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August 29, 2009

Investors Are Enthusiastic About ESG in Emerging Markets
    by Robert Kropp

IFC report finds that sustainable criteria are of increasing importance to asset owners and managers when investing in emerging markets. -- In 2002, when the International Finance Corporation (IFC) released its baseline report on the relevance of environmental, social and governance (ESG) factors in emerging market investment, the amount of socially responsible investment (SRI) assets allocated to emerging markets estimated at $2.7 billion.

According to the IFC's most recent report on the subject, entitled Sustainable Investing in Emerging Markets: Unscathed by the Financial Crisis, "net portfolio equity flows to emerging markets increased to a record $145 billion in 2007." Furthermore, despite the global financial crisis, "the factoring in of ESG issues in investment decisions for emerging market equities is continuing to make inroads into mainstream investment practices."

For the purpose of the report, the IFC defines sustainable investing as being "based on the premise that companies that ignore social and environmental concerns, and that fail the test of good governance, are unlikely to be good long-term investments, regardless of their ability to generate cash flow in the short term."

The report cites a March, 2009 study entitled Gaining Ground: Integrating Environmental, Social and Governance (ESG) Factors into Investment Processes in Emerging Markets, commissioned by the IFC and prepared by Mercer, which found that almost half of emerging market investment considers ESG factors.

Jane Ambachtsheer, Global Head of Responsible Investment for Mercer, told, "Increasingly, we see a drive to incorporate ESG into investment decisions; on the one hand, to manage risk, and on the other hand, to seek additional opportunities. A growing body of reports finds that ESG can help in both areas."

"In particular, this is true in emerging markets," Ambachtsheer continued. "Trying to uncover all the risks and opportunities, it only makes sense that ESG considerations come into play."

The IFC's most recent report bases its conclusions on two sets of interviews of asset owners, fund managers, and emerging market corporate issuers, conducted by the Economist Intelligence Unit in March, 2007, and again in March, 2009.

Respondents were, if anything, more enthusiastic about the incorporation of ESG criteria into investment decision-making in the second set of interviews, which followed on the heels of the global financial crisis. According to the report, "82% of surveyed asset owners say that ESG assessment will become significantly more important in their research, portfolio management and manager selection process over the next three years," a period during which the asset owners interviewed for the report expect to increase their emerging markets investment by an average of 2%.

The report questions whether, in the wake of the crisis, traditional investment methodology can any longer be considered useful, given its disproportionate attention to strictly financial considerations. Arguing that "ESG or sustainable investing is a way of casting a wide net to gather a lot more information and to analyze its impact on a company’s long-term fundamentals," the report cites recent studies that indicate a positive relationship between ESG factors and performance.

Among the primary findings of the 2009 interviews is that asset owners now consider investment or business merit to be the primary motivating factor in sustainable investment practices. In 2007, asset owners considered regulatory and compliance considerations to be of the greatest importance.

In both surveys, asset owners and managers found ESG considerations to be of especial importance in emerging markets. While many publicly traded companies in emerging markets indicate high levels of awareness of ESG criteria, asset owners continue to rank insufficient disclosure and lack of transparency as primary obstacles to sustainable investing decisions. The report notes improvements among companies in transparency relating to governance, but finds that more disclosure on ESG issues would be welcome.

"The desire for enhanced reporting on extra financial issues started long before the crisis," observed Ambachtsheer. "It may have been reinforced by the crisis, especially in the area of governance, but its roots go further back."

And Steve Lydenberg, Chief Investment Officer of Domini Social Investments, said, "Much of the call for improved reporting in emerging markets is coming from governments."

"There is a growing trend for stock exchanges in emerging markets to include SRI indexes," Lydenberg observed, citing South Africa, India, and, most recently Shanghai, as emerging markets where sustainable indexes have been launched, often with the cooperation of governments.

While the IFC report emphasizes that improved sustainable investment research is critical to asset owners and managers, Ambachtsheer noted that improvements have been made on the ESG research front in recent years. "A lot of global ESG research companies are improving and extending their emerging markets coverage," she said. "We're also seeing a number of local research houses forming in emerging market countries."

Lydenberg agreed, saying, "Sustainable investment research is growing rapidly in emerging markets. They want to demonstrate that their companies are ahead of the curve in their incorporation of ESG issues."

In fact, one of the possibilities raised by the IFC report is the "opportunity for regulators in emerging markets to 'leapfrog' developed markets by pushing for ESG information to be included in required and voluntary disclosures."

Asked about areas in which further improvements can be made, Ambachtsheer said, "While managers are using ESG research as a risk management tool, we find very little activity around active ownership."

"There's a lot of interesting work going on, and it does vary according to country," she concluded. "There is room for more sophistication in terms of ESG integration, and a more wholehearted approach to active ownership, either directly or through collaborative networks."

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