The developing world offers potential for greater investment impact.
Emerging market investments have the potential to deliver greater real-world impact than investing in developed markets, said a report from the UN-convened Principles for Responsible Investment (PRI). Increased investment in emerging markets is a key component of the global push to reduce emissions and mitigate the worst impacts of the climate crisis, PRI said.
The report cites the United Nations Conference on Trade and Development figures of a “significant funding gap” in emerging countries in financing the UN’s Sustainable Development Goals (SDGs). Annual financing for SDGs in these markets is running at a shortfall of US$2.5 trillion, a figure that has increased by 50% since the outbreak of the COVID-19 pandemic. For the SDGs to be adequately funded, around US$5-7 trillion is required annually, US$3.5-4.5 trillion of which would be in emerging markets.
Not only did the COVID-19 pandemic create additional capital needs, but it also reduced existing funding in emerging markets. Investments in renewable energy (thus falling under SDG 13), including installations for renewable energy generation, fell by 80%, for example. Investment in renewable energy infrastructure in emerging markets is particularly important in addressing climate change, according to a report by the International Energy Agency. Investment in the provision of water and sanitation (SDG 6) to industry and households fell by 68%.
Barriers to investment
PRI says the funding gap in emerging markets indicates the presence of “significant barriers” that prevent greater investment flows. The most cited risks by investors are political or social instability or corruption – issues that stem from underlying problems such as inequality, health and safety, decent work and gender disparities, said PRI.
“Having a strong understanding of ESG factors and developing robust processes to assess how they apply in different contexts can help investors to overcome some of those barriers associated with emerging markets investing,” said the report. Investors with a strong grasp of ESG factors will be better placed to determine and manage the materiality of the risks in specific emerging markets, “rather than relying on common (mis)conceptions to shape their positions”.
The report sets out how investors can apply responsible investment practices to manage risk and meet return objectives for clients and beneficiaries, while working towards closing the funding gap in emerging markets.
Developing sustainable finance policy frameworks that can support climate and SDG-aligned capital markets is a core part of creating an environment that attracts and enables responsible investment. However, the existence and implementation of sustainable finance policy frameworks varies widely between countries. Another challenge for investors is that coverage of emerging markets by ESG data providers is weak.
Engagement and collaboration
To address these challenges, PRI suggests that institutional investors and multilateral institutions continue to engage with governments and local regulators on developing and implementing sustainable finance policy frameworks that align with the SDGs and the Paris Agreement.
“Creating an enabling environment to attract more long-term responsible institutional capital is an important step for emerging markets economies,” said the report.
Comprehensive policy frameworks that can support climate- and SDG-aligned capital markets are a core component of this, as set out in the PRI and the World Bank’s toolkit for sustainable investment policy and regulation.
PRI urges standard setters, institutional investors, corporates and stock exchanges to collaborate to improve capital market disclosure practices.
As policymakers create an environment that enables responsible investment, asset owners should take steps to understand how their asset allocation decisions can support greater investments in emerging markets.
There are challenges here, too, including a lack of expertise in assessing emerging market risks and opportunities. Moreover, sustainability outcomes and ESG factors are not widely considered in asset allocation. Finally, mainstream and ESG index composition can be problematic for emerging markets, affecting asset allocation decisions.
These challenges can be addressed in a variety of ways, including supporting investment consultants and asset owners to develop strategic asset allocation frameworks that consider sustainability outcomes.
Additionally, relevant stakeholders should collaborate and engage with regulators, ESG data and index providers to expand emerging markets coverage and improve index and rating methodologies. Developed and emerging markets-based asset owners should also consider sharing their experiences to develop best practices.
Investment products and structures, such as green/sustainable development bonds and blended finance, can help asset owners to directly support sustainability outcomes. These products must adhere to green/SDG standards and meet investors’ liquidity and risk constraints.
PRI notes that emerging markets-based managers face “significant barriers” to attracting commitments from institutional asset owners and that not enough private capital is mobilised by multilateral development banks and other public institutions.
Knowledge and capacity building efforts should help institutional investors to access local partners, data and risk mitigation tools and sustainable investment opportunities. Investors should seek opportunities to participate in and/or support asset class-specific activities that aim to grow opportunities and capacity in emerging markets.
“Closing the funding gap while delivering return objectives in emerging markets requires investors, multilateral institutions, service providers and governments to take concerted, collaborative, long-term action,” said PRI.