Environmental, social and governance (ESG) risks can incur harsh financial consequences for long-term investors in emerging markets. Integrating these risks into our investment decisions is part of our duty – for the benefit of our clients and the innocent bystander.
For long-term investors in emerging markets, there is no shortage of ethical problems to negotiate. They include extreme inequality, pollution, water scarcity, forced migration and climate change. In our universe, a lack of corporate transparency and disclosure is widespread. Companies profit by contributing to climate change, operating with scant regard for safety standards and through corruption. Governments restrict press freedom, invade neighbouring countries, and enforce martial law.
As a civilisation – and as investors – the challenges we face are very real. But ignoring the societal implications of investing in our pursuit of returns is not merely the norm: it is mandated, meaning that examining the broader, long-term consequences of investment decisions requires special justification.
At Hermes, it is our view that the investment paradigm of increasing shareholder value above all other concerns is flawed. The ascendance of environmental, social and governance standards is an investment theme so powerful that it could shatter this particular paradigm.
Sure, investing for returns is important. But equally, ownership requires taking some responsibility for companies’ actions – ethical or otherwise. It is Hermes’ view that if we are to profit from gains that the company makes, we are also responsible for the problems it may cause. We are responsible for ensuring that both its gains – and ours – are not ill-gotten. That means extra work in analysing companies: understanding externalities, governance practices, environmental impacts, treatment of workers and their influence on local communities.
ESG investing in emerging markets
Analysing ESG risks alongside financial metrics in the valuation of stocks is still evolving as a concept. But it appears to be reaching a critical mass.
The rationale behind ESG investing in emerging markets is multi-faceted. From a social perspective, companies have a number of obligations to fulfil in the areas in which they operate. These include the effective tackling of bribery and corruption, respect for human and labour rights, managing supply chains with integrity, upholding indigenous peoples’ rights, operating safe workplaces and making efforts to ensure that employees are healthy.
In emerging markets, engagements on social risks typically focus on accident rates among workforces in the extractive industries, tracking the sources of raw materials in the technology industry, the transparency of clinical trial data in the pharmaceutical sector, zero tolerance of child labour, clear oversight of supply chains for consumer goods companies, and for utilities companies, the safety of local populations near high-risk nuclear operations.
In relation to governance risk, the goal is to avoid state-run companies that rarely engage with minority shareholders and businesses with opaque disclosure standards. In Russia, for example, oil and gas companies have invested to further state agendas rather than benefit their operations or improve returns to investors.
In many cases, however, investors are simply happy with a fund manager who outperforms. They don’t query their picks of ‘sin stocks’, such as companies with majority state ownership or those involved in polluting industries, as long as the strong returns continue. They see businesses whose actions have potentially damaging consequences to be a matter of assessing the related risks. For example, effluent from pharmaceutical manufacturing, if untreated, can result in fines as well as lawsuits, putting a company’s relationship with the surrounding community and overall reputation at risk. But the legal system establishes what is allowed in business and penalises any activity it judges destructive to society. In that way, investors can argue that these businesses are not doing anything illegal – even if they are harming the environment or communities.
ESG investing outperforms
And what is good for people and the planet is good for emerging market investors, too. On average, investors who assess and act on ESG risks do better than peers who allocate to polluting industries or state-owned companies that shun best-practice corporate governance.
In recent years, the outperformance of ESG strategies is beyond doubt, with the evidence particularly strong in emerging markets. For example, the MSCI Emerging Markets ESG Leaders index, which includes 416 companies with strong ESG metrics, has consistently garnered better returns than the MSCI Emerging Markets benchmark since the 2008 global financial crisis.
Furthermore, research by our Global Equities team has demonstrated that, in developed markets, avoiding companies with bottom-decile corporate governance rankings can add as much as 30bps per month to returns.
The investor and the innocent bystander
Investors that take to heart ESG matters tend to be closer to the prevailing zeitgeist – acting as a responsible owner, managing risks and engaging with companies to tackle such issues – and are often rewarded through stronger long-term performance.
However, we must be mindful that many emerging markets companies are still learning ESG concepts. As such, we encourage investors to engage with them to help convey the materiality of these concerns. This should help to improve returns and ensure that the healthy planet in which they laboured still exists when they retire.
At Hermes, we believe that ESG risks are too important to ignore. By integrating ESG analysis, an investor’s focus is shifted from outperforming this quarter to generating sustainable returns for many years. In this way, investors can work collaboratively to achieve financial gain while respecting the wellbeing of our planet and each other. Such investors, and we count ourselves among them, seek long-term value not only for shareholders but for the innocent bystander, too.