Investing sustainably in emerging markets – a call to action

When assessing the ESG risks and impacts associated with EMDE assets, and to inform engagement activities, asset managers can contextualise these by using resources such the country’s Nationally Determined Contribution (NDC), considering these assets through a Just Transition perspective, and using region- or country-specific transition pathways, scenarios and modelling  (bearing in mind that region-specific pathways are in principle easier to use for sovereign bond holdings, and more work is needed to juxtapose sectoral and regional decarbonisation expectations to the corporate level).

Pathways should reflect the ‘common but differentiated responsibilities’ principle embedded into the Paris Agreement and be flexible on timelines. For example, asset managers might expect assets in developed countries to decarbonise by 2030 or 2040, while EMDE assets might be expected to decarbonise by 2050 (acknowledging that the practice of introducing shorter timeframes for developed country assets is not yet widespread). Asset managers may also find it helpful to use the data, scenarios and country-specific pathways (including for some EMDEs) developed by the One Earth Climate Model (OECM), which was developed by the University of Technology Sydney. While there are some practical challenges around the OECM model, such as the high level of ambition (1.5C pathway only and no overshoot), OECM includes pathways for several EMDEs and recently consulted on further models for Tanzania, Kenya and Rwanda (NZAOA compares the OECM with the International Energy Agency’s Net Zero by 2050 model here). IIGCC’s discussion paper and framework on sovereign bonds and pathways may also be useful.

This approach, and particularly the use of pathways, scenarios and modelling, helps investors assess projects and assets based on the trajectories countries have set for themselves, and avoids assessing assets using external standards or pathways developed for developed countries which may be inappropriate. In addition, to further prevent unintended divestment from EMDE assets, asset managers can develop differentiated screening approaches.

In following this approach, the overall emphasis should remain on sustained improvement focusing on impact, and there should be no lessening of the overall commitment to transitioning, however the approach and tools used should be appropriate to the asset.

When carrying out investor stewardship and engagement activities, asset managers can develop approaches that incorporate regional context. Such an approach could include working alongside local partners when engaging with companies and updating engagement and proxy voting policies to reflect regional and country-specific norms and areas of focus. As well as engaging with EMDE assets, managers can also engage with other regional and country-specific actors that can indirectly influence assets to improve their performance, such as regulators, government, industry associations and other financial institutions providing capital to EMDE companies. Asset managers that have developed these approaches have noted the importance of setting short and long term targets and finding a balance between meaningful change and regional-specific nuance.

Engagement with assets as they become more sustainable, and encouraging them to do so, can be a viable alternative to immediately divesting from assets perceived as ‘brown’ or unsustainable.

Where asset managers have introduced firm-wide ESG policies or positions (for example climate policies, proxy voting policies, responsible investment policies, screening policies, stewardship policies or firm-level sustainability ‘red lines’ e.g. positions on phasing out investment in fossil fuels), then these can be updated to reflect regional context – while retaining overall discipline and acknowledging that some asset types may ultimately require phase-out – to avoid unintentionally impacting EMDE assets.

Before starting this process, it may be helpful for asset managers to carry out a preliminary assessment of the impact of sustainability investment strategies and ESG-related policies and positions on their allocation to EMDEs, both in total and for individual countries. Should asset managers carry out such an assessment they can share the results with their clients. This initial step will be helpful in raising awareness, both internally and externally (when sharing with clients), about the impact sustainable investment strategies and ESG policies/positions have on their allocation to EMDEs.

Sustainability-related information is important to investors operating in EMDEs. However, financial institutions have flagged that some ESG data and ratings may be skewed in favour of developed countries and penalise EMDE assets. For example, there is evidence to suggest that ESG ratings are systematically lower for EMDE companies[1][2][3][4].

To manage this, asset managers should use (or continue to use) ESG data and ratings while incorporating regional overlays or adjustments (to avoid holding assets to exactly the same standards as in developed countries), or use the underlying data instead of relying on the rating. This underlying data may provide a fuller picture of the ESG risks and impacts associated with an EMDE asset. Some asset managers have also developed ESG data and ratings specifically focused on EMDEs.

[1] IMF, 2022, Global Financial Stability Report, Chapter 2: Scaling up Private Climate Finance in EMDE: Figure 2.5. ESG Scores and Fund Allocations Are Systematically Lower for Firms in Emerging Market and Developing Economies https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=&ved=2ahUKEwjI4YbHmOb6AhVER3wKHdhrAcUQFnoECBYQAQ&url=https%3A%2F%2Fwww.imf.org%2F-%2Fmedia%2FFiles%2FPublications%2FGFSR%2F2022%2FOctober%2FEnglish%2Fch2.ashx&usg=AOvVaw2EwPMf2Uc_jIeQ_XdHrgbC

[2] Gratcheva, Ekaterina, Bryan O’Reilly Gurhy, Andrius Skarnulis, Fiona Elizabeth Stewart, and Dieter Wang. 2022. “Credit Worthy: ESG Factors and Sovereign Credit Ratings.” Report, World Bank, Washington, DC.

[3] Mobilist research (exec summary, page 5) Drivers-of-Investment-Flows-to-Emerging-and-Frontier-Markets.pdf (mobilistglobal.com)

[4] IMF on EM Asia : Unlocking Climate Finance in Asia-Pacific: Transitioning to a Sustainable Future (imf.org)

Several resources setting out best practice for investing sustainably in EMDEs (covering both allocation and engagement) have already been developed, and will be useful to asset managers looking to align their sustainable investment strategies and approach to ESG with investing sustainably in EMDEs. These resources include:

• UN PRI – ‘Closing the funding gap: The case for ESG incorporation and sustainability outcomes in emerging markets’
• Net Zero Asset Owners / ASEAN / WEF – ‘Code Red! Call for Urgent Action on Emerging Markets Transition Investment (EMTI)’; ‘Code Red! Call for Action on Responsible Corporate Engagement in Emerging Markets’;
• Church of England Emerging Markets Just Transition Investment Initiative: Guiding Principles.
• Upcoming guidance and best practice by other industry bodies including IIGCC.

The above best practice examples will be useful to asset managers in avoiding inadvertent ESG-related divestment from EMDEs, while operating within their mandates.

As set out previously, there are multiple reasons why asset managers may choose to invest in, not invest in, or divest from different assets, with multiple factors impacting each investment decision. In addition, the extent to which each individual factor has impacted the decision may not be clear. However, in instances where an asset manager’s sustainable investment strategies or ESG policies and positions are clearly the primary driver behind the decision to divest from an EMDE asset, asset managers can also choose to maintain their overall exposure to EMDEs by strategically searching for reinvestment opportunities in other EMDE assets. In doing so, managers should be mindful that engaging with assets may still be a more appropriate response than shifting their portfolio to greener assets within the same country or region.

WBA also assesses asset managers on whether they disclose their overall assets under management (AUM) in EMDEs as part of our Financial System Benchmark (Indicator 19ii: “The assessed entity discloses the amount and/or share (in monetary terms) products, services and capital provided to low-income and lower-middle income countries.”).