Doing good to do well in emerging market debt

Fixed income investors, especially emerging market debt investors, have been slower to adopt environmental, social and governance (ESG) and socially responsible investment (SRI) strategies, but the tide is clearly turning. 

As active managers, we have been making long-term investments principled on a comprehensive analysis of fundamental factors impacting a company, including the sustainability of its business model. What used to be seen as a tradeoff – generating attractive returns, reducing risk and doing the right thing – is now increasingly aligned. 

Modern ESG analysis arguably traces back to the United Nations (UN) Global Compact (2000) and the UN Principles of Responsible Investment (2005). These treaties helped establish the present framework for thinking about ESG factors. However, bottom-up, fundamental investors have applied many of them dating back much further. And much as ESG investment has been employed throughout the developed markets, we are seeing its growing significance across the world of emerging market debt. 

Integrating ESG analysis into our research process is integral for us to develop a more comprehensive understanding of the risk/reward of each investment and in turn make better investment decisions. Empirical data increasingly shows that adopting ESG-driven or SRI strategies does not translate into lower returns, but can enhance investment outcome. This motivates more investors to use their capital to “do good” in both developed markets and emerging markets. 

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EMBEDDING ESG ANALYSIS

First, governance has long been the focus of ESG investors. This boils down to understanding and evaluating companies’ decision-making. Management teams have tremendous power when utilising the capital entrusted to them by investors, it’s critical that investors have confidence that decisions will be made with all stakeholders’ best interest in mind and that they will be treated fairly. 

Second, environmental considerations have risen in prominence in face of climate change risks. Carbon emissions have become front of mind after the 2015 Paris Agreement, but environmental considerations are far broader. The risks and opportunities a company is exposed to from long-term energy transition or its access to natural resources are other examples of important environmental factors savvy investors incorporate in their decision-making. 

Third, social factors can be a source of headline risk that can result in reputational damage and/or regulatory fines for companies, capturing negative behaviors such as predatory pricing, human rights violations or weak labour practices. Positive social policies such as positive community relations, workplace diversity and talent retention can be sources of long-term competitive advantage. 

THE POWER OF ACTIVE ENGAGEMENT

ESG is a journey, not a destination, and engagement is the mode of transport. Truly understanding a company’s ESG factors and advocating for positive changes requires substantive engagement. As long-term investors, we believe in being proactive partners with our investments. We are obligated to be responsible stewards of our clients’ money. Companies that take a proactive approach and develop more sustainable business models are expected to deliver better long-term investment returns. 

We often get asked if fixed income investors can affect ESG change without equity shareholders’ voting power. Our answer is a resounding YES! As debt investors, we have access to a universe of unlisted private companies, increasing the opportunity to have positive impact. 

Many new to ESG investment may focus solely on the best-scoring companies. This is short-sighted; the greater opportunity to make positive impact lies at helping less advanced companies along the earlier parts of their journey to sustainability. Given the positive correlation between ESG scores and credit ratings, this is also where we can find more attractive investment returns. Most importantly, you cannot have an impact without having a seat at the table. Exclusions can result in portfolios aligned with particular ethical criteria but eliminate the possibility of advocating for positive change. 

Emerging markets are broad and complex with far more forces at play that can influence the outcome of an investment. How does ESG engagement look in the real world? In Brazil, we engaged with a major food producer who is a large consumer of soya beans – the production of which is causing severe deforestation in some countries. As a result of our engagement, this company established sustainable soya sourcing policies and procedures.

In China, we engaged with real estate developers after reports that some homebuilders were using CFC-11 (a banned chemical under the Montreal Protocol) as a foam blowing agent for thermal insulation. Besides ensuring that our investments had remained compliant with rules and regulations, in some cases our engagement raised management awareness and triggered them to more broadly investigate their construction processes.

The combination of active management and active engagement allows managers to urge companies to adopt more sustainable practices, identify companies whose ratings are likely to change, and adjust portfolios accordingly. 

In the emerging markets, there is a need to strike a balance between development priorities and sustainable investment practices. In many aspects the stakes for emerging markets countries and corporates are higher than their developed market counterparts. Much can be learnt from the latter, while there are the prospects for positive momentum in the emerging markets on ESG standards and practices are substantial with the help of asset owners and managers being actively engaged with businesses. 

Achieving better standards across ESG practices is a long game, but investors, including bond investors are able to affect change, however incremental. 
 
Paul Lukaszewski is head of corporate debt - Asia and Australia at Aberdeen Standard Investments.