The integration of ESG in emerging markets

Sustainability in a corporate context is a company’s ability to operate in a manner that does not damage the environment or deplete a resource. This concept not only represents a responsible approach to investing, it also preserves our communities’ values and as a business approach creates long-term shareholder value by capturing opportunities and managing risks that derive from the rapidly-evolving global economy.

As global economic growth shifts from the developed world to the BRIC countries (Brazil, Russia, India and China) these economies are experiencing rapid population growth, mass urbanisation and industrialisation – with all the potential dangers for the environment that these processes entail. In our view, sustainable investing is the recognition that non-financial factors can materially affect a company’s long-term performance. A systematic incorporation of these ‘non-financial’ factors into a disciplined, fundamental investment process can lead to a more accurate assessment of long-term corporate value, and ultimately enhance investment returns.

What do we mean by ‘non-financial’ factors? What follows is by no means a full list, but simply some examples to give the reader more of an idea of some of the issues that are taken into consideration when assessing these non-financial factors:

• quality of management
• corporate governance – practises such as transparency and disclosure, management accountability to shareholders, a company’s branding, image and reputation, new product developments, regulatory fines or litigation costs
• social side – how communities are supported or employees treated

We believe that sustainability leaders achieve long-term shareholder value by positioning their strategies to capture opportunities from these changes while at the same time successfully reducing and avoiding costs and risks.

Corporate sustainability recognises that companies are operating in an increasingly changing and challenging world. Globalisation and new political landscapes have combined with significant changes in populations, urbanisation, resource utilisation, climatic patterns and employee and consumer attitudes. Corporate sustainability looks to create long-term value by managing the risks and capturing the opportunities that result from these trends.

A focus on long-term structural change will become increasingly important in generating superior long-term investment performance. Understanding how different environmental, social and governance (ESG) factors can affect a company’s performance is part of that analysis, as these non-financial factors can have a major impact on a company’s bottom line. In part, this is because these issues carry the potential for material risk, including social and environmental damage and legal liability.

There is also evidence that corporate sustainability makes good business sense. Companies can boost profits by adhering to ESG principles. If, for example a company can save money by reducing waste, utilising raw materials more effectively and using less packaging, it is a win-win situation. It is good for the company’s profits, and good for the planet.

Academic research has identified a positive correlation between companies with high sustainability standing and their financial performance. This is because managers who understand the long-term risks facing their companies and industries will formulate a deeper understanding of the implications for long-term finances and profitability. A long-term investment horizon is critical in order to integrate ESG factors in to the investment process.

We believe ESG factors are relevant in all regions – emerging and developed. But because of the growing demographic and resource challenges, a more sustainable approach to economic development is particularly crucial in emerging markets. Many developing economies face rapidly growing populations, and these challenges force governments and companies alike to focus on a much more sustainable approach. A major problem is that in the past, rules and regulations have been either absent or lax, and where legislation does exist, enforcement has been inadequate. Add to that a lack of available information. Poor visibility and the time-consuming process that it takes to extract that information make the investment side of sustainability challenging as well.

We regard disclosure as an important step along the road to good ESG management because a decent level of disclosure highlights a company’s risk management capability. Disclosure is particularly crucial for those emerging market companies that compete globally, as they are subject to assessment of their abilities to comply with evolving international standards.

Many globally-orientated emerging markets companies are participating in the UN Global Compact. This is a framework for businesses committed to aligning their operations and strategies with 10 universally accepted principles in the areas of:

• human rights
• labour
• the environment
• anti-corruption

As the world’s largest global corporate citizenship initiative, the Global Compact is first and foremost concerned with exhibiting and building the social legitimacy of business and markets. Many other local regulations are also evolving rapidly, and with these will come stronger enforcement powers. One high-profile example is the plan by China to publish efficiency and conservation targets for all sectors.

Extracting the relevant ESG data on emerging market companies can require a large amount of due diligence and patient research. But matters are improving. As more investors engage with management on sustainability issues, an increasing number of emerging market companies prepare separate sustainability reports to accompany their annual reports. This is one of the areas where we have seen the biggest improvements over recent years. Good quality reporting leads to improvements in sustainable development because it allows organisations to measure, track, and improve their performances on specific issues. There are many companies with high standards of sustainability disclosure – from large, internationally recognised names such as Sasol of South Africa, to small-cap names such as Petra Foods of Indonesia.

The standard of disclosure in Brazil has been improved by the creation of the Novo Mercado – a set of stock market listing requirements that demand improved corporate disclosure by companies. An increasing number of companies are choosing to list themselves on the Novo Mercado, and admission to Novo Mercado requires compliance with corporate governance rules that are more rigid than those required by current Brazilian legislation.

When promoting ESG in emerging markets, lessons can be learned from the west – both in terms of what to do and what to avoid. One pertinent example is the role that securitisation of debt played in the credit crunch. Many emerging economies have yet to experience the growth of mass market housing loans. But they can learn vital lessons from the developed market experience - in particular, the need to ensure the gap between the origination of the mortgage and its ultimate ownership and supervision does not grow too wide. Areas such as this are likely to have ramifications for financial sector regulation in many emerging market economies.

Sustainability is a wide-ranging and varied topic, and one that is growing in significance. The identification of companies focusing on long-term structural change will become increasingly important in generating outperformance.

Investor behaviour

As for all individuals, investor behaviour is not always rational. The ‘Odd Lot Theory’, for example, is a reality: it shows that behavioural bias leads to inefficiency in investment timing. Investors 10d to buy when markets are high, as they believe they will continue to rise, and sell when markets are low.

These products also offer great flexibility:

• Their underlying can be chosen from a wide range of asset classes (equities, interest rates, bonds, foreign exchange, commodities, credit, real estate, etc).
• Maturity can vary from one month to 10 years.
• The currency of the product can also vary according to investors’ needs
• They can be designed to guarantee capital growth, income or a combination of both.
• They facilitate access to asset classes which are difficult to get at otherwise, like private equity or emerging markets.

These tailored solutions are certainly not a new concept b

Etienne Roesch is head of the Private Wealth Management team for France & Monaco at Société Générale Corporate & Investment Banking