Sustainable investing, impact investing, responsible investing: Whatever you call it, it is a growing investment strategy, and it's not just for rich nations any more. While there is a perception that sustainable investments are somewhere between difficult and impossible in emerging markets, the investment landscape is changing.
For many years, sustainable investing was mainly the province of a few specialist asset managers, many of them small, which focused on investing in developed market economies like the U.S. market. In recent years, however, the industry has grown substantially. According to the “2014 Global Sustainable Investment Review” produced by the Global Sustainable Investment Alliance — a coalition of national and regional sustainable investment organization worldwide, including US SIF — sustainable investment around the world accounted for $21.4 trillion in assets under management as of 2014, up 61% from $13.3 trillion in 2012.
Anything that accounts for nearly one-third of all professionally managed assets should attract investor attention. Recent research has shown that sustainable investment performs either comparably with or better than conventional investment on a risk-adjusted basis. Research published this year in Morgan Stanley Institute for Sustainable Investing's report “Sustainable Reality: Understanding the Performance of Sustainable Investment Strategies”; UBS AG's report “To Integrate or Exclude: Approaches to Sustainable Investing”; and Allianz Global Investors GmbH's “ESG In Equities” all note that ESG information when integrated into portfolio construction results in funds that perform comparably with or better than conventional peers.
Sustainability reporting — or the newer integrated reporting, which includes both financial and sustainability reporting — is becoming more available in emerging markets, though the quality of reporting varies from market to market and may be an indicator of the growing interest in sustainable investing. The Global Reporting Initiative, an Amsterdam-based organization that helps businesses communicate on critical sustainability issues, has offices in China, India, Africa, South America and Southeast Asia to support efforts in those markets. Of the nearly 5,100 GRI reports published in 2014, about 2,092 came from emerging market countries, including 1,054 from Asia emerging markets, 347 from Africa, and 691 from Latin America and the Caribbean. In some emerging markets, such as Russia, sustainability reporting is rare.
Sustainability or integrated reporting isn't the only place to look for sustainability information. Often regulatory authorities publicly report the extent of compliance and other information on company operations, even when companies themselves don't do so. The expanding scope of news coverage and scrutiny from sustainability-oriented non-profit organizations make it increasingly difficult for companies to have invisible footprints, no matter where they operate.
The challenges for sustainable investing in emerging markets are often very different than in developed markets because of the nature of emerging market economies altogether. Poorer countries tend to be more dependent on natural resources, and transforming resources into goods and services tends to have significant, and often value-destroying, environmental impact. According to world development indicators reported by the World Bank, even the largest emerging economies — such as China, Brazil, Russia, India, Mexico, Indonesia, Turkey, Saudi Arabia, Nigeria and Poland — are much more heavily dependent on agriculture and industry, averaging a combined total of 45% of gross domestic product, compared with the largest 10 developed markets, where an average of 71% of GDP comes from the production of services.
The deepest footprints are often in the sectors that transform raw material into intermediate or final products, which means energy, materials and agricultural commodities. Every step of the process, such as involving agriculture, mining and energy production, can present environmental and social hazards, such as a heavy demand for water and large emission of greenhouse gases. These impacts are increasingly regulated in developed markets, but might not always be so well controlled in less wealthy ones. The damage done by raw materials transformation in emerging markets, for example, can harm their own growth prospects, as well as investors. Environmental damage is usually not addressed until average income levels are relatively high.
Environmental degradation has an economic cost that affects investment valuation. Whether the companies responsible for the damage are domiciled in emerging markets or developed ones, this harm represents an added level of risk for investors. Even institutional investors whose assets are mainly in developed markets may have significant exposure to emerging market problems through holdings in companies whose headquarters may be in Houston, London or Sydney, but have liabilities for unsustainable operations in the developing world. Academic work on the impact of environmental performance on companies and their investors show that poor environmental performance can be costly. A 2014 paper by a group of Canadian, American and South Korean academics — “Corporate Responsibility and the Cost of Capital: International Evidence” by Sadok El Ghoul, Omrane Guedhami, Hakkon Kim, Kwangwoo Park and available on ssrn.com — examined equity capital costs in 30 countries over a 10-year period, finding higher environmental responsibility was positively and significantly correlated with lower cost of equity capital.
Emerging markets, because of their often-greater dependence on sectors and industries with more points of friction between the economy and the environment, often present more challenges for institutional investors. But there is good news here. Larger companies, regardless of whose flag they fly, are more likely to have better investment performance when their environmental impact is understood and managed, and care is taken to reduce or mitigate impacts. Even for institutional investors whose assets are in developed market funds, exposure to emerging markets can be substantial, and sustainability is still a source of value. Sustainable investing is growing in emerging markets, and rapidly in some. Institutional investors should take note. n
Julie Fox Gorte and Greg Hasevlat work at Pax World Management LLC, Portsmouth, N.H. Ms. Gorte is the senior vice president for sustainable investing and a portfolio manager of the Pax Ellevate Global Women's Index fund. Mr. Hasevlat is a sustainability research analyst and assistant portfolio manager of the Pax MSCI International ESG Index fund.