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Alex Kimani

Alex Kimani

Alex Kimani is a veteran finance writer, investor, engineer and researcher for Safehaven.com. 

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Emerging Markets Are Missing Out On The ESG Boom

Emerging markets are considered to be among the most vulnerable to climate change. A 2018 study published in the Geophysical Research Letters says the results are a stark example of the inequalities that come with global warming, with the richest countries that produce the most emissions being the least affected when average temperatures climb 2 degrees Celsius [3.6 degrees Fahrenheit] while poorer nations bear the brunt of changing local climates and the consequences that come with them. It’s, therefore, quite unfortunate that the countries that need climate interventions the most are woefully underrepresented in the ESG universe, with EMs badly lagging when it comes to ESG investing, with very few green funds and little demand for green bonds.

For example, Italy’s inaugural green bond in 2020 was larger than all EM sovereign green issuance in the same year, while the UK has installed more capacity of solar PV than the entire continent of Africa. Meanwhile, the annual issuance of labeled bonds (green, social, and sustainability-linked) in developed economies is on pace to break $1 trillion in the current year.

A report titled Marathon or Sprint? The Race for Green Capital in Emerging Markets, by the Centre for Climate Finance and Investment at Imperial College Business School based on interviews with more than 40 emerging market asset managers and global banks, found that the key barriers to green bond issuance in EMs are high reliance on indexation and the rise of passive investment vehicles; underdeveloped local market investor base and local green finance infrastructure; incomplete, inconsistent and lagged environmental data; and a lack of industry consensus about balancing issuer engagement and exclusions.

How money managers go about ESG investing tends to cement the status quo. 

Related: China Starts Production At Massive Deepwater Gas Field EM funds under pressure to improve their ESG scores tend to buy more bonds from higher-rated (in most cases wealthier) countries and shun those with lower ESG scores, mostly developing economies. Left to its own devices, this process continues to reinforce a trend towards inequality in the financial system as marginal sovereigns and corporates are pushed into a vicious downward spiral of higher yields and deteriorating economic prospects.

Transition bonds

All is not lost, though.

Money managers have proposed the launch of transition bonds for heavy emitters that aren’t able to access the green bond markets.

Transition bonds are environmentally beneficial bonds issued out of ‘brown’ sectors such as oil and gas, mining, and construction materials that traditionally have a high reliance on fossil fuels or other environmentally harmful materials and likely possess a heavy carbon footprint. Green investment opportunities in these sectors are naturally limited but are no doubt pivotal in supporting the global reduction of greenhouse gas emissions and other pollutants and will help plot a path to a more sustainable future.

Transition bonds are both a challenge and an opportunity in green finance. To date, only a handful of securities that could be classified as transition bonds have been issued. 

The report lays out other potential solutions including to the EM green investing conundrum, including:

  • Creation of a new forum for emerging market debt managers to actively address and coordinate climate and environmental concerns with issuers.
  • Decreasing the historic reliance on indexation and cost-cutting to secure assets in favor of a greater emphasis on long-term credit differentiation.
  • Greater involvement by other sources of capital, such as International Financial Institutions, Sovereign Wealth Funds and more active local market investors.

Wall Street steps in

Despite being the primary drivers of global growth and wealth accumulation, infrastructural development in emerging markets, or EM, economies remain grossly undercapitalized. 

According to a McKinsey study, developing countries will require a staggering $2 trillion every year in infrastructure over the next 15 years just to keep pace with projected GDP growth. That’s more than double the $800 million-900 million per year that’s currently being allocated to infrastructure, suggesting the task is beyond the means of EM governments. 

But it’s not just infrastructure projects where EMs are lacking. JPM estimates that the annual investment gap to meet the Sustainable Development Goals (SDGs), which seek to address basic infrastructure, food security, health, education, and climate change in developing countries as set out by the United Nations currently clocks in at $2.5 trillion and could hit $5 trillion-$7 trillion by 2030. 

Luckily for these nations, it might not be long before the private sector starts coming to their rescue thanks to the growing ESG (Environmental, Social, and Governance) investment drive.

Fittingly, the world’s largest financial institutions are beginning to put their money where their mouths are.

In 2019, J.P. Morgan Chase, the largest bank in the U.S. and the sixth-largest in the world by assets, has just unveiled the Development Finance Institution, which will invest more than $100 billion annually in emerging-market projects to boost private investments.

It’s this massive hole that JPM is looking to at least partly fill by turning development finance into a traded asset class. The new fund will also connect public and private pools of capital, from pensions and family offices all the way to philanthropies.

While JPM will probably try to fashion its latest development finance business as an ESG venture, it seems to make sense to the giant lender from a financial standpoint, too. According to Faheen Allibhoy, an 18-year veteran of the World Bank-affiliated International Finance Corp. and leader of the new group:

“The emerging markets are where the action is. Places like Indonesia, Turkey, Mexico and Egypt are countries that are building infrastructure and that are in need of capital, and they’re sizable economies.”

Also, it probably won’t be lost on JPM that EMs have outperformed their more developed brethren over the long-term, though they have tended to struggle over the past couple of years.

CIP

Source: MSCI

JPM has been the biggest financier of fossil fuel projects over the past three years and could be feeling the heat after Goldman Sachs recently announced that it will no longer finance new oil exploration or drilling in the Arctic, as well as new thermal coal mines anywhere in the world.

The so-called Big Six banks tend to move in lockstep, meaning other Wall Street banks might soon follow in JPM’s footsteps.

Nevertheless, even the best efforts by the likes of JPM probably won’t be enough to meet SDGs by EMs and governments will need to develop other avenues to grow the available pool of funds (liquidity) in the infrastructure space. 

Related: The EV Boom Is Coming Much Earlier Than Expected

As per McKinsey, one way they can achieve this is by improving the risk-return characteristics of private investments in order to encourage better flows. For instance, governments can develop long-term infrastructure programs where the delivered assets are used as collateral to guarantee private financing in infrastructure projects. 

A good case in point is Peru’s central bank, Banco de la Nación de Peru, which created a trust division in 2000 to provide collateral and support for infrastructure investors and developers.

The approach has proven a success, the Banco de la Nación having acted as a fiduciary to more than 60 infrastructure projects, including road infrastructure, water, irrigation, and sanitation, with the number of people having access to treated sewage doubling between 2000 and 2015.

This UNCTAD-funded paper also explores the possibilities of securitization of SDG projects in a bid to encourage more private sector investments, and cites the success of Public-Private Partnership models in Nigeria.

By Alex Kimani for Oilprice.com

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