September 2022
 

While China and India are giants of the emerging market investment world and offer huge potential, they also face some significant environmental, social and governance (ESG) challenges. Here, Newton portfolio manager Ian Smith and senior research analyst Richard Bullock weigh the prospects they may offer investors and some potential hurdles that could lie ahead.

As two of the biggest engines of emerging-market growth, China and India face a range of ESG challenges in both their domestic markets and in attracting responsible investors. From an environmental standpoint, they are also among the biggest emerging market (EM) contributors to carbon emissions, with China responsible for about 28% of carbon emissions and India seven percent, ranking them first and third in the world, in terms of emissions.¹

Yet for all this, Newton portfolio manager Ian Smith queries the way both countries have been variously blamed for their role in the current climate crisis². He points to a historic carbon build up over centuries that largely came from other sources and believes ignorance of the scale of carbon emissions in major markets such as the US is unhelpful.

“The bad environmental reputation some large EMs like China and India have gained may be, at least to some extent, quite unfounded. If you look at cumulative emissions since 1750 these countries really haven’t historically been the major source of the problem. It is also worth remembering that while India and China do make considerable emissions the US is also a major contributor.

“While critics point out a lot of offshoring of industrial and processing capacity has gone to EMs such as China and India, if you look at CO2 consumed and as a per capita basis it is roughly 10 times higher in the US than it is in India and almost three times higher in the US than it is in China. Some EMs are gaining strong progress and developing a strong track record in combatting CO2 emissions. China has made major strides in the development of its wind power. In terms of renewables and green commitments it is genuinely putting its money where its mouth is.”

Good COP, bad COP
Last year’s COP26 climate conference in Glasgow saw much debate over whether EM countries should set more aggressive carbon reduction targets. Here, Smith is again keen to defend the work markets such as China and India have already done – and are doing - to embrace renewables and tackle carbon emissions and believes it may be unfair to expect too much progress in the short to medium term.

“Given the many disparate challenges EMs face, it is not unreasonable to expect some will adopt a slower pace of change on carbon reduction than many more developed countries. There can be a tendency to overlook the progress that is being made. Encouragingly we are seeing India set carbon emission targets as China has done.

“In our view, western countries need to recognize EM economies are making significant progress on this and that they too can help via investment and technology transfer. The climate challenges ahead actually present the potential for some huge addressable market opportunities.”

From an investment standpoint, Smith sees the potential for a “win-win” scenario in India and China where major progress is made in tackling climate change and the adoption of renewables, while at the same time creating a raft of attractive new investment opportunities. He points to energy transition, clean energy and electric vehicles – in an Indian market where auto ownership is now roughly where it was 100 years ago in the US - as obvious markets already being developed. Other areas such as energy efficiency, automation and the development of smart power grids could also hold major potential, he adds.

From a macroeconomic perspective, Newton senior research analyst Richard Bullock says that while India is making steady progress on transitioning its energy sources, China is making major strides, while planning carefully for a low-carbon future.

New generation
“China is making very impressive progress in its energy transition. If you look at its power mix, just a decade ago, around 70% of its electricity generation was coming from coal and that has reduced by about 10% in just a decade. China now has a broad mix of electricity supply sources, including nuclear hydroelectric, coal and gas but also has seen some massive cumulative installation of wind and solar.

“Encouragingly, the country is attacking energy transition on multiple fronts by being open minded and not just going with one technology. It also has the advantage of having an established domestic supply chain in the country for solar power, to a large degree wind power and increasingly for battery capacity. “

On this Bullock points to the interventionist role the Chinese government is playing in nurturing this development, supporting lithium supplying companies which have been prolific in acquiring this key element for electric vehicle (EV) production and other key components of the supply chain. “China really is now on the front foot of precuring resources for its EV industry,” he adds.

Either way, both China and India are markets where key local knowledge and detailed research can help avoid investment pitfalls the two agree.

In India, limited understanding of ESG issues is not uncommon among companies, Smith says. “It is always important to analyze the data points on companies and interrogate their ESG credentials. In markets such as India it can be helpful to work with companies to assess where any strengths and deficiencies lie in terms of ESG commitments, while understanding this approach is often more novel in EM regions than in developed markets and the approach to responsible investment can be less sophisticated,” he concludes.

Emerging markets embrace ESG in fixed income
As the worst of the Covid-19 pandemic begins to fade, its legacy could provide a major boost to fixed income responsible investment in both developed and emerging markets (EM), according to Insight portfolio manager Simon Cooke.

Amid soaring new issuance in products such as impact and sustainability-linked bonds, Cooke believes lessons learned from the pandemic are helping to drive interest in responsible investment in areas which can help protect our environment and reduce inequality.

“The last two years have seen a wake-up call that has exposed the damage we’ve been doing to our environment and the sheer scale of inequality across the globe – both in emerging markets and even within large developed markets,” he says.

The good news, adds Cooke, is that reflection on these themes and growing awareness of connected environmental and social needs has led to a sharp rise in interest in impact-based investment opportunity over the last 18 months. Against this backdrop, he adds, the United Nations Social Development Goals (SDGs) are increasingly becoming an industry standard against which they are measured.

EM impact bond issuance is also on the rise. According to Cooke, China, Korea and Chile are leading the way in issuance, though the wider EM market is also diversifying at a rapid rate.

“With 99% of the world’s poorest people living in emerging markets, poverty reduction across EM has become an absolute priority,” says Cooke.

One positive note, he adds, is that responsible investment has been gaining momentum since 2019. The impact bond asset class has rapidly evolved and grown, with more than US$250bn outstanding as of April 2022, issued by 49 countries overall³. The hard currency emerging market impact bond universe now includes over 200 issuers across all major sectors.

“As investors look to identify areas offering potentially attractive total returns and positive impact, emerging market impact bonds are becoming difficult to ignore, as an increasingly diversified, rapidly growing opportunity set with the potential for positive impact needed to help support the delivery of the UN’s Social Development Goals and address key issues facing people, the planet, and prosperity,” he concludes.