Asset managers warn sustainable finance rules could reduce financing to emerging markets

Emerging Markets

Asset managers are warning that new sustainable finance rules in Europe could end up reducing financing to emerging economies, where capital is most needed to fund the renewable energy transition.

The EU published its sustainable finance framework last week, setting out the bloc’s milestones and measures for Europe’s financial sector to show how it is contributing to the goal of net-zero carbon emissions by 2050.

While asset manager Ninety One “fully supports the intention behind” the new rules, it warns that they “set high hurdles for what qualifies as a sustainable investment”. The Anglo-South African firm runs GBP130 billion in assets under management.

Therese Niklasson, global head of ESG at Ninety One, says: “Care must be taken that emerging markets in particular, where some companies may be catching up with respect to reporting, disclosures and other aspects of sustainability performance, are not excluded from the capital needed to drive the net-zero transition.”

Otherwise, emerging market economies could face a “climate investment trap”, with access to low-cost finance constrained by Europe’s new sustainability rules, according to researchers at University College London.

“Emerging market economies need time, support and financial resources to transition, yet the funding shortfall is huge, with just 20 per cent of clean energy-investment going to these regions,” says Niklasson.

Clean energy investment in emerging and developing economies declined by 8 per cent to less than USD150 billion in 2020, according to the International Energy Agency. This needs to rise by more than seven times to put the world on track for net-zero emissions by 2050.

Niklasson adds: “Divesting from high emitting nations and sectors further expedites the problem, diverting away the capital critically needed by these economies to fund their transition.” 

Switzerland-based Pictet Asset Management currently manages USD258 billion in assets, and recently published research with the Smith School of Enterprise and the Environment at the University of Oxford. Together, they found that emerging markets face the highest risks from climate change, with Brazil and India potentially losing up to 60 per cent of their GDP per capita by the end of the century.

However, in the global bond market, the overwhelming majority of financing for green and sustainability-linked bonds goes to developed countries. Italy’s recent inaugural green bond raised more than all emerging market sovereign green issuance in 2020.

The challenge for asset managers is to ensure that financing goes where it can have the greatest impact, says Mary-Therese Barton, head of emerging market debt at Pictet Asset Management.

The EU’s definition of sustainability aims to deter greenwashing, but applying it to emerging markets could be more complicated.

Barton asks: “How should you measure sustainability for EM? Is it on an absolute risk-level in terms of good to bad, or should it be on the ‘Delta’, on the change, on where you're seeing improvement and looking to move the needle?” 

The countries with the lowest ESG scores are often where investors can have the greatest impact, according to Barton. “For us, the focus always needs to be more on that delta, on that degree of change,” says Barton. 

Barton gives the example of Angola, a country whose low ESG ranking has led it to be excluded from its benchmark index.

“We have seen significant improvement on the governance side, and also on some of the social criteria, and thus, that is a name that we will own,” she says.

Pictet has also participated in green and social bond issuance from several countries including Egypt, Chile, and Hungary.

“If you look at your portfolio, and your universe as a whole, you see that improvement from the [worse-performing] part of the spectrum of ESG, actually results in a much bigger improvement on overall scoring. I think what this argues for is that in EM, you need a much more nuanced approach to looking at ESG,” says Barton.

Passive index funds that focus on ESG scores often exclude countries and companies in emerging markets that are improving, if they do not already meet certain standards. Similarly in equity markets, index provider FTSE Russell have threatened to remove 200 companies from a family of its global stock indices for failing to meet tougher environmental standards.

“Particularly from the EM perspective, passive ESG investing does raise a lot more questions,” says Barton. 

Active managers are also facing greater pressure to improve portfolio-level ESG scores, which rewards taking an exclusionary approach to issuers and companies.

Ninety One recently joined the Net Zero Asset Managers initiative, an investor group which aims to align investment portfolios with the goal of achieving net-zero carbon emissions by 2050.

Other signatories include BlackRock, Invesco, and Aviva Investors, and the initiative covers USD43 trillion in collective assets.

Niklasson has warned against focusing too much on reducing carbon emissions at a portfolio-level, which she says risks “shifting, rather than helping to solve” the problem. Instead, the industry “needs greater transparency around changes in portfolio footprints versus achieving decarbonisation in the real world”.