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ESG in EMD: Analyst-Driven, Outcome-Oriented

February 19, 2020 | Emerging Markets Debt

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We truly believe emerging markets debt is the last frontier of investing; you can still uncover a lot of value through rigorous bottom-up analysis. And as environmental, social, and governance (ESG) factors come to the forefront of investing, more and more debt issuers in emerging markets are taking heed.

In this three-part series, we explain how we use ESG to help create sustainable value on behalf of our clients. First up—our philosophy.

“Emerging market companies know where they have to be, and they are focused on getting there.” — Luis Olguin, CFA

Before we discuss ESG in emerging markets debt, could you tell me why you consider ESG important more broadly?

Luis: When we look at corporate credit investments, we like to look at a multifactor risk approach, and we believe ESG is one of these important risk factors. We view the ESG framework as a lens through which we can analyze the potential financial and/or reputational risks an issuer faces.

It is definitely something that has become more predominant in the industry right now, although many of its core beliefs have been around for decades, particularly when it comes to governance analysis. But ESG is about more than that: As society evolves, it is important that investors and the corporate community work together toward a sustainable future.

As emerging markets debt investors, why is ESG particularly important in that asset class?

Yvette: We see ESG as an integral part of sovereign risk analysis. It is important to understand all of the factors that influence a country's ability and willingness to pay. ESG factors are, in addition to macroeconomic factors, extremely important to understanding each individual country's ability to meet its obligations to creditors.

Is ESG more important in emerging markets than developed markets?

Yvette: Understanding the political and social context of countries that are at an early stage of development is most certainly important. We like to analyze how ESG factors relate to the economic and financial development of a country. That is somewhat different from developed markets, where you already have a high degree of social development and well-established institutions.

Social and political factors can be more driven by non-financial sectors when countries are less mature from an institutional and developmental perspective.

Is ESG integration more difficult when investing in emerging markets?

Luis: Somewhat. Emerging markets are quite diverse, and geographic and cultural diversity leads to diversity in terms of ESG integration. Companies may have very high standards in some countries, while other countries need a lot of development. If there's one thing we have learned in our research, it is that a blanket approach to ESG analysis is unlikely to yield the best results.

Are emerging markets becoming more aware of the importance of ESG? Have you seen momentum toward ESG integration changing in recent years?

Luis: It has come a long way. Today, companies are very aware of the importance of ESG. Some even have responsible investment teams fully focused on energy transition, climate change, or best practices in their governance factors.

Developed markets have higher standards, but in emerging markets, there is a path. Emerging market companies know where they have to be, and they are focused on getting there. They know they need to continue to evolve, not only by having high ESG standards but also by improving their transparency and disclosures.

“One cannot have improved environmental and social factors without a degree of focus on improving governance structures and overall performance of the political process.” — Yvette Babb

Is governance the most critical ESG factor in emerging markets debt because default risk is linked to governance?

Yvette: Absolutely. When it comes to a country's default risk, we believe governance is central. Governance informs the degree to which a country can manage its economy and the degree to which it can execute policies. One cannot have improved environmental and social factors without a degree of focus on improving governance structures and overall performance of the political process.

Luis: We focus on governance because we believe governance permeates the other factors. If you have very strong environmental policies but no governance around them, what do they really mean? Are policies being implemented and monitored?

Because of this, it is essential to have a strong relationship with a company. The only way to understand whether a policy is just a check on a checklist or actually engrained in the company's values is to have this intimate, direct relationship—and that is the way we approach it. We do not rely on third-party analysis, although we use it to complement our own analysis.

Could you explain what it means when you talk about the importance of trend rather than starting point?

Luis: Emerging markets, by definition, are still developing—so if you only focus on where an emerging market company currently stands on ESG standards, you may get the wrong sense of where it will be in the future.

Yvette: There is an intrinsic relationship between wealth levels and environmental and social outcomes: Countries that are at low levels of development can have poor environmental and social outcomes. We do not want to penalize a country that has poor environmental and social outcomes because it is at an early stage of development.

At the same time, we are looking for countries that are seeking to improve those outcomes. We want to treat the countries that are improving favorably. That is why the trend is important as we monitor momentum.

“Our ESG framework is analyst-driven. Our analysts have an intimate relationship with companies and thus understand what ESG factor really affects the potential financial profile of an issuer.” — Luis Olguin, CFA

You naturally want to focus on issues that are financially material to an issuer. Is financial materiality different in the context of sovereigns?

Yvette: Yes, materiality in the context of sovereigns is somewhat different than it is in the context of corporates. It is important for us to understand which of the E, S, and G factors have a material impact and the degree to which they influence financial returns. We have found that the E factors, on a five-year horizon, have generally had a limited impact on the financial returns of creditors.

Luis: The approach we like to take when it comes to financial materiality is bottom-up. Our ESG framework is analyst-driven.

There seems to have been a big drive in the industry to apply ESG standards across all companies. In contrast, our analysts have an intimate relationship with individual companies and thus understand which ESG factor really affects the potential financial profile of an issuer.

Is ESG different when evaluating soverign credit versus corporate credit? 

Yvette: Yes, understanding a country's balance sheet, revenue flows, and expenditures is somewhat more difficult because countries do not necessarily present their financial information or ESG information in the same way that companies do. There is no standardized way in which countries present this information. Additionally, these factors may extend beyond the horizon of a single government's tenure.

Yvette Babb and Luis Olguin, CFA, are portfolio managers on William Blair's Emerging Markets Debt Team.