Banks and investors increasingly rely on environmental, social and governance (ESG) scores from ratings agencies to identify sustainable financing and investment opportunities. But what if, due to an ingrained bias, these scores excluded a large proportion of the potential ESG investment universe: companies in emerging markets where ESG reporting and transparency is still relatively underdeveloped?
Although sustainable investments are increasing, most of that money is not allocated to companies in emerging markets. Despite the fact they account for 58% of global gross domestic product, emerging markets continue to receive less than 10% of ESG capital flows due to biases in existing ESG scores, according to ESG Book.
In 2021, just 3.4% of global ESG-based assets under management (AUM) were held in emerging markets, says ESG Book, compared with 20.2% of total global AUM held in emerging markets. According to ESG Book, this equates to an ESG investment gap of $5.4tn.
Today, most ESG capital ends up in sustainability funds which are full of companies such as Amazon and Microsoft, says ESG Book CEO Daniel Klier. “They are low-carbon in well-developed markets and disclose a lot of ESG information,” he says. “But I would imagine that these companies don’t have any problem attracting capital.”
Capturing capital
To address the mismatch between where money is needed and where it is actually available, ESG Book joined forces with the Future Investment Initiative (FII) Institute to launch an Inclusive ESG Score for companies in emerging markets. “Emerging markets have always had problems accessing capital but finding the right investors for the right company is more critical than ever now because capital isn’t free anymore,” says Mr Klier.
He adds that existing ESG scores are not transparent and look at factors such as country risk, which work against emerging markets that typically carry bigger country risk. These scores also tend to reward companies which furnish really good disclosure, but companies in emerging markets typically have less experience with ESG reporting, he says.
Scoring companies on their ESG performance is moving from what Mr Klier describes as ESG 1.0 — a single score (seven out of 10 or five green leaves) — to ESG 2.0, which looks at the nuances and complexity of sustainability.
ESG Book and FII’s Inclusive ESG score, incorporates analysis of both structured and unstructured data (social media, news reporting) and puts more emphasis on year-on-year performance than disclosure of non-financial data, which it says favours markets such as Europe where regulation and experience in reporting is more mature.
The Inclusive ESG Score also looks at ‘sector’ instead of ‘country’ risk. Hundreds of metrics are looked at, in fact, says Mr Klier, such as how much companies are investing in climate change, water usage, HR policies, litigation against companies, how independent their board is and how often it rotates.
Looking to the future
The Inclusive ESG Score not only examines a company’s current performance, but via the Inclusive ESG Momentum Score, which integrates current performance and ongoing change in companies’ sustainability performance, also looks at future performance. Combined with a company’s current ESG Performance Score and Disclosure Score, ESG Book and FII says this provides “a comprehensive and nuanced picture of corporate sustainability performance”.
The score also forms the basis of an Inclusive ESG Ranking, which identifies the 250 most sustainable emerging markets companies from sectors such as the extractive industries, agriculture, telecommunications and software. Both the tool and the ranking were launched at the FII Institute’s flagship conference in Riyadh from 24-26 October.
With regulators pushing for greater transparency around ESG ratings, Mr Klier says anyone can look under the hood of its 250 most sustainable emerging markets companies and see every data point and source behind the rankings.
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In addition to helping investors more clearly identify the companies in emerging markets taking the right steps on ESG and sustainability, Mr Klier says the Inclusive ESG Score also helps companies in developing markets learn and improve on their ESG performance, which ultimately creates greater transparency.
“The hope is to accelerate the adoption of ESG because people actually see it as a tool that helps them rather than a tool that punishes companies in less developed markets,” he explains. “And the second hope is very clearly, access to capital. We all talk about the funding gap in emerging markets. This tool is designed to bring more capital into these markets.”
