On 23 July 2007, Chinese officials announced that the release of a ‘green GDP’ report calculating the cost of pollution and ecological degradation had been “indefinitely postponed”, following strong lobbying by provincial governments and business associations. A previous report for 2004 had calculated that environmental degradation cost 510 billion yuan (US$68bn) or 3.1% of gross domestic product. The State Environmental Protection Administration commented that the total figure could be much higher, in the range of 10–13% of GDP. These figures do not include long-term impacts of global warming, to which China has become the world’s biggest contributor after surpassing the US, according to a recent announcement by the Netherlands Environmental Assessment Agency (see link).
Should institutional investors care? After all, emerging markets investments typically account for only a small portion of their portfolios.We believe they should, for a number of reasons. First, regional and global economic effects from issues of the magnitude described above are unavoidable. Second, investors’ exposure to emerging markets is much larger than is implied by their notional allocations, given the increasing operational exposure of developed world multinationals to emerging markets. Third, such developments are likely to create market inefficiencies from which clever investors can profit.
Although environmental issues in emerging markets are increasingly catching the attention of investors, many material issues in the social and governance domains continue to go unnoticed. The effects of poor governance and corruption on long-term growth, for example, are not fully factored in by many investors. Academic research has indicated that more corruption is related to lower average income, higher poverty levels and lower trend growth rates.
These and other issues relating to emerging markets investments were the topic of this year’s annual Who Cares Wins event (5 July 2007, Geneva), which brought together more than 80 investment professionals representing leading asset owners, asset managers, investment consultants and research analysts.
The fact that asset owners are increasingly demanding a more explicit consideration of environmental, social and governance (ESG) issues in emerging markets investments was confirmed both by the owners present at the event and by preliminary results from an Economist Intelligence Unit survey to be released in the autumn. This is a challenge for asset managers and investment researchers focussing on emerging markets, because these issues are clearly not yet part of mainstream investing. Available research is scarce and emerging markets investment products that explicitly take ESG issues into account are rare.
Hendrik du Toit, CEO of Investec Asset Management, urged investors to allocate a small part of their assets to frontier markets . His experience has been that an entrepreneurial approach to frontier markets can have positive systemic impacts in terms of standards of disclosure, governance and ESG practice, and handsome financial rewards. The key is to establish standards that are in the interests of long-term investors before less scrupulous investors set the bar at lower levels.Participants at the Geneva event agreed that more innovation and a broader offer are needed. The discussions at the event led to the following key insights:
• Perceptions about which ESG issues are most financially material differ between international and local emerging markets investors. Local investors often point to social and governance issues as being most relevant, at least in the short-term
• Many asset managers already consider corporate governance issues in their investment decisions, albeit not always systematically. These issues are seen as particularly important when companies are controlled by governments and families, which is often the case in emerging markets
• Participants stressed that emerging markets can not be viewed monolithically — country specificity and the ability to contextualise ESG issues are very important
• Investors must therefore become more sophisticated in assessing ESG issues; simple ESG country screens are not a viable option, because they risk excluding best-practice companies in non-eligible countries
• Investors should be more vocal in requiring minimum ESG disclosure standards from emerging market legislators and exchanges. The engagement of ASrIA and investors represented on the Hong Kong Stock Exchange Listing Committee, for example, has resulted in such standards being drafted.
In conclusion, we would like to offer a series of simple recommendations for investors active in this field:
• Improve the understanding of portfolio impacts from ESG issues in emerging markets – for all regions and asset classes, not just for emerging markets equity allocations. Investment decision-making can be impacted both at the strategic asset allocation and issuer selection levels
• Identify the ESG issues that are already part of emerging markets investment decisions at your institution (often relating to corporate governance) and support a more systematic approach
• Consider making a small allocation to frontier markets• Include ESG issues in regular company meetings and engagement activities — do not forget that ESG issues can be material for both equity and fixed income investments
• Consider launching innovative investment products to make full use of the ESG business opportunity
• Consider collaborating with other investors in requiring minimum ESG disclosure standards from local legislators and exchanges.
Ivo Knoepfel and Gordon Hagart, onValues Ltd.