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ESG Progress in Emerging Markets

Andrew Ness, Investment Director on the Global Emerging Markets Equities
SWIP

April 2010
 

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. Clearly, the concept represents a responsible approach to investing. But sustainability is also a business approach that creates long-term shareholder value. It does this 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 their potential dangers for the environment.

Sustainable investing is the recognition that non-financial factors can materially affect a company’s long-term performance. If these non-financial factors – examples of which include quality of management, corporate governance issues such as transparency, branding and compliance, and how businesses treat employees and support their communities – are incorporated into a disciplined, fundamental investment process, we can obtain a more accurate assessment of long-term corporate value and ultimately enhance investment returns.

Corporate sustainability is a business approach that 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.

Companies can boost profits by adhering to ESG principles. If 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.

Companies with high sustainability standing can deliver improved financial performance 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.

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.

As one might expect, China is in the vanguard. It is already the world’s largest car market and its third-biggest car producer. In January 2009, Chinese car sales exceeded those in the US for the first time. If we go by the current growth rate and fuel consumption pattern, by 2020, the number of cars on China’s roads will top 150 million, burning up more than 250 million tonnes of petrol every year.

Environmentalists and politicians alike are concerned about the effect on natural resources and air quality if most of these cars should be powered by petrol and diesel. Against this backdrop, the Chinese government has prioritised the development of low-carbon vehicles. Last year, it introduced the Adjustment and Revitalization Plan for the Automotive Industry with the aim of promoting the development of energy efficient, low-emission vehicles. It is backing this plan with a $732 million subsidy.

In 2009, US investor Warren Buffett invested $230 million in BYD Auto, conferring upon the Chinese carmaker both the cash and credibility to develop a “green” car. The BYD e6 made its debut at the 2009 North American International Auto Show in Chicago. According to a ministry of science and technology plan, 10% of China’s new vehicles have to be energy-efficient or low-carbon models by 2012. This could lead to one million low-carbon vehicles on China’s roads within the timeframe, reducing carbon dioxide emissions by 2.3 million tonnes.

Elsewhere, China is playing a leading role in producing the technologies needed to combat climate change. For example, it is the world’s largest producer and consumer of solar water heaters, accounting for 50% of the world’s total production and 65% of all installations. Responding to the growth in the market for solar power, it also supplies 30% of global demand for photovoltaic cells.

Other Asian emerging markets are also responding to environmental challenges – albeit at a less rapid pace than China. For example, India’s imminent introduction of a National Solar Plan will establish a 20-gigawatt target for solar power by 2020. This ambitious plan will eventually lead to the country’s emergence as one of the world’s leading solar markets both in terms of consumption and production. It is seen as crucial to India’s economic development; at the moment, the country has an extraordinary electricity deficit, with more than 400 million of its population lacking access to electricity. While much of this demand will be met through resources such as coal and nuclear, India’s abundant sunshine make it ideal for the cleaner, more sustainable alternative of solar power.

Many globally-oriented emerging markets companies are participating in the UN Global Compact. This is a framework for businesses committed to aligning their operations and strategies with ten universally accepted principles in the areas of human rights, labour, the environment and anti-corruption. The Global Compact is concerned with exhibiting and building the social legitimacy of business and markets. At the same time, many local regulations are evolving rapidly, leading to stronger enforcement powers. One high-profile example is China’s plan 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. 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 to small-cap names such as Petra Foods of Indonesia.

When promoting ESG in emerging markets, lessons can be learnt 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 that 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.

 

 

This article first appeared in www.ipe.com on 1 February 2010.

 

 

 

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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