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Investors and regulators are coming together to improve environmental, social, and governance standards in capital markets as a way to help identify growth opportunities, manage risks, and promote sustainability in developing countries.

Anthony Miller, coordinator of the United Nations’ Sustainable Stock Exchanges initiative, sits in his office in Geneva, peering into his Bloomberg terminal.

Tapping on his keyboard, he enters the names of leading emerging market firms. Significant data on their environmental, social, and governance (ESG) practices fills the screen, offering information on how each company ranks against recognized international sustainability benchmarks.

“When something like this pops up in the standard data sets, that tells me that sustainability investing is now mainstream,” says Miller. This is a far cry from how businesses used to operate. “We all used to say, ‘Wouldn’t it be great if…,’” adds Miller, who has been helping local capital markets and regulators in developing countries improve ESG reporting for 15 years. “Well, we’re getting there now. We have really made significant progress. But a lot more still needs to be done.”

In Tokyo, Hiro Mizuno, the Executive Managing Director and Chief Investment Officer of Japan’s $1.4 trillion Government Pension Investment Fund (GPIF), says the “to-do” list includes reminding governments that part of the responsibility for ESG reporting rests with them. Governments are not just policymakers, but “the biggest user of capital markets in the emerging markets” with the sovereign bonds they issue, Mizuno says. “Political or regulatory leadership of the governments [is] critical to promote systematic ESG reporting in those countries.”

Like Miller and Mizuno, industry leaders around the world agree that ESG data can create levels of trust that strengthen deep and liquid local capital markets. And that’s vital for a thriving private sector.

“Exchanges are showing growing commitment toward promoting ESG disclosures and facilitating finance to address sustainability challenges.”

— Mohamed Farid Saleh, Executive Chairman,
The Egyptian Exchange

When “What If…” Becomes “What’s Next”

ESG reporting can fuel strong capital markets. That’s because high standards of disclosure and transparency mitigate some of the risk of investing in the most challenging countries—where public institutions and governance are often weak and companies are smaller.

Strong ESG standards can lead to improved business performance. Mohamed Farid Saleh, Executive Chairman of the Egyptian Exchange—which in 2010 worked with Standard & Poor’s to launch the first ESG index in the Middle East and North Africa—has seen this dynamic first-hand. “Our companies that are highly ranked on ESG are outperforming others that are not as highly ranked,” he says.

Other evidence throughout emerging markets shows that adhering to high standards is a competitive advantage: companies participating in sustainability indexes in Brazil, India, South Africa, and the Middle East have outperformed their broader markets in recent years.


Toward a New Definition of “Performance”

In many developing countries, though, capital markets are still in their infancy and ESG reporting across emerging markets remains a low priority.

That may finally start to change as more asset managers advocate for companies to deliver positive contributions to society alongside financial performance. Larry Fink, chief executive of BlackRock, the world’s largest asset manager with more than $6 trillion in assets under management, issued a call this year for companies to benefit not just their shareholders, but also their employees, customers, and communities. The impact of this could reverberate widely because BlackRock’s vast portfolio includes a $311 million emerging-market equity fund.

State Street Global Advisors, another major asset manager, recently surveyed senior executives with asset allocation responsibilities at 475 institutions in the U.S., Europe, and the Asia-Pacific region. More than two-thirds said that integrating ESG factors into their investment strategies in developed and developing countries had significantly improved returns.

“We need to focus on the sovereign bonds in emerging markets.”

— Hiro Mizuno, Executive Managing Director,
GPIF, Japan

But they had lots of suggestions, too. Executives stressed that stronger benchmarking would allow investors to track their performance against peers and make more accurate assessments of external ESG managers. They also called for clearer terminology—specifically, a shared definition of ESG—and an approach that takes into account performance measures, internal capabilities, and costs.


Building a Platform for Better Decision-Making

Influencers across the industry are already thinking ahead to what can be achieved as momentum builds for more robust ESG reporting. Mizuno, from the GPIF, is one of those leaders speaking up—in part because of his position as a board member of the UN-supported Principles for Responsible Investment, which brings together more than 1,800 financial firms. He’d like to keep the momentum going by extending ESG reporting to bond markets.

“In the emerging markets where corporate bond markets have not been established, sovereign issuers play key roles,” Mizuno says. “Therefore, we need to focus on the sovereign bonds in emerging markets.”

GPIF recently teamed up with the World Bank Group to study how ESG factors can generate better and less volatile returns in fixed income investments in emerging markets. The joint study found that progress has until recently been held back by a lack of standard ESG definitions and benchmark ESG indexes in emerging markets.

It called for broadening and deepening available ESG data; requiring more rigorous research on the relationship between ESG factors and financial risks and returns in fixed income markets; refining standards, principles, and metrics for applying ESG and impact investing; and developing more innovative, scalable products to accommodate the growing demand for fixed-income sustainable investments.

In April 2018, J.P. Morgan unveiled an index that will support this agenda—the J.P. Morgan ESG (JESG) index, which was created with BlackRock. It integrates ESG factors in a composite benchmark that covers more than 170 countries and more than 650 issuers. Such analytical tools reward issuers for their ESG status, rather than their market capitalization. Investors are responsive because they benefit from the inclusion of ESG factors into their overall investment strategies. In August, BlackRock launched its first set of investment funds using the JESG index. The intent is to channel more investment to ESG-friendly companies over time.


Graph: ESG index outperforms in MENA region
Standard & Poor’s and Hawkamah (the Institute for Corporate Governance for the MENA region) jointly created the S&P/Hawkamah ESG Pan Arab Index in response to investor demand. It is the first index of its kind in the region and uses S&P’s ESG methodology based primarily on quantitative factors, bringing in qualitative analysis as an overlay. The index constituents are selected from a universe of the top 150 companies listed on the national exchanges of Bahrain, Egypt, Jordan, Lebanon, Kuwait, Morocco, Oman, Qatar, Saudi Arabia, Tunisia, and the United Arab Emirates. The index consists of the 50 highest-scoring stocks, according to their composite ESG scores. Since 2009, the index has significantly outperformed the S&P Pan Arab Composite Index.


These initiatives constitute important progress in the development finance agenda. Still, not everyone agrees that high ESG standards automatically stimulate new investment. Saleh, from the Egyptian Exchange, says that although his organization has ramped up local ESG reporting, it has not yet seen an increase in foreign investment. He thinks it is of “paramount importance” for international financial institutions to work with specialized asset managers on new investment vehicles to help usher it in—in Egypt and other markets.

“Exchanges are showing growing commitment toward promoting ESG disclosures and facilitating finance to address sustainability challenges,” Saleh says. “There is a responsibility on international institutions to foster investments in ESG-champion listed securities to further promote the adoption of ESG practices, reporting, and disclosure.”


The Next Stage

Even the most enthusiastic advocates of robust ESG reporting acknowledge that there’s plenty of work ahead.

“Much more needs to be done if we are to transition to a truly sustainable economy and avoid the worst risks of climate change,” says Steve Waygood, Chief Responsible Investment Officer at Aviva Investors in the UK and a co-founder of the UN Sustainable Stock Exchanges initiative.

“A business-as-usual approach is no longer enough,” Waygood says. “Market players and market regulators need to [partner] to deliver a sustainable financial system that works for individual and institutional investors across the world.”

IFC’s Disclosure and Transparency Toolkit

Reliable public information about local companies’ adherence to ESG standards can be hard to find in emerging markets.

That’s why IFC offers a disclosure and transparency toolkit for companies, investors, capital-markets officials, and regulators. It’s already helping to fill the ESG information gap.

The toolkit’s practical guidance is summarized in the free online publication Beyond the Balance Sheet.

Since the toolkit’s release in January 2018, it has been used to develop market and regulatory guidance in Kazakhstan, Kenya, Nigeria, Peru, and the Philippines. IFC clients in several countries have used it to improve their annual reports and disclosure practices. Kenyan Capital Markets Authority Chief Executive Paul M. Muthaura says that IFC’s toolkit suggestions have been “vital” in improving the agency’s corporate governance assessments.

The toolkit guides local companies on an integrated approach to corporate reporting, recommending what should be disclosed, and supporting a better understanding of the critical factors that drive corporate value today.

Among its practical tools: a large selection of ESG metrics that can be used to identify companies’ Key Performance Indicators, drawing on model indicators from IFC’s widely adopted Environmental and Social Performance Standards and Corporate Governance Methodology.

“We hope this toolkit will help build momentum across capital markets—matching responsible companies in emerging markets with institutional investors,” says Ethiopis Tafara, IFC’s Vice President, Legal, Compliance Risk and Sustainability & General Counsel.

Join the conversation: #IFCPerspectives

Published in October 2018