What is the future of emerging market green bonds?
ESG strategies in equities and corporate bonds are now more advanced and comprehensive, while the financial industry still seems to be lagging behind in producing a shared framework that responds to the trade-off between current metrics and funding needs. The analysis by Michele Morra, Portfolio Manager of Moneyfarm
The latest edition of the global conference to combat the effects of climate change, COP27, which recently ended in Cairo, was characterized by the agreement on the "loss and damage" fund, i.e. the fund for compensation to emerging countries for the damages deriving from climate change.
While this agreement is linked to the consequences of climate change, the other major issue that always concerns developing countries is inherent in the financing of the energy transition. Developed countries and international institutions are estimated to need to increase their funding by $1 trillion a year to help them reduce emissions, well beyond the $100 billion pledged way back in 2009 and not yet met.
There are several ways in which this huge investment can be financed: direct donations from the most developed countries, loans, private investments and specific financial instruments such as green bonds.
Financing the transition to net-zero through debt issuance is becoming extremely costly for emerging countries, especially in an environment of monetary tightening, where interest rates and spreads are rising and emerging market currencies are depreciating against the dollar. As far as private investment is concerned, current ESG investment vehicles still do not seem sufficient to attract enough private funds. In fact, socially responsible investors often rely on ESG ratings and social parameters which are the cause of the exclusion of many emerging countries from their portfolios.
In this context, more elaborate climate and social finance tools could help, as also underlined by the World Bank in a recent report. Despite the many limitations, specific financing instruments such as green bonds (bonds linked to environmental projects) and sustainability-linked bonds (bonds whose borrowing costs decrease when sustainability objectives are achieved) remain one of the fundamental options for addressing this problem.
Where to invest?
As ESG managers and investors we are well aware that when it comes to emerging market government debt it is very difficult to apply the more established techniques of the ESG landscape: the scope of activities (and controversies) of a state is much wider than that of private companies, there are fewer countries than investable companies (nearly 200 against about 41,000 listed companies) and some sustainability metrics could penalize developing countries more than developed economies.
The ESG ratings of emerging countries are generally very low and various metrics related to social disputes and forms of government are driving investors away from this asset class.
Transition to net zero
How to finance emerging markets' climate transition is an ongoing debate in the world of ESG investing. This is because some large countries with controversial governance and questionable human rights practices also need to reduce their emissions, but cannot do so without adequate resources.
The question many investors are asking is: should these countries be financially supported, or should we stubbornly refrain from investing until they fully comply with classic ESG criteria?
What is desirable is that a balance is found. On the one hand, linking investments to stringent parameters is a very important incentive for the emerging countries themselves. On the other hand, how could companies or emerging countries achieve their sustainability goals if they don't have the money to do so? Tools such as green bonds and sustainability linked bonds help investors partially answer these questions, but there are still numerous obstacles to overcome, such as the limited supply, the absence of shared frameworks and often even the very lack of projects to finance .
As investors, the idea of looking at the ambitions of emerging markets and not just focusing on their current social, environmental and sustainability risk metrics is certainly inspiring. It's a major paradigm shift but it's a growing trend and shouldn't be ignored.
But there is still much to do. ESG strategies in equities and corporate bonds are now more advanced and comprehensive, while the financial industry still seems to be lagging behind in producing a shared framework that responds to the trade-off between current metrics and funding needs. This means that despite the problems and limitations associated with green bonds or sustainability-linked bonds, these financial instruments could capture the attention of many responsible and non-responsible investors.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/quale-sara-il-futuro-dei-green-bond-dei-mercati-emergenti/ on Sat, 26 Nov 2022 06:49:36 +0000.