Given the higher levels of risk and return associated with investing in emerging markets, governance and sustainability analysis is critical. Investors are generally not able to rely on the same level of regulatory or legal protection as in developed markets. However, when it comes to analyzing environmental, social and governance (ESG) factors in emerging markets, developed-world methods often don’t translate.
ESG awareness is growing in EM
Although emerging market (EM) companies in aggregate may still lag their developed market counterparts, particularly in the areas of disclosure and shareholder engagement, the picture is far from uniform. Indeed, the understanding of best practice continues to evolve, and many EM management teams have fully recognised that poor performance when it comes to ESG impacts not only their access to capital, but is fundamentally intertwined with long-term business prospects.
The scope for companies to cut corners, for example by ignoring labour conditions or skirting environmental regulation, is thankfully narrowing.
This also applies across company supply chains, with an increasing awareness of the reputational damage that can follow weak standards and controls. Cases such as the Rana Plaza factory disaster in Bangladesh or the deaths at Foxconn in China have brought this reality home to roost for many EM companies.
However, while improvements are being made in many areas, standards are far from uniform. When it comes to understanding ESG risks and opportunities in emerging markets, investors need to be particularly vigilant as the traditional techniques adopted for developed markets don’t always translate and this can open them up to unwanted risks.
Analysis techniques don’t always translate
Assessing a company’s corporate governance structure is not always straightforward in an EM context. This contrasts with developed markets, where governance to some extent has been reduced to a box-ticking exercise.
Needless to say, the developed market approach to ESG analysis is adapted to a world in which equity ownership is heavily institutionalized and where there is clear separation between the managers of a business and its owners, as represented by the board. However, this is rarely the case in EM.
Many Asian companies, for example, are still characterized by owner-management, reflecting their family origins, or by a significant government shareholding. In fact, across many emerging markets, the largest companies are often at least partially state-owned enterprises (SOEs). Companies with these ownership structures are often not run in the interests of minority shareholders and tend to exhibit poor levels of corporate governance.
In these situations, a narrow application of developed market governance ideals is not practical.
Beware of unintended biases
Consider also that disclosure levels on ESG factors can vary considerably between companies and countries in emerging markets. This creates wide differences in the quality and consistency of ESG data available to use in portfolio construction. Relying on the data alone could, for example, open up the portfolio to unwanted biases towards large companies, which tend to have greater reporting resources, or to certain countries where local disclosure rules are more advanced.
Relying on data could also severely restrict the opportunity set available as companies with less extensive disclosure are not necessarily the least advanced when it comes to ESG standards.
A more dynamic approach
ESG analysis in emerging markets therefore requires a more dynamic, in-depth and tailored approach. It should involve a qualitative assessment that looks at the governance record, getting to know the management and the board, and considering the extent to which their interests are aligned with those of investors.
This requires extensive research and experience to identify businesses that are likely to sustain higher returns and better resist competitive pressures. In doing so, it is more possible for an investor to limit exposure to capital loss and to generate sustainable returns into the long term.