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April 02, 2009
ESG Trends in Emerging Markets Is Focus of New Study
    by Robert Kropp

Report from IFC and Mercer finds growth in sustainable investing in emerging markets, but notes need for improvement in such areas as active ownership.

Global survey data compiled by Mercer, an investment consulting firm, indicates that investment in sustainable investment funds in emerging markets has grown more than fivefold between 2003 and 2008, to more than $300 billion. $50 billion of this amount reflects funds which are specifically branded as socially responsible or sustainable, while the remaining amount represent mainstream managers who take environmental, social, and governance (ESG) issues into account.

Research by Mercer also found that sustainable investing in emerging markets has been driven by investors in developed markets seeking to achieve diversification in their investment portfolios.

The above research results were among the findings included in a report entitled Gaining Ground: Integrating Environmental, Social and Governance (ESG) Factors into Investment Processes in Emerging Markets, commissioned by the International Finance Corporation (IFC), a member of the World Bank Group, and written by Mercer.

The report's authors focused their inquiry into four major emerging markets: China, India, South Korea, and Brazil. In those markets, as in many emerging markets, rapid economic growth has led to depletion of natural resources and created challenges to sustainable development. Yet despite such challenges, the authors found that sustainable investment is gaining a foothold in emerging markets.

Ewan Marshall, Program Manager for IFC Sustainable Investment, said, "IFC invests $15 billion a year in emerging markets, and through those investments we hope to influence markets. We believe that good sustainability management is good investment management."

Specific questions fueled IFC's interest in sponsoring the report, Marshall said. "What are the best practice sustainable investment strategies within emerging markets?" he asked. "What are the themes and trends we see as sustainable investment in emerging markets grows?"

Danyelle Guyatt, a Principal in Mercer's Responsible Investment team and an author of the report, said, "We found that sustainable investment is taking hold in emerging markets, including on the local level. In general, standards of corporate governance are the starting points, although environmental and social issues are beginning to take hold as well."

While corporate governance was found by the authors to be a relatively well-understood concept when compared with environmental and social issues, they also found that investment managers struggle to obtain clarity on companies' governance structures in emerging markets. Furthermore, active engagement on ESG issues is not commonly pursued by most investment managers in emerging markets, and short-term investment horizons by managers whose portfolio turnovers exceed 100% annually tend to inhibit ESG integration in their investments.

"Active ownership has yet to become a first resort for fund managers in emerging markets," said Guyatt, "And we found few examples where managers felt ESG enhances value. Instead, managers focused more on ESG as a tool in risk management."

Each of the four countries surveyed in the report displayed characteristics specific to its cultural and economic trends.

In China, the report found, rapid economic development has led to environmental degradation and social inequality, which could hamper its long-term economic development. In response to the potential for an environmental crisis, the Chinese government has targeted a 20% reduction in energy consumption per unit of gross domestic product by 2010.

Also in response to environmental concerns, China has developed a Green Security Index that requires heavy polluting companies to undergo an environmental assessment before they seek listing on Chinese stock exchanges.

The report found that ESG improvements at a business level are challenged by China's position as a world factory whose pursuit of profits too often excludes consideration of ESG factors. Corporate regulatory compliance is more often driven by fear of sanction than by a belief in ESG practices.

Guyatt said, "In China, we found a lack of willingness on the part of fund managers to engage companies, even on governance issues." In large part, the difficulty of such engagement can be attributed to the Chinese government's dominant share ownership of most large-cap listed companies.

India was found to have the lowest standards of ESG implementation of the countries surveyed in the report. While some investment managers displayed some awareness of local social issues, especially regarding poverty reduction, access to clean water, and sanitation, active ownership of Indian companies was found to be noticeably absent.

On the other hand, Marshall of IFC pointed out, "The Stock Exchange in Mumbai does have a sustainability index." The S&P ESG India Index, which was initiated and sponsored by the IFC, comprises 50 Indian companies that meet ESG criteria.

South Korea has seen the largest increase of sustainable investment (SI) labeled funds, which grew from two in 2005 to 45 in 2008.The South Korea Exchange is developing an eco index listing, and plans to establish a socially responsible investment (SRI) index in the future. In December 2009, South Korea will be re-classified as a developed economy.

"In South Korea, we found a lot of reform in raising governance standards and addressing climate change." said Guyatt. "But in general there was a lack of good reporting on ESG standards, and little willingness to engage companies was in evidence."

In Brazil, where the concept of sustainability led to the creation of an SI labeled fund in 2001, engagement with companies on the issue of corporate governance has become fairly common, and the practice of proxy voting has begun to take root as well. However, lack of board independence and insufficient financial disclosure were found by the report to be common among Brazilian companies.

"Investment managers in Brazil tend to offer specialty products, rather than integrating ESG into mainstream products," said Guyatt. However, she did note that the Principles for Responsible Investment (PRI), a major driver for global sustainable investment, has 28 signatories in Brazil, including 18 pension funds, 8 asset managers and 2 professional service providers.

The report recommends a number of steps that asset managers should take to improve the incorporation of ESG factors in investments. Asset managers should develop and consistently promote an SI policy, and clarify their expectations regarding investment in emerging markets. They should integrate ESG and active ownership into their investment selection criteria.

Also, emerging market asset owners and managers should consider joining collaborative networks such as the PRI, in order to learn best practice of ESG activities and improve active ownership practices.


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