The Reckoning of Sustainable Investments in Emerging Markets
In recent years, sustainable investments in emerging markets have faced significant challenges, leading to a critical reassessment of environmental, social, and governance (ESG) strategies. As capital continues to flow out of these regions, the allure of higher-yielding energy bonds has raised questions about the viability of sustainable investing in developing economies.
The Current Landscape of ESG Investments
Emerging markets have experienced a troubling trend, recording three consecutive years of capital outflows from ESG investments. This decline is largely attributed to tighter global monetary policies, which have affected both developed and emerging economies. As interest rates rise, investors are increasingly drawn to traditional energy bonds, which have outperformed their sustainable counterparts.
Despite the Federal Reserve’s recent interest rate cuts, which could potentially stimulate new capital flows into developing economies, the reality for sustainable debt backers is stark. The bonds generating the highest returns this year are those issued by companies with questionable ESG reputations. This shift raises critical questions about the financial sustainability of ESG strategies in these markets.
High Returns from Controversial Companies
Notably, companies in the materials, utilities, and industrial sectors have delivered impressive returns in emerging markets. For instance, Vedanta Resources Ltd. from India and Braskem SA, Latin America’s largest petrochemical company, have provided returns of approximately 41% and 34%, respectively. In contrast, a Bloomberg index of USD-denominated emerging-market corporate bonds has averaged a mere 7.7% gain. Both Vedanta and Braskem have faced scrutiny for their ESG practices, highlighting a troubling trend where financial performance trumps ethical considerations.
Philip Fielding, co-head of emerging markets at Mackay Shields, notes that the superior returns from bonds with poor ESG metrics have diminished demand for more restrictive ESG products. Investors are increasingly prioritizing returns over adherence to strict sustainability criteria.
Declining Green Bond Sales
The disparity in performance is reflected in the broader market trends. While hard currency debt sales by developing nations surged to $527 billion—an increase of nearly 55% compared to the previous year—green bond sales contracted by 5%, totaling $45 billion. This decline underscores a growing skepticism towards sustainable investments in emerging markets.
The number of new open-ended debt funds or exchange-traded funds dedicated to ESG causes has also dwindled. Only four such funds have launched this year, a stark contrast to the ten ESG-labeled strategies introduced in 2023. This trend indicates a significant shift in investor sentiment towards sustainable finance in these regions.
The Quest for Energy Security
The outperformance of energy bonds can be attributed to a heightened focus on energy security amid geopolitical tensions, particularly the ongoing conflicts in Russia, Ukraine, and the Middle East. With the latter accounting for a significant portion of global crude supply, investors are increasingly inclined to favor energy-intensive companies. Giulia Pellegrini, a senior money manager at Allianz Global Investors, emphasizes that investing in energy-intensive names may yield better performance in an environment where energy security is paramount.
Navigating Regulatory Challenges
Investors face additional hurdles in the form of diverging regulatory frameworks surrounding sustainable investing in emerging markets. Samuel Bevan, investment director for emerging market debt at Abrdn Plc, points out the complexities of evaluating ESG performances across various regulatory regimes. The lack of a uniform approach complicates investment decisions and may deter potential investors.
Moreover, the European Union’s crackdown on the misuse of the ESG label, coupled with political backlash in the United States, has further complicated the landscape. Major asset management firms, including Pacific Investment Management Co. and Goldman Sachs, have withdrawn from prominent climate alliances, sending mixed signals to the market.
The Importance of Continued Efforts
Despite these challenges, many money managers stress the importance of including emerging market issuers in sustainable finance initiatives. For instance, HSBC Holdings Plc is collaborating with the International Finance Corporation to create a fund that adheres to the EU’s strict sustainability standards, aimed at supporting corporate bond issuers in emerging economies. Such initiatives highlight the potential for sustainable growth in these regions.
Abrdn’s Bevan, who manages a $151 million EM corporate bond fund aligned with the United Nations’ Sustainable Development Goals, believes that emerging markets offer significant opportunities for ESG investments. He emphasizes the potential for rapid growth in areas such as reducing inequality and improving access to clean water and sanitation, particularly when supported by government initiatives.
Conclusion: A Balancing Act
As the landscape of sustainable investments in emerging markets continues to evolve, fund managers are under increasing pressure to balance their ESG investments with those in more developed, less risky counterparts. The challenge lies in ensuring liquidity and maintaining investor interest in sustainable bonds, especially when faced with the allure of higher returns from traditional energy sectors.
While the current environment poses significant challenges for sustainable investing in emerging markets, ongoing efforts to promote responsible finance and support sustainable development initiatives remain crucial. The path forward will require a nuanced understanding of the complexities involved and a commitment to fostering sustainable growth in these vital economies.