RWC Emerging & Frontier Markets
ESG – Fourth Quarter 2019
ESG
Environmental, Social and Governance (ESG) considerations are not new to investment managers, although they have never received as much attention and such a clear-cut focus in capital allocation decisions as they do today. Assets under management with dedicated ESG mandates continue to grow in response to concerns surrounding climate change, corruption, data privacy, product quality, occupational safety and corporate governance, amongst others. An increasing number of fund managers employ some form of ESG analysis in their investment approach.
The world’s leading proponent of responsible investment, the UN PRI (Principles of Responsible Investment), includes over 2,372 signatories and represents c.$86.3trn of assets under management which is projected to double over the next decade. As a practical framework for sustainability and responsible business practice, the principles for incorporating ESG factors into investment practice are applicable globally and are equally relevant for both developed and emerging economies. Progress has been uneven so far. This note looks into challenges and opportunities of ESG integration in Emerging and Frontier markets, long-term risk management, collaborative engagement and, most importantly, positive change with potential to enhance investment returns. RWC Partners has utilised a comprehensive ESG process for many years.
ESG could be defined as a combination of long-term environmental, social and governance factors with potentially material impact on the value of an investment. The most widely used reference for materiality criteria has been developed by SASB (Sustainable Accounting Standards Board). It identifies sustainability issues or risks that are likely to impact corporate financial conditions and operating performance over time depending on the sector of business activity.
The basics of ESG integration and corporate engagement
Notwithstanding investment geography, approaches to ESG application vary and can imply some form of screening, thematic focus, valuation adjustment as well as stewardship and activism targeting changes in corporate behaviour. Common challenges include poor disclosure or low-quality of reported data, lack of regulatory standards, absence of clear-cut measurement and performance attribution methodology. Engagement activity attempts to resolve some of the hurdles through a two-way dialogue. Despite the fact that results have been mixed so far, corporate awareness of and attention to ESG issues are increasing, paving the way for future changes.
It is worth noting that, in most cases, ESG is a necessary but not a self-sufficient set of factors. It does not replace fundamental analysis but works best in combination, supporting the case for an integrated approach. In its 2019 Global Financial Stability Report, the International Monetary Fund made a special case for sustainable finance and emphasized ESG as a multidimensional assessment system that can be applied to any asset class and any market. While country factors have to be taken into account, in many cases, they do not represent a constraint on the corporate ability to adhere to international best practice. Given that environmental protection, governance and social structures tend to develop along with economic growth, corporate engagement and ESG delta opportunities can be greater in Emerging and Frontier markets.
Assets under Management of UN PRI Signatories
ESG risk and GDP growth in 42 equity markets*
Click to view
A global concern for the preservation of the environment and responsible use of natural resources has gained a new sense of urgency in the face of accelerating climate change. As the world braces for extreme weather events, rising sea levels and deteriorating air quality, cross-border public policy debate calls for joint efforts to contain emissions, reduce waste, encourage circular economy and manage risks related to low-carbon transition.
For developing economies, the implications are much deeper as reducing resource intensity becomes a balancing act with economic growth. Adaptation can take longer, however, it is not impossible within a proper policy framework. The example of China, one of the world’s largest consumers of energy and natural resources, shows that taking environmental compliance to the level of a national ambition can lead to a structural shift needed to curb pollution. Despite a certain degree of scepticism when it comes to the eco-credibility of official numbers, the level of disclosure among Chinese companies has improved over time allowing for a case by case analysis and targeted investment and engagement approach.
Pursuing global environmental targets is more of a challenge in countries dependent on oil exports like Russia and the Gulf Cooperation Council (GCC) where budget needs might slow the policy response despite the vulnerabilities to the effects of climate change. Particularly in the Middle East and North Africa, the MENA region, water scarcity, high levels of aridity and long coastal stretch increase the risks of exposure to higher temperature and rising sea levels.
It is crucially important to support agriculture and healthcare in addition to investing in economic diversification, before climate limits and non-oil technologies have a major impact.
As natural declines in producing fields mean marginal investment will still be required even after global demand begins to shrink, another way to approach energy transition is through capital allocation to the world’s most efficient and lowest cost producers, such as Saudi Arabia and Russia.
Oil and gas companies in these countries have also made commitments to contribute to local communities, eliminate spills and further reduce emissions from own operations.
Sustainable energy solutions are essential for emerging economies where access to electricity is far below 100% as is the case in most parts of sub-Saharan Africa. Fortunately, most of these countries are in areas with vast renewable potential, according to the International Energy Agency. As technology costs come down, the IEA expects renewables to account for almost half of sub-Saharan Africa’s power generation growth by 2040.
Water is another critical resource around the world that requires investor attention when it comes to usage and responsible business practice, especially in emerging markets. The United Arab Emirates (UAE), “a country where water might one day become more expensive than oil”, is the world's highest per capita consumer of water despite the scarcity of the resource.
Along with Saudi Arabia, it happens to be one of the global leaders in desalination technology powered by renewable, mostly solar, energy sources. Innovation and search for sustainable solutions do not stop at the government level. Corporates like Emaar Hospitality Group, a subsidiary of the UAE based global developer Emaar Properties, launched sustainability campaigns to conserve water and marine resources.
On the other side of the world, Chile is widely known for its water resources management developed from the 1980s onwards and operating under a free-market structure. It is also known for its mining industry that contributes 10% to the country’s GDP and 50% of its total exports supplying 30% of the world’s copper.
Water usage conflicts, pollution and landscape impact have long been at the centre of activist attention. Understandably, environmental risks for metals and mining companies are among the highest across all sectors. The only way to address them is through investment in new technology and continuous corporate engagement.
Aside from obvious culprits such as mining and traditional energy, it is worth noting that environmental concerns are relevant for any sector, especially, when it comes to waste management.
It is a well-known fact that low-income countries generate less waste. However, the amount is growing faster and their ability to treat it is limited. Local regulators are ramping up bans and taxes, increasing pressure on corporates to bear the costs or change their business practices.
The dominant environmental story of plastics is not new to emerging and frontier markets. It was Bangladesh that became the first country in the world to ban thin plastic bags in 2002 after they were found to be clogging drainage systems and causing street flooding. Others followed, including countries such as Antigua and Barbuda, Colombia, Romania, Senegal and Rwanda. There are more to come according to Credit Suisse Research that predicts accelerated policy action going forward.
On the stock-level, based on the same source, petrochemicals face the largest downside earnings risk, followed by retailers with few exceptions like Thailand’s CPALL, the local 7-Eleven franchise owner, that adopted plastic reduction initiatives ahead of its peers and prior to the official ban introduced in Thailand starting January 2020.
Plastics: rates of waste generation, disposal, incineration and recycling
Global production of primary plastics
by sector
The costs of an environmental failure can be devastating in any market. In January 2019, a tailings dam breach at the Feijao iron ore mine operated by Vale SA in Brazil took 270 lives and led to a giant spill of 3 million cubic meters of waste. On the trading day following the disaster, Vale’s stock price fell 24%, losing 71.3 bn reais (US$19bn) in market capitalisation, the biggest single day loss in the history of the Brazilian stock market. A year later, in early 2020, Brazilian prosecutors charged the ex-CEO and several other high-level executives with homicide resulting from the dam collapse. The incident had a global impact, renewing questions on government regulation, existent controls and, most importantly, corporate responsibility with respect to both environment and society.
Source: Financial Times, Ngyab
Reconciling a broad range of social and cultural norms under a single standard is ultimately impossible. However, focus on a basic set of universal rights, safety and equal opportunity can make assessment and engagement more manageable. At this point, many large corporations globally recognize internationally proclaimed human rights and abstain from outright abuses. Most risk resides in the supply chain where working conditions are harder to monitor, and violations are frequent. The Government Response Index reveals that a lot of the G20 countries are yet to formally enact laws and regulations aimed at stopping procurement of goods and services produced under forced or sub-standard conditions. In the meanwhile, responsible sourcing remains at corporate discretion.
1/5
The Social component of ESG, more than any other, depends on the nature of business activity. Certain sectors, like technology and healthcare, are relatively better off while Oil& Gas, Construction and Mining tend to be in the range of laggards. Rather than avoiding these sectors, this is precisely where progress has to be sought and government, management and investor efforts joined. The example of South Africa, where injuries are common, especially, in underground mines, shows that it can take years for changes to happen. However, all efforts should be acknowledged and supported towards the ultimate goal of zero fatalities, as expressed by AngloGold Ashanti that had long established this target across all its operations.
Social
2/5
Growth and development are not always equally shared. In many emerging economies, social divides persist and differences in “haves” and “have nots” continue to increase.
India, despite significant progress in poverty reduction over the past years, has not been able to fully overcome old disparities, especially, when it comes to housing. In an effort to address inequality, the government unveiled the Pradhan Mantri Awas Yojana (PMAY) mission that aims to provide proper housing to all homeless and also to help disadvantaged communities in both urban and rural areas. Housing Development Finance Corporation (HDFC), pioneer in the mortgage industry for three decades, is one of the private players involved in the credit linked subsidy schemes.
The company decided to pursue the Low Income Group (LIG) and Economical Weaker Section (EWS) to support the mission. In the current fiscal year, 36% of new loans in volume terms and 18% in value terms have been to customers of these two groups. The company has been able to deliver solid shareholder returns and at the same time contribute to a greater purpose. While “housing for all” might still be a distant target, every step counts no matter where you start.
3/5
Few countries have to deal with such extreme inequalities in so many dimensions. It is more common to see subtle differences in economic prospects, access to benefits and compensation than outright discrimination. The evolution of labour relations has in most cases been shaped through history. This has led to varying degrees of unionization and collective bargaining structures that continue to play an important roles in doing business today. In Latin America, Brazil and Argentina, in particular, organized labor has to be considered as both a political force and an ESG factor.
4/5
Few countries have to deal with such extreme inequalities in so many dimensions. It is more common to see subtle differences in economic prospects, access to benefits and compensation than outright discrimination. The evolution of labour relations has in most cases been shaped through history. This has led to varying degrees of unionisation and collective bargaining structures that continue to play an important roles in doing business today. In Latin America, Brazil and Argentina, in particular, organised labor has to be considered as both a political force and an ESG factor.
5/5
Environmental
Institutional Shareholder Services (ISS), a globally recognized proxy advisor, has highlighted that “emerging markets continue to have a unique set of characteristics which require special attention when assessing corporate governance at the country level and at the company level. At the country level, the legal framework, the strength of institutions, and the rule of law all affect the quality of governance of individual firms. And at the company level, ownership structures will often determine the types of governance challenges a company may face…” Unlike developed markets where companies tend to be widely held, a significant portion of emerging and frontier corporates are still controlled by their respective states or large family groups.
1/6
Governance
Emerging-market firms (by weight) were majority state-owned or had a single principal shareholder
2/6
In Eastern Europe and Russia, where state ownership is particularly common, governance analysis takes additional considerations of the expected public policy stance, budget balance and fiscal objectives. Alignment with minority shareholder interests has to be considered on a case-by-case basis and investment success is, ultimately, determined by the quality of people on the management team and directors’ board. Herman Gref, an emblematic leader of Russian Sberbank, is one of such individuals who managed to turn the former Soviet Union’s savings monopoly into a well-run modern institution to the benefit of both the state and minority shareholders.
3/6
Family-run conglomerates, an ownership structure prevalent in emerging Asia, carry risks and benefits of their own. South Korea, where the so-called chaebols, “wealth cliques” in Korean, represent half of the market, offers most prominent examples.
According to Bloomberg, the likes of LG, Hyundai, SK, Lotte and Samsung are “long-time pillars of the nation’s miracle economy” and the drivers of “South Korea’s transformation from economic minnow to one of the world’s largest exporters”. However, consolidation of wealth by the chaebols, cross-ownership and close ties with political elite have come under increased scrutiny in the recent years, marked by influence-peddling scandals, highlighting the need for a revamp of the existent governance structures.
4/6
Reforming chaebols became the next step in the country’s economic development and a way to eliminate the “Korea discount” or historically lower valuation multiples relative to global peers. This is where opportunities come to exist as governance shortfalls turn into catalysts upon remediation.
The Car Wash (Lava Jato) corruption scandal has made governance an urgent topic in Latin America. Regulators forced companies to develop codes of conduct and ethics. The percentage of independent board members increased to levels comparable to developed market peers with some of the most notable examples including Argentine YPF and Brazilian Petrobras.
Despite the fact that the corruption investigation is still on-going, financial risks for Petrobras have been reduced after it finalized payments related to the settlement with shareholders and implemented a set of policies and corporate governance measures that, according to Sustainalytics, are credible and lower the risk of recurrence.
5/6
Adopting the right policies might be a necessary, but not a self-sufficient measure. Enforcement, efficiency and regress often come into question. While there is no easy answer, properly structured executive remuneration and employee incentive schemes are frequently considered as a tool to achieve both core operating KPIs and ESG objectives. The need for external funding and foreign investment, could be another driver leading to a faster adjustment to meet international standards related to board practices, shareholder rights, disclosures, voting mechanics, as well as environmental and social risks.
6/6
1/10
2/10
3/10
4/10
5/10
6/10
7/10
8/10
9/10
10/10
The basics
1/3
2/3
3/3
Conclusion
ESG analysis remains essential for investment in Emerging and Frontier markets. In combination with macro and fundamental factors, it is a determinant of long-term investment success. Lack of relevant disclosure can be mitigated through on-the-ground research while many sustainability risks can be addressed through voting and active engagement with companies and regulators.
The RWC Emerging and Frontier Markets team has always incorporated ESG considerations into its company analysis framework and continues to monitor new developments within ESG research in order to integrate best practice into the investment process.
The aim is to stay ahead of the market and to be proactive, engaging with companies in a more structured way to promote change. The team expects a broader acceptance of SRI principles, more standardization in reporting requirements and further ESG integration into corporate strategy across Emerging & Frontier markets. Key focus areas include board independence, remuneration structures, diversity, occupational safety, supply chain management, product governance, data protection and climate impact.
Political risks and regulatory differences account for a significant part of the divergence between countries. However, we firmly believe that we can apply a consistent approach across geographies and that it is within the scope of corporate social responsibility in any market to compensate for these gaps by adhering to the highest international standards and best business practice.
Social
Governance
Conclusion
Environmental
The basics
China update
Q4 update
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No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment
The team
John Malloy and James Johnstone co-manage the RWC emerging and frontier markets team. The team is composed of a further 17 analysts, economists and strategists based in Miami, London and Singapore, many of whom have worked together for over twenty years. The team joined RWC Partners in 2015 and now manages c. $9bn for its clients. Emerging and frontier markets represent the fastest growing countries in the world. The RWC team believes the continued growth in these markets represents opportunities across a range of industries.The highly experienced and dedicated team takes an index-agnostic, opportunistic approach which allows it to explore investment opportunities that are often off the beaten track.
RWC Sustainabily Report