Emerging market companies narrowing the sustainability gap

Emerging markets (EM) may not be the first choice for sustainability-minded equity investors. But this could be about to change.

Traditionally reliant on heavy industry rather than services, developing economies have large and growing carbon footprints, which also means they have weaker environmental credentials than their developed market counterparts.

This partly explains why they’ve struggled to attract foreign capital in recent years.

However, there is growing evidence that, despite operating in locations and industries that present sustainability challenges, emerging market companies are improving their sustainability scores faster than the global average; in some industries, the top three performers come from the EM world. All of which suggests they could soon become a key feature of sustainable equity portfolios. 

Cutting intensity and emissions

In the years since sustainable investing went mainstream, emerging market companies have often lagged behind their developed counterparts as green or social investments.

That is in part a reflection of deep-rooted structural trends. Emerging economies are, by definition, industrialising and urbanising – processes that are both resource and energy intensive. As a consequence, many of the companies based there operate in locations and industries with large carbon footprints.

But there is another important factor at play: efficiency.

Emerging countries often have less developed and energy efficient production processes than their developed counterparts, which lead to higher carbon intensity, or the amount of CO2 emitted per unit of GDP.

Encouragingly, though, the efficiency gap is beginning to narrow. One reason is that emerging countries are starting to leapfrog their richer counterparts in the adoption of low-carbon solutions and materials.

Proving that point, recent research has found that production technologies in Chinese export industries improved three times faster than the world average between 2000 and 2014. Other emerging economies, such as Taiwan, have improved even faster.¹

Not only do Asian companies become more efficient themselves, they are also helping others become greener by offering world-class climate solutions. Seven of the 20 most commonly held companies in climate solution funds are based in China.²

The country also leads the rest of the world in all seven critical technologies on energy and environment, such as hydrogen, batteries and nuclear energy, while Korea, India and Malaysia are coming in top five countries in the same category.³

At the same time, more emerging companies are setting voluntary emissions targets.

According to the Science Based Targets initiative (SBTi), growth in the
cumulative number of companies with validated science-based targets was especially strong emerging economies, with triple digit growth experienced in India, Korea, Indonesia, Mexico, China, Turkey and South Africa in the year to 2023.⁴

Embracing science-based targets

Growth in the number of G20 organisations setting science-based targets

Value up: enhancing governance standards

While emerging markets’ environmental credentials have been improving steadily, their governance standards are also catching up.

Beijing, for example, has intensified efforts to transform the governance of China Inc.

Among a series of key laws passed in the past year alone, amendments to China’s Company Law perhaps represents the most significant change to the legal set-up governing Corporate China. Crucially, the revised legislation allows more flexibility in corporate structures and more specifically defines the roles and duties of directors and executives.⁵

What is more, China’s State Council issued a sweeping set of guidelines to strengthen regulatory supervision and investor protection and plug corporate governance loopholes. For the country’s large state-owned enterprise (SoE) sector, the government has added “lifting the dividend payout ratio” as one of the key performance indicators, which should benefit minority shareholders.

South Korea has also introduced a “Corporate Value-Up” programme aimed at improving shareholder value and tackling the “Korea Discount” –  comparatively low valuations seen in the domestic stock market. The country’s stock exchange now has the Korea Value-Up index featuring 100 “best practice” companies on profitability and shareholder returns, such as Samsung Electronics, SK Hynix and Hyundai.

According to a study by BCG, governance is a dimension for which emerging markets are making the biggest progress and where the gap with their richest counterparts is the narrowest.⁶

If the improvement continues at the current pace, the governance gap could close further, encouraging more capital flows into emerging markets.

Closing in on DM

Research firm Sustainalytics estimates EM companies now stand at a similar sustainability risk level to developed markets four years ago.

Sustainalytics’ ratings measure the degree to which a company’s economic value is at risk from ESG factors and how well it manages those risks. According to the latest findings, the average ESG risk rating scores of companies in EM improved by 6 per cent between 2018 and 2022.

Although this falls short of the pace at which risk ratings are improving in DM economies, some EM companies are nonetheless outshining their developed counterparts. Nine emerging economies improved their scores faster than the global average between 2018 and 2022, while over 13 per cent of companies that are among the three top ESG performers in their subindustry were from emerging economies in 2022.

Roadmap and opportunities

The amount of capital flowing into sustainable investments has slowed sharply in the the past year or so, partly due to higher financing costs for green projects and a shift in the political landscape.

But it would be wrong to assume sustainability has fallen down the priority list – either for investors or companies.

Investors are in fact increasingly incorporating sustainability factors into their investment decisions.⁷ According to a recent study by Deloitte and The Fletcher School at Tufts University, nearly 80 per cent of investors have sustainable investment policies in place, up from just 20 per cent five years ago.

What is more, investment objectives of nearly nine out of 10 large asset owners have an explicit reference to climate change; and those for more than 70 per cent mention net zero targets, according to Mercer.⁸

And there are also early signs that equity investors are once again allocating capital to sustainable investments, with capital flows into the global universe of sustainable funds tracked by Morningstar recovering to over USD10 billion in the third quarter of 2024 from just USD6 billion in the previous three months.⁹

If the momentum picks up, this is sure to help EM companies with improving sustainable credentials.

Efforts by companies, consumers and governments in emerging economies promise to improve the developing world’s sustainability standing in the coming years. This highlights the potential of the EM Inc to offer a source of diversified return for global investors with sustainable portfolios.