The conundrum of ESG in emerging markets

Editorial note: This piece is sponsored by T. Rowe Price

Integrating environmental, social and governance considerations into emerging markets portfolios can assist investors in finding companies that outperform their peers. However, they also present challenges for managers that take ESG into consideration. ESG-related data is improving, but still lags developed markets, opening up both risk and opportunity for investors.

Further, the growth story that many emerging markets is predicated upon comes with some significant risks in terms of climate emissions, varying standards of corporate governance and concerns over issues like occupational health and safety, worker rights and other considerations.

The MSCI Emerging Markets ESG Leaders index has outperformed the wider MSCI Emerging Markets index this year - returning 4.56% to the end of September, compared to -0.91% for the wider Emerging Markets index to the same date.  By comparison, the MSCI ACWI had a year to date return of 1.77% and the MSCI World index had a return of 2.12%.

It has long been a perception that ESG data in emerging markets has lagged that of developed markets. While true historically with information improving, gaps in ESG information can mean that companies in emerging markets are more exposed to ESG risk.

In 2019, research provider Sustainalytics compared the stocks comprising the FTSE Emerging Index with the stocks comprising the FTSE Developed Index, and found emerging market stocks are exposed to over 14% more unmanaged ESG risk. Sustainalytics also noted that a further indicator of the higher ESG risk facing EM equities is that 10% of the FTSE Emerging Index falls into the severe ESG risk category, compared to just 3% of the FTSE Developed Index, the report found.

Nevertheless, an overly generalised view that all emerging markets and all emerging market companies are deficient in measuring, managing and reporting on material ESG issues can present opportunities for active investors to identify mispriced companies were ESG standards are either strong or on the upswing.

A 2015 article, ESG and financial performance: aggregated evidence from more than 2000 empirical studies by Gunnar Friede, Timo Busch and Alexander Bassen, published in the Journal of Sustainable Finance and Investment found a high correlation between emerging market companies with strong ESG performance and strong financial performance.

It is thus possible to combine both approaches - an active manager portfolio construction strategy that integrates ESG considerations - to achieve risk adjusted returns for clients. This investment belief permeates asset classes - fund managers from equities to private markets have previously told FS Sustainability that constructing a portfolio on the thesis that emerging markets are drastically underserved in terms of both products and services and by focusing on investments that prudently consider ESG material issues can provide a source of long term financial return.

Q&A with Irmak Surenkok, portfolio specialist in the Equity Division at T. Rowe Price

Q: How do E, S and G factors influence the consideration of Emerging market stocks?

A: Governance has been an important consideration in emerging markets, and environment and social issues are increasingly gaining importance for these corporates. From our perspective, these are important factors that will contribute to the long term sustainability of the business.

The most common issues we observe in environmental and social considerations when we do our research is a lack of disclosure and preparedness. Our solution to this is to regularly engage with companies and move them in the right direction.

Q: How do ESG megatrends and global events play into the growth story of emerging markets?

A: We like to invest in fundamental change that can help companies improve their operations in the mid-to-long term. These can be governance-related, such as an improvement in management which means that they now favour minority shareholder interests. For example, when management incentives become more aligned with minority shareholders' interests, this can unlock value in the share price. But other considerations can be a really fine balance in emerging markets. We are very cognisant that some of these heavy polluting and carbon emitting companies are a necessity in emerging markets. As a principle, we do not like to invest in coal, but on the other hand, we do recognise that a country like India cannot run hospitals, schools, fire stations, etc. without using coal-fired generation.

Q: You've noted that ESG can be used to avoid so-called value trap companies in emerging markets. How does that play into your analysis?

A: We do not invest in companies with harmful products and behaviours which is where we can see a lot of value traps in this region, there are no marginal buyers for these companies. Again, corporate governance is a key consideration in the region where many businesses are still family or state owned. When investing in such companies it is very important to understand the way management is incentivised. Are their interests aligned with minority shareholders' interest? Such considerations and in depth fundamental research can guide us to avoid value traps. An improvement in the way a company handles ESG factors can also be a positive sign that will prompt us to do a deep dive on a corporate. We could end up investing in companies with a low ESG perception if we see that they are, for example, providing remedial action to correct a past incident or if we gain comfort that some corruption allegations have been officially cleared. If the company is actively taking care of these problems, we will gain comfort and be willing to give them the benefit of the doubt in some cases.

We like to hold our shares for a three to five year horizon. In our emerging market value products, we actually invest in undiscounted change. We aim to identify where fundamental changes are happening and we like to give the company enough time to make these changes, so at least two to three years to see the results. If we do not see a stock price react following fundamental change, this can often be sign of value traps.

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