus on governance was a contributing factor to the crisis.
As mainstream investors have started to look for ESG risk-adjusted returns, the positive screening approach has tended to predominate, says Wong. This has evolved into a “best-in-class” approach with regards to sectors or countries and investing more into “good” companies and less into “bad” ones. There has been a more systematic integration of ESG data in portfolio construction, she notes.
Wong believes there are more opportunities in emerging markets as well as greater efficacy. For instance, in terms of carbon reduction, it can be possible to engage with an emerging market company to achieve a higher reduction in carbon emissions for the same level or at a lower level of risk than with a company in the developed markets.
A possible threat to the convergence of trends between emerging and developed markets is the potential introduction of more protectionist trade policies in the U.S., says Cazalet. These could force emerging markets to take a more protectionist stance in return and may stall or slow the progress of that convergence. However, he notes there has already been considerable progress in this respect, citing how companies in South Korea or Taiwan compete with their counterparts in developed markets in many sectors.