As the dust settles after the Glasgow COP26 meeting, it is clear that emerging markets and particularly the two largest players of China and India have emerged with their reputations tarnished. Despite India’s major announcements at the start of the meeting, its insistence along with China to adapt the wording to “phase down” rather than “phase out” unabated coal power stole the headlines. Should we characterise these countries as the villains in the fight against climate change or is the situation more nuanced? What implications, if any, does this have for the future of ESG and sustainable investing in emerging markets?
Beyond the headlines
The reality today is that both India and China (as well as other major emerging markets such as South Africa) have archaic power grids reliant on coal powered electricity. India gets 70% of its energy through this source. Will India be able to transition to clean power whilst still trying to substantially improve the lives of approximately 800 million people that live in poverty? The Glasgow Climate Pact acknowledges the need for a just transition stating in its opening paragraphs that:
“Acknowledging that climate change is a common concern of humankind, Parties should, when taking action to address climate change, respect, promote and consider their respective obligations on human rights, the right to health, the rights of indigenous peoples, local communities, migrants, children, persons with disabilities and people in vulnerable situations and the right to development, as well as gender equality, empowerment of women and intergenerational equity”
It is clear that India still expects to be using coal power for some time, but the government has nevertheless committed to reducing the carbon intensity of the economy by 45% by 2030. To achieve this, the switch from coal to renewable energy will still need to be dramatic. As countries are now required to produce Nationally Determined Contributions (NDCs) on an almost annual basis, there is hope that this will provide the momentum and the transparency to turn rhetoric into reality.
Thus, we see both protectionism at a national level (which may be viewed as short-termism) but also a greater willingness to commit to time-based targets. What does this mean for an investor who wants to invest sustainably in emerging markets?
New impetus, familiar problems
COP26 and the ongoing wave of sustainability related disclosures and regulations have led to increased investor focus on this area, as well as greater scrutiny of companies. Emerging markets are part of this trend, but still suffer from data availability issues when compared to developed markets. As seasoned emerging market investors, we are sadly accustomed to this issue, and we prefer to gather key data ourselves. Whilst this is very achievable, we fear that many of our peers do not have the depth of experience nor willingness to undertake this exercise.
So, whilst we expect to see much higher disclosure levels from companies in emerging markets over the coming years, the starting point is unfortunately so low that bottom-up, fundamental research is required, and still will be for an extended period.
Emerging sustainability trends in emerging markets
Emerging market growth is well known for being driven by urbanisation, increased consumption and great demographics. Whilst these clearly have implications for raising rather than reducing emissions, the subsequent increase in wealth is driving trends that mitigate these factors.
Firstly, we are seeing people move from the informal economy to the formal economy. Even small shifts here can have an impact as consumption switches to more regulated and less environmentally damaging products.
Another key driver is digitisation. For example, banking will be much less reliant on physical branches and can scale at much lower marginal cost and with lower resource requirements. This also helps the switch to the formal economy, with less cash-based payments and flows that are easier to track for taxation purposes. We are already seeing rapid adoption of digital services across many emerging markets, as we have witnessed in the UK. It is important to note however that modern computing is responsible for about 3% of global Co2 emissions – which matches the Co2 emissions from the entire aviation industry (source: Yale School of the Environment, 2018). Investors focused on sustainability therefore need to maintain the same level of vigilance around the environmental impact of these companies as they do for “bricks and mortar” businesses, particularly in terms of water usage (which cools data centres) and the ultimate source of the electricity used (renewables, or from burning fossil fuels).
Climate change adaptation and mitigation also presents opportunities for investors in emerging markets. As the unit cost of solar and wind power has plummeted, companies are increasingly investing in these sources, resulting in a surge in renewable energy generation. At COP26, India announced a new goal of 50% of power capacity to be based on clean energy by 2030 (versus 23% now, according to the International Energy Association) and by the same year to reduce total projected carbon emissions by one billion tonnes. Perhaps surprisingly, India already ranks as 4th globally in terms of wind capacity and 6th largest in terms of solar photovoltaic (PV) capacity. The use of solar power has grown almost 15-fold in the six years to the end of 2020, from 2630MW to 39211MW, encouraged by a government scheme which funds between 30% and 70% of the installation costs for rooftop PV systems.
However, we need to be cautious with regards to investments in the generation sector, as these companies typically sell electricity to the local governments, where there are significant counter-party risks (for example, the government can be very slow to pay, or reduced payment terms mid-contract). We prefer to have impact through engaging with corporates on their use and sources of energy, and to encourage change at the individual company level where required. For example, Hero Motocorp, a two-wheeler manufacturer, has been a trailblazer by dramatically increasing their solar capacity as part of their goal to become carbon neutral by 2030. Banks, such as ICICI is also installing solar capacity as well as purchasing renewable energy from external sources. In Taiwan, we have invested in Century Iron and Steel, which is a specialist manufacturer of the underwater portion of wind turbines.
Food production is another area that will undergo a huge transformation. We face twin challenges as agriculture contributes 30% of global GHG emissions but we also need to feed a global population that will approach 10bn by 2050. Agriculture also significantly impacts biodiversity, water scarcity and anti-microbial resistance caused by overuse of antibiotics in intensive livestock farming. Many companies in the food retail sector, such as Atacadão in Brazil, have policies regarding zero deforestation and animal welfare. But Atacadão goes much further, not only engaging with meat suppliers to explain their requirements, but mapping the locations of their farms and using satellite imaging to ensure deforestation is not occurring. In terms of animal welfare, Atacadão encourages suppliers to follow the five freedoms of the Farm Animal Welfare Council, as well as specific policies for pig rearing and will ensure all eggs are from cage-free chickens by 2025. This is a template that we encourage other emerging market food retailers to follow.
ESG is not enough
Investors focused on sustainable investing in emerging markets are poised to benefit from one of the biggest economic transformations ever, and certainly one of the biggest in our lifetimes. Emerging markets are not homogenous and can range from highly developed economies such as Taiwan and Korea (which are driven by innovation) to new, emerging economies such as Bangladesh, Peru and Egypt (where growth is driven by urbanisation, and the shift from the informal to the formal sector). But along with these opportunities come responsibilities. ESG analysis is a great first step, but is not enough on its own. Investors need to think about the long term environmental and social impact of their investments and allocate their own capital to support sustainable development. This is not a cost, but an investment in the future. The way you allocate capital shapes society.
In the words of Jaqueline Novogratz (CEO of Acumen) “You have got to have the humility to see the world as it is, but have the audacity…to imagine the way it could be”
Head of Emerging Markets
Alquity Investment Management Limited
The views expressed in this article are those of Mike Sell and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact, nor should any reliance be placed on them when making investment decisions. Any stock examples used in this article are not intended to represent recommendations to buy or sell.
 Adam Bryant “How to be a CEO, from a Decade’s worth of Them’ New York Times, 27.10.2017
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