In order to integrate ESGP considerations into an investment process for emerging markets, the starting point is indicator selection. Thankfully, a plethora of data is provided by international organizations, think tanks and non-governmental organizations. A careful selection is therefore needed to isolate those indicators that are the most relevant from an investment perspective.
Environmental sustainability is a challenging aspect to assess in emerging markets, partly due to the trade-off that often exists between air quality and rapid industrialization that can lift many from poverty. Besides climate change, the extent to which populations have access to clean sources of drinking water and basic sanitation has been flagged as a key prerequisite to sustainable development.
Social indicators are at the same time an outcome of past economic policies and a catalyst or impediment to future economic development. As such, they are strongly linked to governance and political factors. Among the variety of social indicators, four dimensions in particular are related to the potential for economic development: economic and gender inequalities, the quality of infrastructure, access to education and access to basic health care.
Governance stands for the quality of democratic institutions and the stability of political frameworks. It is embodied, for instance, in the strength of the rule of law, government effectiveness, the ease of doing business and the level of transparency of central government budget. For investors in emerging markets debt, assessing the use of proceeds from bond issues can be challenging. This is where indicators of fiscal transparency can help evaluate these risks to some extent.
Politics is a key aspect for investors as it drives economic policy and growth in emerging markets potentially more significantly than in developed economies. A key challenge for many emerging countries is corruption in the public sector; it distorts decisions to the detriment of the public good and diverts resources away from productive investments. Along with transparent policymaking and sustainable growth comes a greater likelihood of debt repayment.
An ESGP framework is a useful tool for investing in emerging markets as it can explain differences in sovereign credit spreads, even after controlling for macroeconomic variables. It appears then that ESGP factors offer additional information to explain sovereign risk. Differences between market sovereign spreads and what an ESGP score would imply can inform investors of potential richness of cheapness of sovereign bonds.
An ESGP measure can also form the basis to design an emerging markets portfolio in line with investors' specific concerns and restrictions. For instance, it is recognized that institutional failings and the prevalence of corruption are often factors that lead to stunted development and lower social outcomes. This could be a reason to exclude from the investment universe those countries below a certain threshold on governance and political dimensions.
A back-testing exercise suggests that an emerging markets debt portfolio designed with a focus on ESGP would help mitigate risk, thanks to the enhanced average quality of issuers from an ESGP perspective, without compromising performance.