Ignoring sustainability in emerging markets debt is, for want of a better term, no longer sustainable.

Today’s CIO Weekly Perspectives comes from guest contributors Sean Jutahkiti and Kaan Nazli.

Delegates from almost 200 countries will head to Glasgow next weekend for the 26th United Nations Climate Change Conference of the Parties to the Paris Agreement (COP26). There is no better illustration that sustainability is a truly global issue.

And yet sustainable investing all too often stops at the border with the emerging world. While Environmental, Social and Governance (ESG) issues are now a leading topic of conversation in emerging markets, the differences between sustainability factors and ESG performance are often confused, in our view.

We think that the active, engaged and forward-looking perspective of genuinely sustainable investing is critical because of the rapid evolution of the sustainability landscape in these regions, particularly Asia. But this approach can appear challenging when it comes to emerging markets bonds, and even more so when they are issued by sovereigns.

Raising Capital

Data suggests that emerging countries contain around 80% of world’s population, contribute around 60% of the world’s GDP and generate two-thirds of its carbon emissions. Regarding environmental development alone, HSBC has estimated that China needs to invest RMB200 trillion, or 200% of its current GDP, to achieve net-zero emissions by 2060. Bank of America reckons that India has more than $400 billion of investment lined up for emissions reduction in the current decade.

Sovereign and corporate debt has a major role to play in raising that capital. So, too, have Green, Social and Sustainability (GSS) bonds. According to the Climate Bonds Initiative, the emerging world accounted for the fastest-growing share of Green Bonds in 2020—the same year that the Asian Infrastructure Investment Bank (AIIB) issued its first Sustainability Bonds and China became the largest national issuer of Social Bonds.

We believe emerging markets debt investors have an important role in promoting sustainability. But it does pose challenges.

Undesirable Outcomes

Let’s start with sovereign issuers.

Because sovereigns make policy and regulate industries, the sustainability of a country’s public sector is only one aspect of their impact. In our view, a responsible sustainable sovereign debt investor requires a deep understanding of a country’s business and economic profile, as well as its evolving legal and regulatory context. Without it, we think standard ESG ratings of a sovereign’s norms and institutions can be misleading.

We also think those ratings can lead to undesirable outcomes. Relatively richer countries tend to have stronger institutions and lower social inequality, which feeds into higher ESG ratings. The World Bank has calculated that 90% of the variation in ESG scores from seven providers across 133 countries can be explained by differences in per-capita national income. If money follows ratings, richer countries tend to get richer and poorer countries miss out on the funding required to meet the United Nations’ Sustainable Development Goals (SDGs). That can be a big disincentive to progress.

That is why we advocate an emphasis on a forward-looking perspective, alongside our view of “current best-in-class” considerations. Exclusions also have a role to play: Currently, 20 sovereign issuers account for a quarter of the market that, at this moment in time, we would not expect to see in a sustainable emerging markets debt portfolio. But we can look much more favorably on countries that are poorer and perhaps even have lower ESG ratings than the ones we exclude, if they show strong progress.

We also see an increasing role for engagement even though this poses particular challenges with sovereign issuers. While country-level progress can be slow and modest, we think focused investor engagement would contribute to better performance in key areas such as carbon emissions, contribution to global tax transparency or countering corruption, money-laundering and terrorism financing. 

Importantly, we also think that this forward-looking perspective influences the sustainability goals that an investor should emphasize. Not all SDGs are equal, in our view, especially in the emerging world. We believe issues like climate change adaptation and mitigation are important wherever you invest, but in the emerging world social goals, and particularly life expectancy and education, are key—because they create the essential foundations for enhancing so many other SDGs.

Corporate and Consumer Attitudes

The picture is similar for corporate issuers.

Especially among high yield issuers, which are generally less prepared for and more exposed to sustainability-related transitions, we already see evidence that the market recognizes the higher quality of high ESG scorers. Over the past five years, for example, the return and volatility of the JPMorgan ESG Asia Credit High Yield Index (JESG JACI HY) has been similar to that of the traditional JACI HY. Over the past 12 months, however, the more challenging period for the asset class, the JESG JACI HY has exhibited higher returns and lower volatility—and we think this outperformance is likely to become still more pronounced. While emerging regions such as Asia still lag on sustainability, in many cases they are the places where the investment need is greatest and where government, corporate and consumer attitudes are evolving fastest.

We have already mentioned the huge climate-related investments required just by China and India, for example. We also see growing demand for social equality and, especially in Asia, growing responsiveness from governments: The goal of “common prosperity” in China’s recent strategic reorientation is only the most high-profile and impactful example.

In addition, and again with an emphasis on Asia, we notice regulators fine-tuning their corporate sustainability disclosure requirements: Hong Kong has taken the lead with a number of steps, but another prominent example is the Securities and Exchange Board of India (SEBI) upgrading its requirements with the introduction of its Business Responsibility and Sustainability Reporting (BRSR) rules. Alongside coordinated input from the United Nations’ Sustainable Stock Exchanges (SSE) initiative, we think measures like these could help to highlight sustainability performance parameters across countries, sectors and companies, increasing competitive pressure for progress.

As with sovereign issuers, to our minds this underlines the importance of a forward-looking perspective and a substantial engagement program, especially with high yield issuers, to identify potential winners and losers from the transition and to help companies adjust.

Considerable Momentum

Let’s end with a couple of examples to show what we mean about being forward-looking.

Among sovereigns, we would highlight Ivory Coast. It doesn’t seem like a sustainability leader at first glance. It took armed conflict for the 2010 presidential election loser to concede, and political stability remains a challenge. It has an uncomfortably high level of child labor.

Despite these challenges, it is making remarkable progress, including steady improvements in life expectancy (from already relatively high levels) and in expected and realized years of schooling. According to the Bertelsmann Stiftung and the Sustainable Development Solutions Network (SDSN), among African countries, only Kenya achieved greater improvement in its Sustainable Development Report Index scores over five years to 2020.

Among corporates, consider a Chinese aluminum producer that we have been engaged with for some time. It is in an energy-intensive sector and its carbon intensity is higher than the sector average because more than 90% of its energy comes from coal-fired power stations.

We regard its senior management to be forward-thinking on this challenge, however—not least because of the Chinese government’s latest emissions-reduction targets. The company has commissioned a third-party consultant to map out its decarbonization strategy by early next year. We already know that it plans to switch a third of its energy supply from coal to hydro power by the end of fiscal year 2022. We believe that this, together with a joint venture with German recycling company to produce recycled aluminum, puts it well ahead of its peers on a forward-looking view.

To ensure that capital goes where it is needed most to promote sustainability in the emerging world, we believe debt issuers such as these, starting from a low base but already showing considerable momentum, have an important role to play in sustainable portfolios.

In Case You Missed It

  • China 3Q 2021 GDP: +4.9% year-over-year
  • NAHB Housing Market Index: +4 to 80 in October
  • U.S. Housing Starts: -1.6% to SAAR of 1.56 million units in September
  • U.S. Building Permits: -7.7% to SAAR of 1.59 million units in September
  • U.S. Initial Jobless Claims: +290,000 for the week ending October 16
  • U.S. Existing Home Sales: +7.0% to SAAR of 6.29 million units in September
  • Japan Consumer Price Index: +0.1% in September year-over-year
  • Japan Purchasing Managers’ Index: +1.5 to 53.0 in October
  • Eurozone Purchasing Managers’ Index: -1.9 to 54.3 in October

What to Watch For

  • Tuesday, October 26:
    • S&P Case-Shiller Home Price Index
    • U.S. Consumer Confidence
    • U.S. New Home Sales
  • Wednesday, October 27:
    • U.S. Durable Goods Orders
    • Bank of Japan Policy Meeting
  • Thursday October 28:
    • Eurozone Central Bank Policy Meeting
    • U.S. 3Q 2021 GDP (Preliminary)
    • U.S. Initial Jobless Claims
  • Friday, October 29:
    • Eurozone 3Q 2021 GDP (Preliminary)
    • U.S. Personal Income and Outlays

    – Andrew White, Investment Strategy Group