Magda, isn’t EMD investing all about crunching fiscal numbers? How can Environmental, Social, and Governance factors help with number crunching?
Understanding non-financial risk factors is paramount to understanding sovereign creditworthiness, even more so in emerging markets.
Creditworthiness encompasses both an issuer's ability, and willingness, to repay debt. If ability to pay is greatly influenced by a country’s long term growth potential, willingness to pay is intimately related to issues of governance. We believe that these in turn depend on the way countries access and utilize all the forms of capital available -- social, human, and natural capital in particular, in addition to economic capital.
Kroum, it seems counterintuitive that non-financial elements can contribute to growth -- capitalism is usually associated with “growth at any price”, meaning growth at the expense of the environment for instance. How do you resolve this ?
Going back to the 4 forms of capital- let’s focus on human capital for instance. Education allows a country to generate and absorb new technology, and to diversify its sources of income. Healthcare increases productivity by helping minimize sick days and increase worker productivity. Developing human capital is of the essence when it comes to broadening the camp of resources available to an economy. Another salient example involves Natural Capital – the World Health Organisation estimates that air pollution is responsible for 9 million deaths every year, more than war, malaria, tuberculosis, HIV/AIDS, and murder combined. The vast majority of pollution-related deaths occur in emerging economies. Such topics are increasingly entering the conversation in society, helped by popular media such as the Guardian reporting that in India, for example, pollution is responsible for a quarter of all deaths, a huge drag to the economy.[1]
Magda, governance issues have always been key to investment risk in emerging markets. What can ESG factors add?
The importance of identifying the potential misallocation of state resources through corruption, lack of accountability or mismanagement of public institutions is widely accepted in sovereign analysis. Democratic accountability helps the social and economic systems function more efficiently by minimizing wasteful practices.
Our ESG approach extends that analytical method to a broader range of factors that play into a country’s long term development.. For instance, economic and gender inequality starves the system of consumer purchasing power. Excessive concentration of wealth can impede a healthy middle class, which is the engine of growth. For instance, the IMF estimates that closing the gender gap in countries such as Pakistan and India could add up to 59% to their economic welfare, and up to 21% in the Middle East and North Africa region[2]
Kroum, isn’t environmental protection a rich man’s problem?
On the contrary. Environmental protection is vitally important to the economic growth of emerging nations.
On one hand, many EM countries rely on natural resources for growth. Sustainably managing their natural capital is critical to maintaining long term growth. On the other, emerging nations are major victims of climate-related risks, such as extreme weather events. A flood or a drought in a small, non-diversified economy can significantly disrupt GDP.
Furthermore, environmental preservation is likely to become increasingly embedded in trading relationships – for example, the Mercosur trade deal between Latin American countries and Europe is under threat because of deforestation policies in Amazonia[3]. Going even further, in September 2019, Costa Rica, Fiji, Iceland, New Zealand and Norway launched the Agreement on Climate Change, Trade and Sustainability, which envisages that the countries participating would remove any trade barriers in environmental goods and services, work towards removing fossil fuel subsidies, and encourage eco-labelling schemes[4]
Costa Rica is a particular bright spot, as it has generated almost all its electricity from renewable sources since 2015[5]. It also exports renewable energy in the Central American market[6]. In the UK, renewables generated more energy than fossil fuels for the first time in Q3 of 2019[7].
Magda and Kroum, how do you compare the integration and exclusion approaches to ESG investing?
Exclusion helps avoid some extreme risks, while integration helps determine whether the return compensates investors for their risks. Exclusion is useful, one might even say necessary, to avoid the most extreme violations of the UN Sustainable Development Goals (SDGs), those which could risk a significant impact on a country’s creditworthiness. Integration ensures that investors are compensated for risks. Considering non-financial factors, including ESG factors, allows for more realistic pricing of risks that are not accounted for by purely "crunching fiscal numbers".
We believe the optimal approach is to combine the two.
----
[1] https://www.theguardian.com/environment/2017/oct/19/global-pollution-kills-millions-threatens-survival-human-societies and https://www.thelancet.com/commissions/pollution-and-health
[2] IMF Staff Discussion Note- “Economic Gains from Gender Inclusion”, J.D.Ostry et al., October 2018
[4] https://www.iisd.org/blog/time-accts-five-countries-announce-new-initiative-trade-and-climate-change
[5] https://www.iea.org/statistics/
[7] https://www.weforum.org/agenda/2019/10/uk-renewables-generate-electricity-fossil-fuels