Are investors ready for the next systemic risk?

Emerging markets should be at the core of climate-focused investment strategies

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The economic fallout from the coronavirus pandemic and the resulting market volatility are reminders to governments and investors that ignoring systemic risks is perilous. Even as the world grapples with the immediate health and economic crises, it’s clear this may not be the last time that public health is severely compromised, global supply chains are disrupted and trade paralyzed, as another existential threat looms over humanity – the climate crisis.

Governments around the world are currently dealing with unprecedented challenges. Yet, after addressing immediate liquidity needs, governments must take steps to build sustainable, net-zero-emissions economies. Doing so will improve public health, create energy security, and drive industrial and technological modernization.  

Investors, too, must come to terms with the enormity of financial and material risks from the climate crisis, even as they face current market uncertainties. One way they can do this is to place emerging market opportunities at the center of long-term strategic asset allocation to profitably decarbonize their portfolios. The current economic slump is unlikely to change the strong macroeconomic fundamentals of emerging market countries, including growing urbanization, a rising middle-class, steady growth in exports and lower debt. All these make a good investment case as these countries strengthen environmental policies and launch clean-energy projects.  

As the Trump administration has rolled back environmental regulations and begun pulling the U.S. out of the Paris Agreement, it has left the door open for other countries, including China and India, to step in to potential climate leadership. These two emerging market countries have pursued policies that drive innovation and investment in clean energy, electric transportation and reducing toxic waste. Therefore, investors would do well to look for opportunities in China and India which, after all, contribute one-third of global emissions.

While we don’t know if China will continue to implement these policies as it recovers from the pandemic, investors should not ignore the fact that China is already, by far, the top global destination for clean-energy investment. Since 2013, China has led in renewable energy investments, accounting for one in every three dollars invested worldwide.

Moreover, half of the world’s electric vehicles, as well as 99% of its electric buses, are in China. Meanwhile, India produces the world’s cheapest solar power and is on track to generate 175 GW of renewable power by 2022. Its development needs mean India will have to double its electricity output by 2030 while also, hopefully, honoring its Paris Agreement commitments. These goals present an opportunity of more than $30 billion per year based on an India Economic Survey.

The thirst for clean energy goes beyond China and India. Brazil, Chile and Kenya are also attracting sizable clean energy investments as they transition their emerging economies. Such astonishing transformation efforts in these countries have led to an explosion of clean-tech innovation. 

Clearly, opportunities abound in zero and low-carbon investments in such emerging market countries. There’s an estimated $23 trillion in climate-smart investment opportunities in 21 emerging market countries that together account for 48% of global emissions. Last year, green bond issuance from emerging markets grew 25% from the previous year.

While the clean energy transformation in these countries might not occur overnight, investors should not lose sight of these opportunities. Long-term investors seeking to decarbonize portfolios should consider:

Reviewing asset allocation: With global markets experiencing one of the worst downturns since the 2008 financial crisis, it is time to review and rebalance portfolios. A January 2019 forecast shows by 2030, seven of the top 10 economies will likely be in current emerging markets – with China and India leading the pack. Investors who study the characteristics and fundamentals of emerging market countries will be better positioned to identify opportunities in these markets. Canada’s largest pension plan, Canada Pension Plan Investment Board, is one example of a major investor revising asset allocation in this direction. Last year it announced it will invest one-third of its assets in emerging markets by 2025. 

Then, investors choosing to buy direct assets in emerging markets should also consider: 

  • Putting boots on the ground: Investing in emerging market countries can be perceived as challenging and complex, partly because investors lack on-the-ground information and often classify all emerging markets under a single risk pool. But this perception might be merely a lack of local knowledge and expertise. Investors should actively work with local investment managers and partners such as local entrepreneurs to improve these assets and create value for all stakeholders. For example, Caisse de dépôt et placement du Québec (CDPQ) opened its India office in 2016 and hired local expertise to swiftly ramp up investments in the country to $5 billion. 
  • Building partnerships: While there are risks to investing in climate-linked infrastructure in emerging market countries, there are also many tools available to investors to mitigate risks, including political risk insurance, credit enhancements and development policy loans. One way to access these tools is to partner with multilateral development banks and asset managers who have deep exposure and experience in emerging markets. For example, Green Climate Fund, which supports developing nations’ responses to the climate crisis, has launched several sustainable investments worth $5.6 billion in partnership with private investors. 

Investors who would rather buy emerging market stocks and bonds should consider:

  • ESG Investing: Factors arising out of loose regulation or changing policy environments are less likely to impact better managed, more sustainably run companies. As concluded by several studies, environmental, social and governance (ESG) investments in emerging market countries can deliver better risk-adjusted returns than traditional investments in already developed economies.
  • Collective Engagement: Considering the often complex legal and ownership structures of companies in emerging market countries, investors might consider collaborating to identify risks. More than 450 investors with approximately $40 trillion in assets are working to move the world’s largest corporate greenhouse gas emitters through the Climate Action 100+ to reduce emissions and improve governance standards. The initiative is a prime example of how investors globally are driving the net-zero emissions transition through collective engagement with companies. 

As mounting systemic risks from the climate crisis come into focus because of the lessons learned from current market disruptions, investors will have to reduce emissions to net-zero by 2050 or sooner. In order to achieve this ambition, increasing allocations to emerging market countries would be wise not merely for diversifying portfolios, but also for capitalizing on the wave of climate solutions being developed in the largest-polluting and fastest-growing world economies. 

Dazzle Bhujwala is Director of the Ceres Investor Network