The role of ESG investing in Emerging Markets: Winners and Losers

The Role of ESG Investing in Emerging Markets: Winners and Losers

Introduction

Business investments are affected by a wide range of factors. Before a company undertakes any investment activity, it must first understand the prevailing environment. In this case, it must comprehend the demography, politics, climate, and social and cultural dynamics. The aim of analyzing the environment is to ensure that business decisions are uniquely tailored for that type of an environment (Kular, 2017). Every market has unique characteristics and a business which is able to recognize these traits and utilize them in operations is likely to compete effectively. Developed markets and emerging markets exhibit different traits. Companies in emerging markets may not compete at the same level with those in developed economies following the traditional investment models (Authers, 2018). Thus, the adoption of the ESG (environmental, social, and governance) model gives businesses in the emerging markets a somewhat similar competitive platform with those in developed markets.

Today emerging economies offer multiple business investment opportunities. The adoption of the environmental, social, and governance (ESG) approach is particularly a superior approach embraced by businesses to boost their sustainability. ESG refers to the three core factors in the measurement of sustainability and ethical impact of business investments (Authers, 2018). In recent years, emerging economies have been hit by market volatility and political disruptions as well as unstable interest rates in developed countries like the U.S., thus, with some much uncertainty in the traditional markets, companies in the emerging markets have opted to invest in ethical, social, and corporate governance. ESG investing is also viewed as a parameter to encourage cultural shift towards corporate governance transparency. Businesses in emerging markets are trying to attract potential investors using openness and transparency. Similarly, environmental sustainability is a trending issue that has attracted the adoption of ESG investing. Investors are looking for sustainable businesses, hence the significance of ESG investing. Organizations with poor environmental management policies may be fined for regulatory breaches, those with poor social practices may experience high staff turnover and labor-related problems, and entities with poor governance framework may not attract potential investors (Msci.com, n.d.). Basically, ESG is a modern day model for business operations in emerging markets.

Background

The predominant aspect considered in making decisions related to financial assets was the financial returns. However, there were other criteria such as political, social, and environmental elements considered. In the 1950s and 60s, there was an opportunity for trade unions to consider social environments in their capital investments. Massive investments were made on workers by developing affordable housing projects and in healthcare facilities (Kapadia, 2018). There was a radical change in the 1970s at the time when South Africa was governed by the apartheid system. In a bid to fight the apartheid regime, there were massive disinvestments along ethical lines in addition to the growing calls for sanctions. The Sullivan Principles were drawn in the 1970s by the board of General Motors U.S. and Reverend Leon Sullivan. The principles attracted great attention leading to the development of numerous reports commissioned by the government, and this is what catalyzed ESG investing decisions (Msci.com, n.d.). ESG investing in emerging markets has led to an increase in foreign direct investments (FDI). These markets rely on ESG investing to attract potential investors inclined to the ESG provisions. Today, investors are looking for companies that conserve the environment, address societal issues, and encourage good governance. Realizing the opportunities that can be exploited if businesses align their processes to the ESG investing framework, emerging markets have adopted the environmental, social, and governance approach in their financial industry.

Stakeholders in the investment industry hold that ESG factors are inevitable considerations. Moreover, the evidence towards the relationship between financial performance and ESG issues is greater and recognized by many companies in the industry. ESG is growing in significance in both institutional and retail investors (Kular, 2017). The concept commenced in the 1950s and 60s as a socially responsible approach to investment. This lead to the exclusion of stocks or businesses from investor portfolio that did not correlated to the provisions of ESG. Today, focus is placed on ethical considerations and alignment with societal values (Kapadia, 2018). Investing is viewed as a lifeline to businesses in emerging markets. So far, ESG investing has skewed the cultural and political dynamics of emerging markets. The amount of FDI attracted and the aspects of enhanced social and environmental position of emerging countries have made it possible for these economies to develop policies and regulations that favor ESG. In fact, this is what happened in South Africa during the apartheid era where the country was compelled to discard the practice. Table 1 below shows the key issues associated with ESG.

Table 1: ESG Key Issues

Environmental	Social	Governance
·         Climate Change ·         Natural Resources ·         Pollution and Waste ·         Environmental Opportunities	·         Human Capital ·         Product Liability ·         Stakeholders ·         Social Opportunities	·         Corporate Governance ·         Corporate Behavior

ESG aligned companies focus on some of the pertinent issues affecting the society, environment, and governance. Market demand and investment rationale are likely to drive the growth of ESG assets. The three core drivers of ESG include market changes, investor behavior, and data analytics. As opposed to the past century, global sustainability challenges are bringing about new risk factors never expected (Vavrek, 2017). Today, companies face rising complexities in the global market, and modern investors are reevaluating traditional investment options. ESG investments are estimated at over $20 trillion across the world, and the figure is growing. The rapid growth of ESG builds on the socially responsible investment (SRI), a concept coined by the United Nations. SRI was developed as a means to guide businesses in making decisions that protected the environment and the society (Vavrek, 2017). Essentially, SRI is based on ethical and moral criteria and tends to use negative screens to encourage or discourage investments. ESG is based on assumptions that ESG factors have financial relevance.

For a long time, emerging markets have been linked to corruption, child labor, non-transparency in corporate governance, and pollution. The combinations of all these factors have made it difficult to apply the traditional investment models. In fact, investors would tend to shy off from markets that go against the traditional principles. However, the introduction of ESG has re-shaped the approach and the mentality of the investors. The continued reliance on ESG makes it possible for emerging markets to attract investors (East Capital, 2017). For a long time, emerging market fund managers have focused on governance as the primary rule of investment. ESG is becoming easier today as governments in emerging economies focus more on environmental elements. For example, China and India are addressing the issue of climate change to positon themselves as global economic powers (Vavrek, 2017). Similarly, social issues are beginning to gain attraction in developing countries despite cultural differences. To ensure social issues are solved, companies are becoming keen and scrutinizing their supply chains to get rid of issues such as child labor and poor working conditions.

Table 2: summary of the benefits of ESG investing

Category	Summary of Benefits
Environment	ESG investing has improved the global environmental sustainability across emerging economies. For example, China and India are continuously reviewing their policies to align their operations with the global environmental standards.
Social	ESG investing has contributed significantly to the increase in FDI in emerging markets. In turn, it has led to an increase in per capita, making it possible for people to afford the basic needs. Similarly, ESG investing has contributed significantly to the institution of policies and regulations against unethical behaviors like child labor and exploitation of societal resources.
Governance	ESG investing emphasizes on good and transparent governance structures. Emerging markets are catching up with developed economies in terms of financial reporting in line with the IFRS provisions. In addition, economies like China and India are developing their own policies to enhance transparency to encourage local investing.
Policies and Regulations	Policies and regulations play a major role in enhancing ESG investing. Investors would want to feel protected, and as such emerging economies have developed protective policies in line with ethical standards of operation.

Industry Background

The financial industry denotes a category of the economy that encompasses businesses that provide financial services to commercial and retail clients. The sector is characterized by banks, investment funds, real estate businesses, and insurance entities. The performance of the financial sector is mainly anchored on environments with low interest rates. Moreover, a large segment of the sector gets its revenue from mortgages and loans, and value is gained as the interest rates decline. The financial services industry is relatively new; however, some segments have stayed longer such as the insurance sector which goes far back in history. The insurance industry was officially established in 1680 (Shaikh, 2017). The most recent historical events involving interests in the financial industry is the Gramm-Leach-Bliley Act which was enacted in 1990s in the U.S. The Act was instituted to repeal the Glass-Steagall Act in a bid to allow banks to offer investment, insurance services, and commercial banking (East Capital, 2017). Moreover, the deregulation of the industry led to the automatic quotation system for the stock exchange. Also, the deregulation led to the establishment of multi-service financial conglomerates to offer such services as investment offerings, and mortgages. With a need to enhance profitability, the financial industry catalyzed the finance of the home buying craze in the 1990s through mortgages (Shaikh, 2017). The 2007 housing market collapse almost led to the collapse of the financial services market.

Technology has drastically affected the way companies do business in the financial sector. The internet particularly continues to be the main disruptor in the industry. The role of technology is particularly important in the banking sector where businesses link directly with banks and other clients. Online transactions have led to the avoidance of handling large sums of money making it easier for complex or cross-border transactions to occur. Moreover, technology has spurred investment in the financial sector. Today, investors can track the performance of organizations and decide whether to invest or not. In a bid to make investment decisions, investors look out for such factors political stability, financial performance, social responsibility, environmental issues, and the overall reputation of an organization (Christensson & Skagestad, 2017). Thus, the price share of a business can either rise or drop depending on these factors.

Investment management encompasses the use of other people’s resources to create value. Thus, it is literary termed as the buy side of the financial sector. Important investments managed in the sector include hedge funds, mutual funds, venture capitals, and other-related investments. Traditionally, the banks and insurance companies have dominated the industry, however, today there are many entities in the sector that include pension funds, non-profit organizations, and endowments. Asset management is a major segment in the financial industry. Effective and reliable management of this industry allows investors grow and prosper in the market. Moreover, it plays a fundamental role in the global economy. In fact, the U.S. financial crisis was largely linked to the collapse of management of the industry (Christensson & Skagestad, 2017). During this period people failed to service their mortgages and as a result the prices of properties declined tremendously leading to huge losses.

Hedge funds are privately offered and managed by professionals, and like other financial investments, investors seek to get positive returns in the long run. Hedge funds are used as essential tools in the collection of large pools of funds (Nejad, 2016). Similarly, mutual funds are managed by portfolio managers who are positioned to ensure that investors get value for their money. Another form of investment is the private equities which constitute funds collected from investors and put in private companies to generate returns (Shaikh, 2017). Over a set timeline, a private equity firm builds its stake with a goal of taking over the company and making profits from the investments. Venture capital denotes the funds collected from investors to aid innovative companies in exchange for a stake which will ultimately become profitable in the long run (East Capital, 2017). For the past century, the asset management industry was mainly limited to stocks, bonds or cash. However, there have been phenomenal growth in the number of options available in the sector, and this is what led to the creation of hedge funds, private equity, venture capital, and other-related investment options.

Research Aim

The aim of this research is to explore the role of ESG investing in emerging markets. The research will commence by offering a detailed analysis of the financial industry with a view of understanding why the industry continues to face multiple changes. The sector continues to be the most dynamic and continually changing sector as compared to other industries. Some of the factors affecting this industry include political, social, economic, environmental, and technological factors. As opposed to the conventional investment system where investors assessed the performance of an organization on the premise of profitability, today investors tend to take a different angle; investors have realized that the most successful businesses are those that align their corporate models to the ESG investing approach. This means that businesses have to be rated as socially responsible, ethical, and their governance acceptable by the society. In fact, the need for governance transparency is aimed at ensuring that investors understand the governance structure of their companies. Also, it is a way of ensuring that investors are confident that their investments are protected. Thus, this study seeks to understand how ESG investing is a crucial approach to business success in the emerging markets.

The study will explore existing data to understand the significance of ESG investing in emerging markets. As compared to the developed markets, emerging countries offer a somewhat different model of operating. Developed markets are mainly guided by the conventional investment model, while emerging markets tend to take a newer approach aligned with the ESG investing technique. In fact, this is the only way that emerging markets can compete with developed markets in the financial industry. Developed countries have already established strong infrastructure and systems to support their operations and it may take decades or longer for emerging markets to have the same infrastructure. Thus, the aim of this research is to assess why emerging markets opt to align their policies and procedures to the ESG investing as opposed to the conventional investing techniques. A clear understanding of the distinction between the emerging and developed markets is important in answering the research questions.

Research Questions

The study seeks to answer the following research questions

·         What is the role of ESG investing in emerging markets?

·         How can emerging markets compete with developed markets?

·         What is the significance of ESG investing in the modern society?

·         How can investors leverage on the merits of ESG investing?

Research Methodology

A qualitative study denotes a process that seeks in-depth understanding of a social phenomenon within a natural setting. The technique focusses on the “why” as opposed to the “what” in a social setting. Moreover, the technique relies on the direct experiences of the human beings. In this case, case studies, historical analysis, and phenomenology are integral in answering the research questions. The focus of a qualitative research method is on individuals, societies, and cultures. The significance of this method is that a research learns from the participants in order to understand particular phenomena (Khan, 2014). On the other hand, a quantitative methodology focusses on objective measurements and numerical analysis of the data collected. The primary focus of a quantitative research method is on the numerical data collected using questionnaires, surveys or polls (Mohajan, 2018). The analysis of the collected data is used to derive findings that answer the research questions.

This study will adopt a qualitative research methodology. The technique suits the purpose of this study as it seeks to explore the significance of ESG investing in emerging markets. The use of secondary sources of data will be integral in answering the research questions. The financial sector is vast and there are numerous studies conducted on various subjects in the industry. Thus, instead of collecting data from scratch, it will be advisable to leverage on the existing data to develop findings and conclusions on the study. Existing literatures will be searched from reputable journals. Some of the journals that will be used for the purpose of this study include journal of internet banking and commerce, industrial engineering and management, international journal of economics, journal of business and financial affairs, journal of accounting research, and journal of accounting and marketing. These journals will proof significant assessing the significance of ESG investing in emerging marketing.

Timescale and Resources

The table below shows the activities that will be undertaken in the 12 week period in a bid to complete the study. The project will commence by developing a proposal. The proposal is expected to take 11 days to complete. The length allocated to this activity is based on the need to develop a reliable and effective research proposal to warrant approval. Moreover, the research topic is complex and involves vast information. Sieving through this information to get the specific data that will be used will take considerable time. The second activity is the approval process. In this stage, the proposal will be submitted to the professor for approval, and the entire period from approval to the correction of necessary sections of the proposal is expected to take 7 days. The third activity is the project scheduling which will take approximately 10 days. This entails the whole processes of planning and launching the research. Data collection and literature review will take a cumulative of 19 days. Data collection is particularly complex due to the amount of resources to be evaluated. Similarly, resources from the suggested journals will be evaluated and the best articles published 2014 and above will be used in the research. The final activities include data analysis, review of the findings, and development of the conclusions on the role of ESG investing in emerging markets.

Figure 1 below shows the proposed Gantt chart. From the figure below, it is imperative to note that the successor activities will run after the predecessor activities. Essentially, no activities will be run concurrently, this is to ensure that there is a systematic approach to the study.

Figure 1: Proposed Gantt chart

Moreover, running the activities concurrently may lead to confusion and inability to address some segments of the study. Nevertheless, all the sections of the study rely on each other, thus, it is impossible to run the processes concurrently. The step by step approach is encouraged in this study from the start to the end as illustrated in the Gantt chart.

Table 3: Resources

Task Name	Duration (days)
Proposal development	11
Proposal approval	4
Make corrections and submit for approval	3
Project scheduling	10
Data collection	10
Literature review	9
Data analysis	9
Review of findings	2
Conclusion	4

Conclusion

ESG investing offers emerging markets a lifeline to compete with the developed markets. Developed markets have superior developed infrastructures making it impossible for emerging markets to compete equally using the conventional investment system. ESG investing is centered on three core factors environmental, social, and governance. Thus, investors using this approach measure the sustainability and ethical impact of an investment in a company. Using this criterion, investors are able to determine the future financial performance of an organization. Traditionally, businesses focused on the financial performance of entities before engagement. However, the ESG model brings in a perspective that takes care of the welfare of the society and the investors themselves. Hence, its applicability in the emerging markets is gaining momentum.

Reference List

Authers, J. (2018). ESG investing poses big challenge for fund management industry | Financial Times. [online] Ft.com. Available at: https://www.ft.com/content/53c1d3c4-63f0-11e8-90c2-9563a0613e56 [Accessed 15 Feb. 2019].

Christensson, L. and Skagestad, O. (2017). Performance of Sustainable Investments A comparison of sustainable and conventional mutual funds in emerging markets. Norwegian School of Economics.

East Capital (2017). Sustainable investment report: ESG — a key tool for emerging and frontier market investments.

Kapadia, R. (2018). ESG Investing in the Emerging Markets Is Tough, but Lucrative. [online] Barrons.com. Available at: https://www.barrons.com/articles/esg-investing-in-the-emerging-markets-is-tough-but-lucrative-1528491920 [Accessed 15 Feb. 2019].

Khan, S. (2014). Qualitative Research Method - Phenomenology. Asian Social Science, 10(21).

Kular, D. (2017). ESG in EMs: the winners and losers in the SRI stakes. [online] Citywire Global. Available at: https://citywireselector.com/news/esg-in-ems-the-winners-and-losers-in-the-sri-stakes/a1008536 [Accessed 15 Feb. 2019].

Mohajan, H. (2018). Qualitative Research Methodology in Social Sciences and Related Subjects. Journal of Economic Development, Environment and People, 7(1), p.23.

Msci.com. (n.d.). ESG Investing - MSCI. [online] Available at: https://www.msci.com/esg-investing [Accessed 15 Feb. 2019].

Nejad, M. (2016). Research on Financial Services Innovations: A Quantitative Review and Future Research Directions. International Journal of Bank Marketing.

Shaikh, N. (2017). The Financial Industry Needs to Start Planning for the Next 50 Years, Not the Next Five. [online] Harvard Business Review. Available at: https://hbr.org/2017/07/the-financial-industry-needs-to-start-planning-for-the-next-50-years-not-the-next-five [Accessed 16 Feb. 2019].

Vavrek, E. (2017). ESG in emerging markets depends on better data and disclosure | Financial Times. [online] Ft.com. Available at: https://www.ft.com/content/017dc6fa-7057-11e7-93ff-99f383b09ff9 [Accessed 15 Feb. 2019].