ESG Prescriptions for Issuers of Emerging-Market Sovereign Debt

by Shamaila Khan, Katrina Butt, and Salima Lamdouar, AllianceBernstein

More than 60% of global carbon emissions come from emerging-market (EM) countries, and the World Bank estimates that climate change could push between 68 million and 132 million people into poverty by 2030. The need for progress on environmental, social and governance (ESG) issues is clear. In fact, the United Nations’ sustainability goals call for EM countries to make substantial advancements in meeting ESG and economic challenges by 2030.

But the multilateral development banks focused on those sustainability goals have a US$2.5 trillion annual financing gap. So how can amenable but often cash-strapped EM countries afford to tackle such issues? By engaging with investors on ESG challenges and issuing sovereign debt investments that fund ESG-friendly projects, EM countries and investors alike can realize big benefits.

Increasingly, EM countries are funding those advancements by issuing ESG-related bonds—green, social and sustainability—whose proceeds are used to fund environmental or social projects. Issuance of these ESG-related bonds in EM has doubled over the past year.

The Benefits—and Costs—of ESG in Emerging Markets

The stakes are high for making progress on ESG initiatives. Both investors and ratings agencies are including ESG criteria in their assessments and are refining that analysis as more data and tools become available. EM countries that advance their ESG credentials can earn higher ratings, lower their financing rates and diversify their lender bases.

At the same time, there are costs to nations that choose not to address their ESG challenges. For example, carbon taxes could be assessed on countries that ignore their environmental footprint. In addition, some ESG-related bonds have preferential funding rates that are available only to countries improving their ESG profiles. And as investment mandates direct more capital into ESG-related bonds, countries with low ESG scores may be excluded, losing out on capital flows and increasing their funding costs.

The surge in issuance of ESG-related bonds is a win for both issuers and investors—and reflects the importance of adhering to ESG standards. ESG investors are eager to engage with EM officials to understand and advocate for improvement in ESG profiles, and EM officials are willing to engage because they are keen to receive funding.

Addressing ESG Challenges on Tight Budgets

As the focus on investing responsibly intensifies globally, scrutiny of EM nations’ progress toward the United Nations’ sustainability goals will increase. The tools investors use for making these assessments are constantly evolving, but openness and communication will be key for countries that want to be borrowers of choice.

We understand that many countries’ resources are constrained, and many of these sustainability challenges require a commitment of capital. However, nations can take measures that have a big impact but require little money.

First, we believe that having a specific agency or office dedicated to fielding questions from stakeholders and disclosing advances in ESG metrics may pay for itself through improved financing costs. It also will likely aid transparency and help to quantify those goals and measure progress.

Second, countries hoping to be destination borrowers should consider strengthening creditor rights, including better bankruptcy laws. While Brazil and India have recently added new bankruptcy laws, creditors are still frustrated by unwieldy processes throughout EM. Streamlining these processes could lead to increased cash flows for both fixed-income and equity markets.

What Does Good ESG Engagement Look Like in EM?

Addressing sustainability and the environment is the right thing for governments and investors to do. But by incorporating ESG considerations into their regular public policymaking, EM countries can also lower borrowing costs and improve economic growth.

• • Social issues such as the gender gap can have a direct impact on countries’ long-term economic prospects. For example, a report by the United Nations Economic and Social Commission for Asia and the Pacific Countries found that restricting job opportunities for women is costing the region between US$42 billion and US$46 billion annually.Inequality contributes to poverty and food insecurity, which can lead to social unrest and a demand for populism if left unchecked. Large-scale protests can lead to strikes, affecting economic activity. And, once in power, populist leaders usually increase fiscal deficits and the country’s debt-to-GDP ratio, harming its future ability to borrow.

• • Governance issues address items such as the structure of the government, including separation of powers and transparency. Centralized power, for example, can signal the potential for future risks. Government structure can have direct financial implications, affecting both ratings and ESG governance scores. A fair and effective judicial system helps promote business and economic activity and reduces crime. The quality of a country’s governance also shows up in its ability to manage crises ranging from conflicts to pandemics.

• • Environmental issues are centered around climate change and include protecting against physical damage, insuring against financial losses, and slowing its progress. For example, improved building standards can mitigate real financial risks. And when natural disasters do strike, insurance or contingency funds benefit the country and lower bond risk premiums. Finally, countries should guard their environmental reputation through action. Failure to act on conservation and climate change may trigger outflows, foreign-exchange depreciation, and inflation.

• • Broader sustainability goals are also important. We believe countries looking to expand energy capacity would be better off investing in renewables, even though upfront costs are higher. The long-term ramifications are all positive: lower marginal cost of operation and reduced emissions, which improve air quality and drinking water. Responsibly managed resources also can make a country more resilient in the future.Finally, we encourage countries to consider moving quickly on sustainability goals. Overnight, COVID-19 went from an unknown illness to a global pandemic. We believe climate change could snowball even faster, with costs for the unprepared that could be exponentially higher.

Left unaddressed, ESG challenges carry an economic cost and can serve to limit outside investment where it is needed most. But those countries that are proactive in addressing issues not only position themselves for better future sustainability but also may attract investment capital at preferred rates.

Addressing ESG challenges was once considered something that EM countries couldn’t afford to consider. It’s quickly becoming something they can’t afford to ignore.

Shamaila Khan is Director—Emerging Market Debt, Katrina Butt is Senior Latin America Economist—Fixed Income and Salima Lamdouar is Associate Portfolio Manager—Credit at AB.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

This post was first published at the official blog of AllianceBernstein..