Closing the funding gap: The case for ESG incorporation and sustainability outcomes in emerging markets

Nonetheless, the funding gap indicates that there are significant barriers preventing greater investment flows into emerging markets:

• Global indices do not always reflect overall size of emerging markets: Emerging market economies represent a very small proportion of global public equity indices – just 12% of the MSCI’s All Countries World Index – despite comprising 57% of global GDP on a purchasing power parity basis. Market capitalisation to GDP ratios in emerging markets are also much lower. ^[7] Consequently, it is more difficult for investors to gain public markets exposure, and this is reflected in average allocations. ^[8]
• Capital flows are concentrated towards countries with least need: Market capitalisation-weighted benchmarks tend to direct institutional public market capital flows towards emerging economies with less capital shortages. For example, China, Taiwan and South Korea account for 65% of holdings in the MSCI emerging markets index , a widely used benchmark for pan-emerging markets listed equity funds, despite it covering 26 countries in total.
• Smaller capital markets and opportunity sets: Capital markets are often underdeveloped, especially for instruments such as sustainable or green bonds, and can be less liquid than in developed markets. Moreover, investment opportunity sets are limited – public markets do not provide deep access, and private markets are challenging, not least because individual opportunities are often too small for large asset owners.
• Concentrated ownership structures; limited corporate governance: Minority shareholder rights can be less secure while a higher prevalence of state-owned ^[9] or family-owned enterprises may also limit investment and stewardship opportunities.
• Perceptions of political and corruption risks are stronger: Investors and companies point to weak rule of law, regulatory instability, and higher levels of bribery in some emerging markets countries.
• Macroeconomic (in)stability and currency risks: Developed market-based investors have persistent concerns about macroeconomic instability and its impact on local currencies and exchange rate risks.
• Lack of data: Although also a developed markets problem, this is particularly acute in emerging markets. Availability ranges widely across different countries and becomes particularly scarce outside the large-cap universe.
• Lack of experience: Institutional investors often lack the resources and experience, particularly in private markets, to commit substantial capital.

This paper discusses how investors can use responsible investment practices such as ESG incorporation to identify opportunities and to manage risk and meet return objectives for clients and beneficiaries. It also highlights how a focus on sustainability outcomes can in some cases present solutions to the perennial challenges facing emerging market investors.

We consider the different roles that investors can play – from engaging with policy makers to working with investees.

Creating an enabling environment to attract more long-term responsible institutional capital is an important step for emerging markets economies. 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 .

Doing so can:

• enhance the resilience and stability of emerging market economies;
• improve market efficiency by clarifying and aligning investor and company expectations; including where considering sustainability outcomes is required or allowed;
• increase local ESG and sustainability standards, and encourage other countries to take similar steps; and
• increase the attractiveness of countries as investment destinations.

A growing number of countries are developing these policy tools – of the 750 sustainable finance policy tools tracked by the PRI from 86 countries ^[10] , 253 can be found in emerging markets. Some examples are listed in Figure 3. 

Figure 3: Emerging markets sustainable finance framework developments

While the examples above indicate progress, it is also clear from our research that many emerging market governments need to introduce or strengthen sustainable finance policy frameworks.

Interviewees pointed to gaps such as:

• a lack of consistent policies and regulations that set a clear pathway to deliver on the Paris Agreement goals or on countries’ climate commitments. For example, China put 38.4 gigawatts of new coal-fired power capacity into operation in 2020 , despite the government’s commitment to be carbon neutral by 2060.
• a lack of coordination between key stakeholders and/or a lack of resources to hold laggards or rule-breakers fully to account. For example, in Brazil, the government’s funding cuts for official environmental and indigenous rights’ protection work is undermining positive action on climate disclosure requirements by the central bank and broader industry initiatives such as the Finance Innovation Lab .

The COVID-19 pandemic has exacerbated these gaps. Despite exposing critical environmental, social and governance issues, many governments have focused on short-term fiscal fixes ahead of long-term development needs.

Investors, businesses, international institutions and civil society have a role to play in supporting, incentivising or pressuring governments to improve their sustainable finance policy frameworks.

Some governments and institutions are increasingly using the SDGs and high-level climate commitments as a way of signalling their commitment to building more sustainable economies to investors. As noted above, in certain cases this has not yet translated into definitive or consistent action at the policy level. However, there are examples of how countries are aligning policy, financing plans and development strategies with the SDGs and climate goals to attract more responsible capital. These include:

• Kenya’s third Medium Term Plan under its social and economic development strategy – Kenya Vision 2030 – which seeks to align all policies and programmes with the SDGs.
• Colombia’s Inter-Sectorial Commission on Climate Change (CICC), which supports stronger government coordination and planning in relation to the country’s infrastructure needs to meet its climate change goals. Through the Ministry of the Environment and Sustainable Development and the National Planning Department, the CICC brings together ministries and regional authorities, government climate policy and national and sub-national action. There is also a clear remit for fostering dialogue with and communicating investment opportunities to the private sector.

Several countries have also issued green and sustainability bonds that link directly to development strategies and projects that are aligned with the SDGs and/or climate-related goals ( see Supply of investable opportunities for more detail ).

Creating an environment that enables responsible investment is not just the remit of governments, and often requires extensive collaboration with multilateral institutions, including the World Bank and various development finance institutions (DFIs).

Such organisations have long been involved in providing technical assistance and financial resources to emerging markets – an increased focus on sustainability outcomes directly aligns – and gives impetus to – their core missions. Institutional investors can also play a role beyond finance to provide expertise on myriad issues to push the emerging market sustainability efforts further.

Examples of recent collaborative initiatives include:

• The International Finance Corporation-led Scaling Solar programme, which has helped build competitive renewable energy markets in several countries since 2015, including Zambia, Senegal and Uzbekistan.
• FAST-Infra , which aims to accelerate the flow of private investment to sustainable infrastructure in developing countries. The private-public partnership involves infrastructure investors, banks, DFIs and non-governmental organisations.
• The UN-convened Global Investors for Sustainable Development Alliance  (GISD), which brings together several large global financial institutions and corporations, and works to overcome barriers and scale up financing for long-term investment, including in emerging markets.

The need for meaningful and comprehensive ESG data is a theme that cuts across all elements of this paper. For emerging markets such data is often severely lacking, caused by weak or non-existent disclosure requirements and poor coverage by most major data providers, among other factors.

This represents a significant barrier to increasing responsible investment in emerging markets, making it more difficult to eliminate the gap between actual and perceived risk and to assess the ESG performance of investee companies and assets. ^[11] This has a negative effect not only on decisions around asset allocation, manager selection and different investment products, but also on the way that engagements can be conducted with investee companies or how assets and portfolio companies are managed on the ground.

Some progress has been made, albeit starting from a low base. Some investors are either building their own datasets and data assessment capabilities (see Developing an ESG rating system – China Southern Asset Management), or accessing free datasets provided by institutions such as the World Bank, to help identify potential opportunities or strengthen their investment decisions.

Interviewees also point to evidence of progress among policy makers and stock exchanges:

• Financial regulators in Brazil and South Africa have developed corporate ESG disclosure rules, while Russian authorities are considering introducing these on a comply-or-explain basis.
• An increasing number of emerging market countries are also adopting the recommendations of the TCFD, including Mexico, Brazil and South Africa.
• The Sustainable Stock Exchanges initiative is working to develop model guidance on climate disclosure and has developed training programmes for stock exchanges on ESG issues more broadly.

Nonetheless, ensuring that ESG data on emerging market companies, sovereigns and assets is meaningful and comprehensive will require extensive, and intensive, collaboration by a range of stakeholders ( see Next Steps section ).

Having a strong understanding of ESG factors and developing robust processes to assess how these factors apply in different contexts can help investors to overcome some of the barriers associated with emerging markets investing.

Some of the risks most cited – around political or social instability, or corruption, for example – stem from underlying issues such as inequality, health and safety, decent work, and gender disparities.

Investors with a strong grasp of these are therefore better placed to determine and manage the materiality of those risks in specific emerging markets, rather than relying on common (mis)perceptions to shape their positions.

Ultimately, developing better knowledge of emerging markets will drive more informed decisions on what products, investments and managers can best meet their requirements. Our interviews revealed some of the ways in which asset owners are building the capabilities to do so, including:

• Establishing local offices  in or around the countries they want to invest in, particularly if they view emerging markets as a core source of long-term growth. For example, the Canada Pension Plan Investment Board aims to have one-third of its capital invested in emerging markets by 2025 , and has built a significant presence in markets such as Latin America and Hong Kong to support that effort.
• Collaboration with external parties that have a longer-term track record in emerging markets or specialist investments. For many years, institutional investors have partnered with DFIs, in large part to benefit from their local knowledge and potential to de-risk projects. Other examples point to deeper levels of collaboration and bringing together expertise outside of the development finance world:
  • STOA , a French entity that invests in sustainable infrastructure and energy projects in emerging markets, is a collaboration between the pension fund Caisse des Dépôts and Consignations, and Agence Française de Développement, the French development agency. The former provides the financial expertise, the latter primarily the sustainability knowledge and experience of emerging markets.
  • A Canadian pension fund with a track record in infrastructure investing has partnered with a Latin American pension fund to share asset class expertise and local knowledge respectively.

The belief that investing in emerging markets can deliver greater real-world impact than investing in developed markets is also evolving as a factor in asset allocation decisions, according to several interviewees, alongside more traditional considerations such as the potential for strong returns and diversification.

For example, some asset owners are making a direct link between emerging market investments and delivering on the SDGs or on climate change commitments.

This can take different forms. The Institutional Investors Group on Climate Change’s Net-Zero Investment Framework encourages asset owners to consider less familiar asset classes, such as renewable energy. Emerging economies that develop renewable energy industries can benefit from this, with India, Vietnam, Chile and Mexico already proving attractive for institutional investors. ^[12]

In Scaling Blended Finance , the Net-Zero Asset Owner Alliance (NZAOA), highlights greater investment in emerging markets as a critical means for its members to help meet their commitments to decarbonise their investment portfolios to net-zero by 2050.

“You can’t be an emerging markets investor without thinking about development goals – the high [political] risks make it essential to align your investments with the needs of the local markets.”

Private equity general partner

The need for meaningful and comprehensive ESG data is a theme that cuts across all elements of this paper. For emerging markets such data is often severely lacking, caused by weak or non-existent disclosure requirements and poor coverage by most major data providers, among other factors.

This represents a significant barrier to increasing responsible investment in emerging markets, making it more difficult to eliminate the gap between actual and perceived risk and to assess the ESG performance of investee companies and assets.11 This has a negative effect not only on decisions around asset allocation, manager selection and different investment products, but also on the way that engagements can be conducted with investee companies or how assets and portfolio companies are managed on the ground.

Some progress has been made, albeit starting from a low base. Some investors are either building their own datasets and data assessment capabilities ( see Developing an ESG rating system – China Southern Asset Management ), or accessing free datasets provided by institutions such as the World Bank, to help identify potential opportunities or strengthen their investment decisions.

The strategic use of development finance to mobilise additional capital towards sustainable development ^[19] has attracted much attention for its potential to make projects and companies more investible.

Mechanisms such as first-loss guarantees, currency hedging and risk insurance can lower the risk for institutional investors, making blended finance an important tool for attracting increased investment to projects that contribute to the SDGs and climate goals, as recognised by the NZAOA and the GISD. The latter published a report in 2020, Renewed, Recharged and Reinforced: Urgent actions to harmonize and scale sustainable finance , calling for a global blended finance fund to be established to rapidly scale up investments that contribute to the SDGs.

However, despite the increased attention it has received, the scale of blended finance activities remains small ( see Figure 6 ) compared to overall financing needs. Research by Convergence , a global network for blended finance, highlights that more private capital needs to be mobilised through blended finance structures by multilateral development banks (MDBs) and other public institutions.

To this effect, the Business and Sustainable Development Commission’s Blended Finance Taskforce recommended that MDBs set ambitious targets for mobilisation, standardise products, reduce transaction times, pool assets and recycle them off their balance sheets, and create shifts in incentives and capabilities. These are all measures that could help improve the attractiveness of blended finance opportunities to institutional investors.

Figure 6: Blended finance flows 2010 – September 2021. Source: Convergence (2021) The State of Blended Finance 2021 .

The challenge here is not just financial – creating enough bankable projects to invest in is equally important.

For example, the SDG Investment Fund, a blended finance fund managed by the Danish development finance institution IFU, had total commitments of around €650m in 2018, but it had only managed to deploy 46% to active investments by its third year due to a lack of such projects. ^[20]

Bankable projects can grow if emerging market governments develop the market conditions to enable them – with technical support from multilateral institutions and other stakeholders, as discussed in Creating an enabling environment .

While some asset owners access emerging markets investment opportunities directly, others use third-party investment managers. Interviewees highlighted various approaches to doing so, including:

• Allocating to large investment managers and funds: Some asset owners prefer to invest in large emerging markets-focused funds run by some of the world’s biggest investment managers – such as KKR, which closed a US$15bn Asia-Pacific-focused fund in April 2021 , or Hillhouse Capital, which raised US$18bn for its most recent fund . They do so for several reasons, including cost considerations, to gain exposure to a broader range of investments and economies, or familiarity with bigger managers compared to smaller specialists. However, some interviewees expressed concern that this approach can exclude smaller managers and lead to more investments in larger companies rather than the small and medium-size enterprises that may have more urgent capital needs.
• Investing in funds of funds: Some asset owners prefer to use a fund of funds structure for their emerging market investments – even if they wouldn’t take this approach for their developed market investments – as it can provide highly diversified exposure to managers, markets and opportunities that they would otherwise not have access to.
• Allocating to managers with specific expertise: Others increasingly look to investment managers with specific regional expertise, rather than firms that cover all emerging markets, on the basis that they better understand those geographies and the ESG factors that are most material to them.

Regardless of their overall investment objectives, most interviewees emphasised the importance of assessing a manager’s responsible investment approach to establish their credibility. Although relevant to manager selection in all markets, it is considered particularly relevant in emerging markets, because strong ESG and sustainability capabilities can:

• better distinguish which factors are most relevant per country, given the diversity of emerging markets ( see also Asset allocation and ESG incorporation and active ownership sections );
• ease the reluctance that some asset owners have to invest with managers that lack an established investment track record; and
• offset the lack of quality emerging markets ESG data that is readily available, particularly if managers develop their own data and analytics beyond what third-party firms can provide ( see also ESG data in emerging markets ).

Most interviewees agreed that while key ESG factors are often assessed in the same way across many different developed markets, assessing them in emerging markets requires real understanding of each country’s nuances and contexts.

For example, labour standards can be considered reasonably homogenous across much of the EU but can vary significantly in emerging markets, including within the same region – indeed, 86% of the world’s informal employment is in emerging countries, the International Labour Organisation estimates .

“You need [to take] a nuanced approach in the implementation of ESG standards, as they can differ between countries [given their different] cultures, legislation, business integrity and corruption [risks]. It needs to be done on a case by case basis.”

Developed markets-based investment manager

Interviewees also highlighted that greater emphasis is often placed on social and governance factors than environmental factors – that in turn requires investors to adopt different approaches to understanding and managing these critical issues.

For example, in Latin America, many economies and companies depend on ‘dirty’ industries such as mining, oil and gas, and cement. In this context, while investor support for decarbonisation efforts is hugely important, more consideration must be given to the jobs and broader socio-economic development that those industries support. Failing to do so risks further exacerbating the already-high levels of poverty in the region. This could subsequently drive greater levels of inequality, political instability and unrest and undermine longer-term growth prospects.

Investors therefore have a significant responsibility to understand and help address these long-term challenges as they engage with governments and companies – from the perspective of facilitating the transition to a cleaner economy and of advancing human rights, an agenda that will grow in importance for investors in the years ahead .

Developing the expertise internally to assess ESG factors in an emerging markets context – whether in a dedicated team or more broadly across the organisation – can take time and resources.

However, in the absence of widespread coverage of emerging markets by ESG data providers ( see ESG data in emerging markets ), this is regarded as a necessity by most emerging markets-focused managers.

Many firms use external consultants to support this work, although interviewees noted that environmental expertise is more prevalent than social and governance expertise among such third-party organisations.

Private markets investors also highlighted that frameworks such as the IFC’s Environmental and Social Performance Standards are an excellent starting point for work on identifying ESG risks and opportunities. Many other DFIs have similar frameworks of their own.

Assessing opportunities through an outcomes lens

Several organisations are using sustainability outcomes to further assess individual investments:

• The SDGs : One private markets investor interviewed cited an investment in a company providing temporary energy solutions for social infrastructure such as hospitals and schools. The investor used the SDGs to help identify the social benefits that the deal could deliver, while at the same time working with the company post-investment to mitigate the negative impact caused by using high-emission fuels, helping the investee transition to cleaner technology.
• The Nationally Defined Contributions (NDCs) : Another investor highlighted how it considers opportunities in the context of each individual country’s climate trajectories in their NDCs under the Paris Agreement. An investment in a (more developed) country may be rejected because its associated emissions are too high, but the same type of investment in a different (less developed) country may be accepted because the emissions fall within its climate trajectory, and because of the wider societal benefits the investment can bring.

“We evaluate across the SDGs and how an investment impacts on [them], both positively and negatively. We look to the opportunities to improve over time, by decreasing the negatives.”

Developed markets-based investment manager

The concept of engagement is not always well understood and investors may need to dedicate more time or resources to articulate the value they bring.

Regardless, responsible investors have a duty to be active stewards of capital. For PRI signatories, this is enshrined in Principle 2 .

If engaging individually is not effective or feasible, collaborative engagement provides another route for fulfilling this duty. ^[21]  This is also a core component of the PRI’s Active Ownership 2.0 , which prioritises delivering outcomes on systemic issues. This can only be achieved through enhanced collaborative engagement, where investors coordinate on specific objectives while taking some actions individually.

Research on PRI-coordinated collaborative engagements between 2007 and 2017 found that success rates increased by about one-third when there was a lead investor heading the dialogue on behalf of a coalition. They were particularly enhanced when that investor was headquartered in the same region as the target firm.

It noted: “For maximum effect, coordinated engagements on ESG issues should have a lead investor that is well suited linguistically, culturally and socially to influencing target companies.” This is particularly important in emerging markets, given their diversity.

“The value that the investor brings, through the due diligence it does, its gap analysis against the IFC Performance Standards etc [needs to be] articulated … in a way that the [investee] can understand.”

Development markets-based investment manager

The predominance of family- or state-owned enterprises can change the dynamics of an engagement, with investors potentially having to navigate a range of political or private considerations in the process. Company structures – including their boards – may not always be institutionalised, which can also affect investor engagement and its outcomes.

Nonetheless, according to research by Credit Suisse , family-owned businesses can have a longer-term focus compared to non-family-owned companies, which can contribute to their outperformance.

Emerging and frontier equities specialist East Capital points out in its annual sustainability report that its starting point for identifying potential investments (and the basis for its engagement activities) is to assess a company’s ownership.

It notes that the more personal nature of company management requires investors to have boots on the ground – “you have to meet the owners, virtually if not physically. While some shareholders may be reluctant to engage, those in it for the long haul will most likely be glad to establish a dialogue.”

Escalating an unsuccessful engagement with or divesting from emerging markets holdings may be harder than in developed markets, given the lack of potential alternative investment options. Divestment may also be difficult where a country or sector is financially significant to a portfolio or index.

As a consequence, one asset owner noted that it has developed a country engagement framework based on the salience of human rights issues and is using that to increase its engagement efforts with companies, including obtaining information on their processes for human rights risk management. This is aligned with the responsibility all investors have to respect human rights.

Key challenges :

• The existence and implementation of sustainable finance policy frameworks varies widely between countries.
• ESG data provider coverage of emerging markets is weak.

Suggested actions :

• 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.
• Standard setters, institutional investors, corporates and stock exchanges collaborate to improve capital market disclosure practices.
• Interested stakeholders collaborate to engage with ESG data providers to improve emerging markets data coverage and methodologies.

Key challenges :

• Asset owners can lack expertise to assess emerging market risks and opportunities.
• Sustainability outcomes and ESG factors are not widely considered in asset allocation.
• Mainstream and ESG index composition can be problematic for emerging markets, affecting asset allocation decisions.

Suggested actions:

• Support investment consultants and asset owners develop strategic asset allocation frameworks that consider sustainability outcomes.
• Relevant stakeholders 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 share their experiences to develop best practices.

Key challenges :

• Accessing opportunities and bankable projects that:
  • adhere to green/SDG standards;
  • meet investors’ liquidity and risk constraints.
• Poor signposting of green/SDG investment opportunities.
• Not enough private capital mobilisation by multilateral development banks and other public institutions.
• Emerging markets-based managers face significant barriers to attracting commitments from institutional asset owners.

Suggested actions:

• Continue knowledge and capacity-building efforts to help institutional investors access:
  • sustainable investment opportunities (such as green, social and sustainability bonds, blended finance);
  • local partners, data and risk mitigation tools.
• Further align incentives between donors, development finance institutions and institutional investors.
• Investors seek out opportunities to participate in and/or support asset class-specific activities that aim to grow opportunities and capacity in emerging mar

Key challenges :

• Cultural and structural differences in the understanding and application of active ownership.
• Insufficient local ESG and impact knowledge and experience, whether within the investment community or companies.

Suggested actions:

• Raise awareness about the different engagement approaches and how to identify critical sustainability issues in local contexts.
• International and local investors find opportunities to engage collaboratively, share information and develop best practice.
• Continue partnerships between development finance institutions and local emerging market partners (investors, government agencies, regulators etc) to provide ongoing technical support on responsible investment.