Emerging markets are losing the race for green finance:
The gap between developed and emerging markets is widening
The key questions on how to mitigate the serious economic impact of Covid-19 on developing countries are now at the top of the international political agenda. As advanced economies recover, the IMF expects production in emerging markets outside China to be below pre-pandemic levels by 8% by 2024. The obvious solution is to use Western models to increase yields. Environmental, social and managerial investments to put emerging markets back on track. But it could be a mistake.
Sustainable financial players have made significant progress in recent years. They did this by showing that real financial risks were contained in ESG themes. Many have achieved impressive returns.
In an era of historically low returns, the huge investments needed for clean energy in emerging markets can be seen as an equally historic opportunity. Better infrastructure, more work, and more resilience can, after all, not be achieved through public spending or debt relief alone. But greater participation in the private sector will not happen if today’s green ideas for the financial market are applied to the needs of emerging markets.
There is no doubt that green finances are making great progress. As our work with the International Energy Agency has shown, clean energy supplies in developed economies have tripled in the last decade compared to the supply of fossil fuels. In terms of debt, the annual issuance of labeled bonds (green, social, and sustainable) will amount to $ 1 trillion this year.
But these success stories are largely limited to developed markets. Italy’s first green supply this year outperforms all sovereign green emissions in emerging markets by 2020. The UK, not exactly known for its sunny skies, has installed more solar PV than the entire African continent. As Western countries increase the issuance of green bonds to stimulate recovery efforts, the gap between developed and emerging markets widens.
These differences cannot be explained as initial problems in adapting to new protocols and structures.
The real problems are the underlying market structures in emerging markets and the underlying assumptions about sustainable investment in general.
With the increase in passive investments, emerging market bonds have become an index-based asset class. As a result, proactive involvement in issuers and fundamental analysis declined. Many bond investors do not understand the structural trends that are reforming the investment process.
Although ESG has a long history in fixed markets, it is almost exclusively about management. Environmental pressures are rarely considered: water stress, extreme weather conditions, and depletion of natural capital. With a flurry of warnings that the weather-related risks in government bond markets will be discounted and that the outlook for future downgrades will increase, the decline inequities in the emerging market are slowing.
But applying broad ESG frameworks in developed markets is not a solution.
As we highlighted in a recent discussion article, ESG often consolidates the status quo. Emerging market funds that are under pressure to improve their ESG scores buy more bonds from higher-rated countries (in most cases richer). They avoid those with a lower ESG score. Units with the greatest investment need and the greatest potential to improve carbon efficiency are unlikely to have more capital. If this process is carried over to its destination, it will exacerbate the tendency towards inequality in the financial system, as governments and marginal companies are driven into a vicious spiral of declining revenues and deteriorating economic prospects.
However, there are encouraging signs on the horizon. The transition effects are still in their infancy, but they are a promising innovation that could help bridge the gap between green aspirations and the reality of many high-emission emitters in emerging markets. International financial institutions are slowly beginning to develop better risk-sharing mechanisms that free up capital from the private sector. But we need to go beyond individual pilot projects and move towards repeatable integration.
In the long run, it is essential that the local capital markets are in the capital markets