Promoting responsible business and moving towards ESG-standards

Lower ESG-ratings for Emerging Markets due to their level of development

Emerging Markets is an expression that covers a large number of very different countries. This applies to their level of economic development, income levels for their citizens, and the degree of sustainability and compliance with ESG-criteria. Generally speaking, they exhibit a lower level of ESG-standards and sustainability than the developed, industrialised countries. In part, the reason for this is that some production processes that generate more environmental pollution and climate problems have been outsourced from the industrialised countries to the Emerging Markets.

One of the most important factors is that the relative weight of manufacturing, agriculture, and mining is generally higher in most of the Emerging Markets. This is typical for their phase of economic (under-)development. Among other things, these economic sectors basically have a larger carbon footprint and result in more environmental and climate burdens than the services sectors, which dominate developed economies. Social inequality and poverty tend to be more prevalent in the Emerging Markets than in the industrialised countries, often also as a result of the weak economic power and development levels.

Progress in ESG and sustainability are thus closely linked to the development levels of the individual economies; consequently, they are not just a question of intentions and depend to a large degree on what is or is not yet possible. Additionally, there are cultural and societal differences in terms of how people approach the governance of countries, communities, and companies. This can, but does not necessarily, lead to weaker outcomes in comparison to Western standards.

Why ESG-ratings don’t show the whole picture?

The ESG-ratings of the big international rating agencies and the logic behind these criteria are predicated on the value-based decision-making structures from the developed countries and take the conditions and prerequisites of these countries as a basis. At times, this can lead to unjustified negative assessments and to recommendations that are not always helpful. Anyone who takes a serious approach to responsible investment should not only draw their conclusions from the perspective of the prosperous industrialised countries and certainly not only view the situation on the basis of a limited range of absolute indicators, such as ESG-ratings.

The real, fundamental goal of sustainable investing with the consideration of ESG-criteria is to promote more responsible business practices. In the Emerging Markets, the main point is to gradually approximate the ESG-levels that are already taken as the minimum standards in many industrialised countries. In line with this, the fund Raiffeisen-EmergingMarkets-Rent will also bear the name “ESG-transformation” in the future and will consciously invest in issuers with comparatively lower ESG-ratings.

Risks and opportunities in the Emerging Markets

The lower ESG-levels in the Emerging Markets present both opportunities and risks for investors. The lower the levels of ESG and sustainability, the higher the risks associated with possible reputational damage, regulatory penalties in cases when labour rights and environmental regulations are violated, higher costs due to occupational and environmental accidents, damages due to corruption, etc., all of which can reduce earnings. On the other hand, in countries and/or companies that still have a lot of catching up to do in the field of ESG-issues, there are also significant potentials for improvement and thus for better earnings.

In this regard, one should not underestimate an advantage that many Emerging Market countries enjoy: In some cases, important sustainability projects, such as the energy transition, recycling, and more sustainable economic systems, are easier to implement in these countries, since they can be started with a clean slate. For example, building a new “greenfield” city in accordance with the most modern standards is easier than modernising an existing city.

Challenging, but rewarding: Betting on improvements in ESG rankings

The goal of the fund management is to recognise countries/issuers with high long-term ESG-potential and a positive ESG-trend, to invest in them, and thus to support them to a certain degree. Similar to the approach of the European Union, the first step is a focus on environmental and climate aspects. However, social (S) and governance (G) aspects are also taken into consideration as well. At the same time, the goal is to avoid investments in countries which have ESG-indicators that are too low, where the ESG-risks are too high, and/or there are default risks.

These quantitative selection methods are complemented with a qualitative assessment of the ESG and default risks. While quantitative indicators can provide a great deal of information, they do not always paint the whole picture. In the course of this work, the decisions of the fund management are documented in a logical and comprehensive manner. Countries with a trend of strong improvement in ESG-matters which have an adequately strong basis are given particular emphasis in this process (in the sense of “promoting and rewarding”). One integral part of the idea of ESG-transformation is that the ESG-level of the fund portfolio will increase over time.

In this regard, Raiffeisen-EmergingMarkets-ESG-Transformations-Rent harnesses three of the core competencies of Raiffeisen KAG:

• global bond management,

• Emerging Markets, and

• sustainable, responsible investment.

In this process, the fund draws on a wealth of award-winning sustainability expertise that has been developed over the course of many years. One important aspect is that – despite the transition to a more sustainable investment approach and the avoidance of certain issuers – the fund portfolio remains adequately diversified and that the investment characteristic of the fund as an Emerging Market government fund is maintained.

Current market conditions

USD-denominated hard-currency bonds from the Emerging Markets currently offer yields of just over 8% p.a. for maturities of around ten years (market average – the yield can differ significantly from this depending on the country). Even with currency hedging (the fund hedges EUR/USD exchange rate risk), this leaves a very impressive 5–6% p.a. in euro terms. However, this current portfolio return is not the same as the actual return for the investor, which is influenced by various other factors and can turn out to be higher or lower.

The current yields could also go a long way to offset potential further (moderate) yield increases for USD-denominated issues or a widening of spreads versus US government bonds. The latter would be entirely possible in connection with the US election. In general, however, the fund management also remains optimistic regarding the trend for spreads, and believes that they will continue to narrow slightly, which would mean additional earnings potential.