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Investing for tomorrow: applying ESG principles to emerging market debt

Bryan CARTER
 

There is no longer just a single EM group, with poor countries converging to industrialized status slowly and surely over time, and advanced emerging markets graduating to developed countries. With a deeply skilled ESG research team, we have amassed the data and monitoring capabilities to tailor and craft a unique approach suited to the nuances and dynamic realities of emerging markets. The novelty of our approach is that instead of inclusion lists or exclusion lists, we use our composite score on each of the 90 EM countries to determine position sizing for investments in our portfolios. We must look to the future and take a stand on the implications of our enterprise and the long-term viability of our holdings.

Many investors balk at the idea of using environmental, social and governance (ESG) criteria when investing in emerging markets (EM). Pictures of wood-burning stoves polluting tropical air or military tanks in a coup d’etat are often the associations one has with emerging markets and run counter to the growing need for environmental sustainability and good governance.

Just a decade ago, most countries facing fragile situations (whether political, social or economic) were low-income. This situation has hugely improved, with human development indices and other metrics demonstrating significant progress as many countries have graduated to middle income status.  If we look ahead, some of the poorest countries with the lowest ESG scores may in fact produce the largest improvements.

Combining the expertise of our Emerging Markets Fixed Income team and our dedicated Sustainability Centre, our ESG in EMD report explores:

  • How – and why – we apply an ESG framework to EMD
  • Examples of the factors included in ESG screening
  • Incorporating ESG into the EMD investment process
  • The future of EM and the role of ESG

Without question, many emerging markets are departing from a lower base. We agree that many of these countries arguably face the lowest hanging fruit in terms of gaining environmental efficiencies, safeguarding social goods and improving institutions of government. But these are precisely the countries that are most in need of long-term responsible investment to stimulate economic growth, job creation and strengthen their economic foundations.

We think it is also possible that these countries harbour the best set of long-term improvers capable of generating outsized growth and asset gains for patient investors. Demographic trends and a growing middle class in many of them are generating rising demand for consumer goods, infrastructure, services and agribusiness, which provide new opportunities for investors.

 

MOTIVATION

How — and more importantly why — do we mould this asset class into an ESG framework? We at BNP Paribas Asset Management do this not because we can demonstrate past returns from ESG factors but rather because we believe there is a moral imperative that drives our investment ethos to concentrate fiduciary assets in sustainable investments.  This is driven by who we are as a firm, our role as first among peers in ethical investing, our long term investment horizon, and our overarching risk mitigation philosophy.

It is our conviction that the future will not look like the past:  there is no longer just a single EM group, with poor countries converging to industrialized status slowly and surely over time, and advanced emerging markets graduating to developed countries. The reality is different: some countries are evolving in a positive direction, with improving standards of living, strong policy frameworks and an institutionalisation of democracy; while others are retrogressing, with deteriorating policy trajectories and declining quality of life factors. Here, an ESG framework helps us separate the wheat from the chaff, applying a forward-looking focus on long-term success that is different from our daily, alpha-oriented investment process. Such an approach sends a clear signal to countries of the increasing value investors accord to sustainability-related factors.

A related point is this: there are two ways to generate alpha — overweighting the champions but also underweighting the pitfalls. EM investing is not just about finding the best markets; it is also about avoiding the worst ones. Long-term sustainability, in our belief, is synonymous with minimising crisis or ‘blow up’ potential. Moreover, it is potentially harder to predict crises than it is to find alpha in EM given that the environmental, social and governance risks in the world have evolved. We cannot rely on past cycles and backtests; for the future, we must have a forward view on what will matter in this brave new world.

This brings us to our final point: investors do increasingly expect asset managers to don ESG lenses. Asset holders’ ethos and views are increasingly shaping the industry. In many countries, the drive toward ESG-tailored investing is inescapable. Investors have grown sceptical of exclusion lists and are looking for a more innovative, nuanced implementation of ESG research.

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