Big questions about how to cushion the harsh economic impact of Covid-19 on developing countries are now at the top of the international policy agenda. While advanced economies rebound, the International Monetary Fund has forecast that, by 2024, output from emerging markets outside China will be as much as 8% below pre-pandemic levels. The obvious solution is to tap Western models for more environmental, social and governance investing to get emerging markets back on track. But that may be a mistake.
Actors in sustainable finance have made impressive strides over recent years. They’ve done so by demonstrating that there are real financial risks embedded in ESG topics. Many have made impressive returns.
In a time of historically low yields, the big investments required for clean energy in EMs could be viewed as an equally historic opportunity. After all, better infrastructure, higher employment and increased resilience cannot be accomplished by public sector spending or debt relief on their own. But greater participation by the private sector won’t happen by grafting ideas from today’s green finance market onto the needs of EMs.
There’s no doubt that green finance is making huge advances. As our work with the International Energy Agency has demonstrated, clean energy shares have outperformed fossil fuel stocks in advanced economies by four times over the past decade. On the debt side, annual issuance of labelled bonds (green, social and sustainability-linked) is on pace to break $1tn this year.
But these success stories are largely confined to developed markets. Italy’s inaugural green bond this year was larger than all EM sovereign green issuance in 2020. The UK, not exactly known for its sunny skies, has installed more capacity of solar PV than the entire continent of Africa. As Western nations scale up green bond issuance to fund recovery efforts, the chasm between developed and developing markets is growing wider.
These disparities cannot be explained away as teething problems in adapting to new protocols and frameworks. The real issues are underlying market structures within EMs and basic assumptions about sustainability investing in general.
With the rise of passive investing, EM debt has become an index-driven asset class. The result is that proactive engagement with issuers and fundamental analysis has atrophied. Many fixed income investors are failing to grasp structural trends that are re-shaping the investment process.
While ESG has a long-standing history in fixed income markets, the concerns are almost exclusively about governance. Pressures coming from the environment – water stress, extreme weather events and natural capital depletion – are rarely considered. With a spate of warnings that climate-related risks are already priced in sovereign bond markets and will raise the prospect of future downgrades, the capital trap for emerging markets is growing tighter.
But adopting the ESG frameworks common in developed markets is not a solution. As we highlighted in a recent discussion paper, ESG often cements the status quo. EM funds under pressure to improve their ESG scores buy more bonds from higher-rated (in most cases wealthier) countries. They shun those with lower ESG scores. The entities in greatest need of investment, and with the greatest potential for improvement in carbon efficiency, are in danger of being starved of capital. Left to its own devices, this process will reinforce a trend towards inequality in the financial system as marginal sovereigns and corporates are pushed into a vicious downward spiral of higher yields and deteriorating economic prospects.
However, there are encouraging signals on the horizon. Transition bonds are still in their infancy but comprise a promising innovation that could help bridge the gap between green ambitions and reality for many high-emitting EM issuers. International financial institutions are slowly coming around to developing better risk-sharing mechanisms that unlock capital from the private sector. But we need to move beyond one-off pilot projects and into replicable mainstreaming.
Longer term, it’s vital that domestic capital markets in EMs build their own green finance ecosystems. The competitive threats to state-owned enterprises from a global low-carbon transition are massive. Governments can get ahead of the curve by creating credible plans for integrating low-cost renewable energy into national energy systems, prepare shovel-ready infrastructure projects and make space for private sector investors in critical areas such as education, health and transportation.
More strategic thinking is urgently needed up and down the international finance chain as the pressures posed by climate change intensify. EMs cannot afford to be shut out of green finance as they struggle to gain their footing from a lingering public health crisis. The world’s fastest growing economies should be leading the race for green capital that can serve their energy needs. Instead, they are being left behind. We’ll all lose if that marathon doesn’t quickly turn into a sprint.
Charlie Donovan is Executive Director of the Centre for Climate Finance & Investment at Imperial College London and Visiting Professor of Finance at the University of Washington.