Laying firm Foundations

Investors into emerging markets want to see greater attention paid to the fundamental issues of ESG. Nina Röhrbein reports

Interest from institutional investors in emerging markets investments has grown significantly, spurred by a strong 35% five-year average return on the MSCI Emerging Markets index, according to John Deosaran, head of product development, financial research and analysis group at RiskMetrics Group. "But in many cases - and although some emerging market companies do a good job of reporting and communicating their practices and policies - the transparency these investors have come to expect in the developed markets is just not there," he says. RiskMetrics' report ‘Corporate Governance and Climate Change - The Banking Sector' revealed earlier this year that with regard to climate change, disclosure was generally lowest among banks in emerging markets.

"Emerging markets are generally in earlier stages of economic development and maturity so they have got other challenges ahead of them," agrees Douglas Cogan, (pictured right) director of climate risk management, ESG analytics group, at RiskMetrics. "But as more money is flowing into emerging markets ESG is quickly moving up the line of priority."

"There are many privately-owned family businesses all over Asia that want to go public at some point and they now recognise that investors have some good ideas and want to be involved as shareholders in a public company," says Bill Crist, (pictured left) chairman of the board at Governance for Owners. "And so there are certain aspects of governance, such as best practice codes, they should probably adopt. Companies that have their home base in an emerging market and are already established as public companies appear to be more receptive to corporate governance strategies than longer-established companies in the UK or the US, which generally follow long-established industry practices."

"But taking best practices from developed markets and simply applying them to emerging markets is very risky because the governance challenges investors face in these regions are quite different," says Peter Taylor, head of corporate governance at Aberdeen Asset Management Asia. "In the UK and US, for example, a company usually has many shareholders, each owning a small percentage of the company, which leads to the question how the management team can work for all these diverse, atomised interests. In emerging markets, however, the controlling shareholder - often a family - typically owns 60% and the minority shareholder only 40% of the business. So there the problem is how to ensure the fair treatment of the minority shareholder versus the controlling shareholder."

"To drive corporate governance forward in such markets, the basics need to be improved such as pushing companies to take proxy voting seriously, voting by poll and disclosing the vote tally at annual general meetings," says Taylor.

"Few investors expect emerging market companies to hold the same standards as those in developed markets," says Cogan. "However, they would definitely expect them to be progressing towards best practice standards."

Initiatives such as the UN Principles of Responsible Investment (PRI) and the International Corporate Governance Network (ICGN), are trying to bring ESG standards into emerging markets, says Cogan. "For the first time this summer the ICGN had a specific endorsement of encouraging analysis within an ESG framework around the globe including emerging markets," he says.

"Smaller emerging markets companies may feel less external pressure to implement ESG criteria than larger companies," adds Cogan. "However, if they do implement these and are on the hunt for foreign capital they may even move ahead of some of their competitors."

"Sometimes more can be gained financially in emerging markets because in the more developed markets governance is to a degree already integrated in the way management behaves, and it is hard to change," agrees Crist. "In other words the demand for foreign capital is a strong driver behind improvements in governance."

"Pockets of companies already face the reality of raising capital in a global marketplace amid various environmental regulations, product safety and work place standards," agrees Deosaran. "And they have come to understand to some degree what investors expect and require from them."

According to Deosaran, all three ESG areas receive attention although following the Enron and WorldCom scandals the focus is particularly on corporate governance. "Environmental and social issues have a potential to impact companies differently because of the reputational issue involved," he says. "Plenty of companies need to trade on their name, so environmental and social issues have become very important too."

"Whether the E, S or G has priority depends on the particular sector and company," says Andrew Ness, (pictured right) investment director in Scottish Widows Investment Partnerships' (SWIP) global emerging markets team "Materiality is key in this instance. In other words the specific factors that have the most material impact both on the negative and the positive side of a company's business. In financial services, for example, human capital retention and the issues surrounding credit worthiness, balance sheet leverage and the sustainability of the credit model are important, whereas in some industrial sectors, environmental impact and the human rights of local indigenous populations can be key issues."

"In China, for example, it is currently more important to produce power than to cut greenhouse gases and Western investors are not holding back their funds to prevent that," says Cogan. "However, there is going to be more focus on the environmental impact in terms of greenhouse gas emissions in the post-Kyoto regime after 2012 and that is going to be especially true in some of these rapidly growing emerging markets. And investment restrictions - such as seen in South Africa during the apartheid years - are still in place when it comes to countries such as Burma or Sudan or ones that are alleged to have terrorist links."

Deosaran names South Korea, South Africa and Turkey - where he says corporate governance practices exceed that of many developed European markets due to the country's desire to join the EU - as some of the markets ranking high with regard to ESG standards. "As economies reach a developed market level, there is also a growth in regulation and listing requirements and the way in which companies plan for and monitor issues related to ESG," he says.

"A number of Brazilian corporates have also been very pro-active in disclosing material ESG issues and demonstrating their ability to manage those issues effectively," adds Ness. "This was helped by the creation of the Novo Mercado, a set of stock market listing requirements that demands greater corporate disclosure by companies, as well as providing greater governance protection for minority investors. The fact that many companies are now willing to list themselves on the Novo Mercado is a strong statement of their recognition of ESG issues."

Indeed, after a slow start in December 2000, the 100th company listed on the Novo Mercado in June.

"According to the Asian Corporate Governance Association (ACGA), Hong Kong and Singapore are ahead of the rest of the pack when it comes to governance," says Taylor. "Others such as Indonesia, Vietnam and the Philippines lag behind although even they have now a framework in place which did not exist a decade ago. In each market there are now a few good companies that set themselves apart from the rest. And so the best-governed companies in Indonesia are likely to be better governed than the average-governed company in relatively better markets such as Hong Kong, which means investors will be able to find a few companies even in relatively difficult markets."

In a study by the Social Investment Research Analyst Network (SIRAN) in January 2008 - which looked at sustainability disclosure in seven emerging market countries [Brazil, China, India, Russia, South Africa, South Korea and Taiwan] and 75 companies operating out of those countries - South Africa emerged as overall leader in sustainability reporting, while China was the laggard.

"We regard disclosure as an important step along the road to good ESG management because it highlights the risk management capability of companies," says Ness. "Disclosure is also important because many emerging market companies compete on a global basis and are increasingly being assessed on their ability to meet and comply with evolving international standards."

"Because of the growing demographic and resource challenges, a more sustainable approach to economic development is particularly crucial in emerging markets," says Ness. "Many of these economies face rapidly growing populations and have limited resources to deliver sustained economic growth to provide for that growing population. These challenges ultimately drive both governments and corporates alike to focus on a much more sustainable approach. A major problem they are facing is that legislation in the past has been either absent or lax, and where legislation does exist there have been low levels of enforcement. Also, the lack of available information, its poor visibility and the time-consuming process that it takes to extract that information make the investment side of sustainability challenging as well."

"But local regulations are also evolving rapidly," Ness adds. "And with that will come stronger enforcement powers, such as plans by China to publish efficiency and conservation targets for all sectors."

"The challenge in most markets is still the mantra of growth at the lowest possible cost, which often entails either using an inferior technology or using technology that does not meet a best practice standard in the environmental or social sphere although in fact things such as improving disclosure are virtually free," says Deosaran. "And when it comes to governance many emerging market companies find it more expedient to be less open and transparent. Those that are already used to competing in the global market place and have looked for outside capital will have got beyond those hurdles; they are a reality they already deal with. But for many of their peers who may still be localised in their business or operational base it is a dilemma."

"From a very short-term corporate cost perspective companies probably do have an advantage when regulations are more lax than in developed markets," concedes Ness. "However, in the longer term both the companies and the societies that they operate in will probably have to pay larger costs if those environmental measures are not fulfilled."

Another challenge, according to Deosaran is to research emerging markets companies and obtain their public data. "In the last couple of years some companies have started to become fairly good at communicating the various policies and practices they have in place for managing risks in the ESG sphere," he says. "But that is the short end of the development curve. A lot of these companies are just starting to look at that. Another problem is the investor resource issue because investors have to a large extent only increased the level of engagement in developed markets or even just within their local markets. So in many cases it is a two-fold effect of generally less available information but also fewer resources within the investment firm to find and collect it."

However, for Taylor the issue lies elsewhere. "The real challenge in terms of accessing information is that often companies fail to provide timely and detailed information from which we can derive our voting decisions," he says.

"A large amount of due diligence and patient research is required to extract the relevant ESG data on emerging market companies," says Ness. "But it is increasingly being provided by the companies themselves. As a minimum we are seeing improved disclosure in annual reports while the best practice companies compile separate sustainability reports and publish them on their websites."

"With regard to corporate governance, there are two main challenges across emerging markets: One is that although emerging markets have the basic structures of governance in place a lot of it is form over substance," says Taylor. "The second one is a feeling that the job has been done due the reforms and that it is no longer an issue."

"On top of that there are region-specific challenges," he continues. "Asia is a particularly diverse region but for most of Asia corporate governance became particularly important following the Asian financial crisis of 1997. A lot of reforms relating to the strengthening of shareholder rights and corporate governance codes have taken place since then. But Latin America, for example - despite Mexico's so-called tequila crisis and Brazil's devaluation of the real - never had that kind of financial crisis and so their motivation for improving governance was the drying up of the capital markets.

"They faced the dilemma of whether to ease governance standards so that more companies can come to the market or tightening them even further, such as in the Novo Mercado, so that only the best companies are in the market, which would attract more interest from investors. In Eastern European markets assets were transferred from the state to the private sector very rapidly without having a governance framework or culture in place and the challenge there has been how to create shareholder capitalism in the space of a decade."

"One of the questions is whether they need to modernise their economies using the same traditional technologies of industrial countries or whether they can leap-frog some of the steps," says Cogan. "In some areas such as telecommunications we see that happening, however in others such as energy we do not."

"Another issue is the large cap bias," adds Cogan. "As companies become larger, more multi-national and more diverse in terms of their shareholder base they put resources into creating transparency around these issues in order to answer investor questions. But when the company is small or at an earlier stage of evolution, internal resources are likely to be put into other areas."

"Lessons can certainly be learnt from developed markets," says Ness. "One current example is the credit crunch and the role securitisation had to play in that. Many of the emerging economies have yet to experience the growth of mass market housing loans and vital lessons have been learned from the developed market experience about the need to ensure that the gap between the origination of the mortgage and the ultimate ownership and supervision of that mortgage does not go too far. That is likely to have ramifications for financial sector regulation in many of our emerging market economies."

"Making that ESG transition in an emerging market where they are still building the industrial infrastructure can be less disruptive than if you go to a developed market and try to retro-fit a capital investment base that has been mature for decades," says Deosaran. "So there is potentially a comparative opportunity for companies in emerging markets who embrace ESG. The 2002 World Bank study entitled ‘Corporate Governance, Investor Protection and Performance in Emerging Markets' found that emerging market companies with better corporate governance rankings outperformed companies with lower corporate governance rankings. It also found that companies in countries with worse legal and regulatory frameworks actually benefit more from making corporate governance improvements than those in countries with more advanced frameworks."

"Benefits resulting from companies taking a more sustainable approach are new revenue opportunities, more accurate growth and risk projections, superior transparency and better legal and compliance oversight, potentially resulting in lower costs of capital," adds Ness. "Other potential tangible benefits could be lower litigation costs, lower regulatory fines and lower credit risks, better branding and customer loyalty as well as superior human capital and retention."

Indices

Global emissions index series

Dow Jones Indexes and the Chicago Climate Exchange (CCX) - North America's legally binding, integrated greenhouse gas emissions reduction registry and trading system - have launched the first two indexes in a series of global emissions indexes that are to be launched jointly by both parties.

The Dow Jones/CCX European Carbon index and Dow Jones/CCX Certified Emissions Reductions (CER) Index are intended to serve as benchmarks for participants seeking exposure to the EU Emissions Trading Scheme (ETS) and the Kyoto Protocol Clean Development Mechanism (CDM) respectively.

The Dow Jones/CCX European Carbon Index is composed of actively traded EU Allowances (EUA) futures contracts on the European Climate Exchange. It measures their present discounted value of EUAs, the carbon credits issued in the EU ETS Emissions Trading Scheme, across different maturities. The Dow Jones/CCX CER index measures the present discounted value of CERs - the carbon offset allowances issued by the United Nations under the Kyoto Protocol CDM - across different maturities.

All contracts used in the indexes' calculations are the European Climate Exchange Carbon Financial Instrument Futures listed on ICE Futures. And both indexes are rolling indexes that roll once a year in December over a four-day period.

US small caps outperform large counterparts

Smaller US companies outperformed their larger brethren over the three months leading up to 18 August 2008, according to Richard Wilson, US equities fund manager at Threadneedle, with the Russell 2000 Index moving ahead by 0.11% in contrast to a fall of 10.3% by the S&P Composite index.

"Recent months have seen an acceleration in the slowdown in economies outside the US and this is expected to have an adverse impact on the major US exporters, likewise the recent strengthening of the dollar will also reduce the competitiveness of US exports," said Wilson. "Smaller companies are more reliant on the domestic economy and continue to obtain a greater proportion of their revenues from customers in the US."

ETF licence

European equity index provider STOXX has licensed the Dow Jones STOXX 600 Basic Resources, Dow Jones STOXX 600 Oil & Gas and Dow Jones STOXX 600 Utilities indexes to ETF Securities in order to underlie three exchange-traded funds (ETFs).

The ETFs were listed on the Irish Stock Exchange in mid September.