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BY STEFFEN REICHOLD, Stone Harbor Investment Partners

Sustainable investment assets globally reached $30.7 trillion at the start of 2018, an increase of nearly 35% in two years, according to the Global Sustainable Investment Alliance. And while the majority of these assets are invested in equity strategies, bond investors are actively participating in the growth of environmental, social and corporate governance, or ESG, investing through various approaches, including purchasing green, social and/or sustainable bonds, launching ESG funds, benchmarking against ESG indices, and embedding ESG factors into the overall investment framework. 

In our view, integration of ESG factors into the fixed income investment process is complementary with fundamental credit analysis and engagement activities with sovereign and corporate issuers. Importantly, active investor involvement can drive change and positively affect sovereign and corporate issuers by creating incentives for them to improve ESG performance and by supporting economic development through fixed income investments.

Of the primary ESG factors, governance is particularly important to bondholders due to the impact it can have on improving institutions and on the rule of law that supports economic development. From a bondholder’s view, the sovereign’s commitment to political stability and security, and the strength of the institutional framework that supports the financial sector are strong indicators for improving creditworthiness. Considerations that are particularly relevant with corporate issuers include management incentives to ensure that their actions do not disadvantage bondholders in favor of stockholders, the structure of the board of directors, and the nature of the shareholding structure, among other factors.

Social issues and environmental factors, while still relevant and important, are somewhat more narrowly applicable compared to the governance factor. For a bondholder, the ability to influence social issues (e.g., worker rights, fair pay and adequate living standards, etc.) is limited. However, where these social issues are inequitable, concerns about the stability of the country are raised, along with questions about the sovereign’s ability to service its debt. Environmental factors are crucial for sectors such as the extractive industries. Again, from a credit perspective, the ability to effectively manage environmental risks (e.g., lapses and accidents) is a key concern as the company’s approach could have significant economic implications for the company, thereby affecting its debt servicing capabilities, as well as causing potential fatalities.

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Improvements in ESG scores, particularly as they apply to governance, are often connected to better returns as the market prices in the improved fundamental (and thus lower risk premium). Therefore, the incentives for both issuers and investors to take actions to positively impact ESG scores are clear: improved ESG factors tend to be associated with lower spreads and thus better returns, benefitting bondholders; and countries and corporations that experience improving ESG scores also tend to undergo economic development and reduce their borrowing costs.

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The increasing demand for fixed income ESG products have also led to the development of tools for investors. Morningstar introduced their Sustainability Rating, which measures how well the holdings in a portfolio are performing on ESG factors relative to a portfolio’s peer group. Fixed income ESG indices have also been developed to provide a comprehensive and efficient coverage of the investable universe. For the JP Morgan ESG index suite, weights are set by scalar as determined by ESG score. For fixed income asset managers, tools that aid in analysis of ESG factors and provide better transparency are critical in managing ESG strategies.

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The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Stone Harbor Investment Partners nor TEXPERS, and are subject to revision over time.

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BY BLAKE S. PONTIUS, William Blair Investment Management

The January 2019 collapse of a Brazilian mine tailings dam—which released 11.7 million cubic meters of toxic mud, killed at least 150 people, and led to a corruption probe—underscores the critical but underappreciated value of environmental, social, and governance (ESG) considerations in emerging markets.

ESG: More Important in Emerging Markets?

The majority of ESG-aware asset managers surveyed by Citi Research in October 2018 expressed the view that ESG factors are more important in emerging markets than developed markets, particularly from a corporate governance risk perspective.

Generally, weaker corporate governance practices in emerging markets relative to developed markets have played a role in shaping this opinion. More seasoned, quality-focused investors have long appreciated the need to be sharp on governance considerations when investing in frontier countries such as Kenya and Argentina, as well as the more mainstream countries such as China, India, and Brazil.

We’ve seen a variety of environmental and social issues become increasingly relevant to investors.

Emerging markets have more state-owned enterprises, necessitating a higher level of scrutiny of governance practices by prospective investors. While varying across different countries, there is generally a greater prevalence of family founders with majority stakes within emerging markets. Lower rates of board director independence and weaker corporate transparency are other realities contributing to the elevated governance risk profile.

Beyond these more obvious considerations related to governance and business culture, we’ve seen a variety of environmental and social issues become increasingly relevant to investors. From an environmental perspective, combating air, soil, and water pollution is becoming a more significant focus of government policy in China and India. And from a social perspective, investors are increasingly scrutinizing how companies are managing broader stakeholder relationships that can materially impact financial performance.

Back to the Brazilian Dam Disaster

The latter point takes us back to the Brazilian dam disaster.

The resource-intensive energy and materials sectors continue to play an important role in the socioeconomic welfare of many emerging and frontier economies, with concomitant ESG risk factors that can have severe consequences beyond share price performance.

For example, mining companies that operate in environmentally sensitive areas where indigenous populations live have to be thoughtful about how they develop resources. They must also ensure the safety of their employees through ongoing capital investments and training.

Brazil’s Vale SA, which owns the dam that collapsed in Brumadinho, knows that all too well. The company has since announced that it will close all 10 of its dams in the country with a similar design. 

Ratings Reflect Greater Risks, but also Opportunities

These risks can be seen in the ESG ratings distributions of emerging versus developed markets. Conventional ratings distributions, such as the one shown below from MSCI, reflect a negative skew in emerging markets relative to developed markets. (Applying MSCI’s ratings methodology, CCC is the lowest ESG rating assigned to companies on an industry-relative basis and AAA is the best.)

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This negative skew in ESG ratings reflects some of the risks I discussed above, with a consistent overhang being weaker governance structures for companies across different sectors within emerging markets. Companies lacking a majority independent board, for example, are systematically penalized. The existence of a combined chairman and CEO or dual share classes with unequal voting rights are also detrimental to the rating.

Over time, we expect ESG ratings for emerging market companies to broadly improve as more capital flows into ESG-focused equity and fixed-income strategies, and as more asset managers integrate ESG considerations in traditional strategies.

Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Growth of ESG Assets in Emerging Markets

We’ve already seen tremendous growth in ESG-focused emerging markets fund assets, from less than $1 billion in 2008 to $20 billion in 2018, as measured by EPFR and Citi Research. Emerging market ESG funds now account for nearly 10% of global emerging markets funds, up from just 2% a decade ago, as illustrated below.

Asia ex-Japan represents a significant percentage of ESG-focused assets in emerging markets based on data collected by the Global Sustainable Investment Alliance (GSIA), with the largest markets for sustainable investing being Malaysia (30% of total professionally managed assets), Hong Kong (26%), South Korea (14%), and China (14%).

Malaysia’s prominence may come as a surprise considering the high-profile scandal involving its state-owned investment fund, 1MDB. Similarly, China’s inclusion on the list of prominent ESG markets contradicts the conventional perception of weaker governance given the role of state-owned enterprises (SOEs) and environmental mismanagement (ambient air pollution kills hundreds of thousands of citizens every year, according to the Chinese Ministry of Health).

But, perhaps surprisingly, according to a recent biannual review of corporate governance practices in Asia by research firm CLSA, Malaysia was the “biggest mover in 2018,” climbing to 4th place in Asia’s corporate governance market ranking.

And China was the fastest-growing market for sustainable investing from 2014 to 2016, according to the GSIA. Sustainable assets there were up 105%, followed closely by India (up 104%).

Much of that growth was driven by investment opportunities arising from public policy initiatives to clean up the environment, including China’s efforts to improve air quality by working to transition away from coal toward natural gas and renewables.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of William Blair Investment Management nor TEXPERS, and are subject to revision over time.

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