KHYB - Innovative Strategies Help Overcome ESG Hurdles

Summary

• Events of 2022 could have a lasting effect on emerging markets debt investing.
• In a rare event since the emergence of EMs as an asset class, a meaningful market was severed from global financial markets through the sanctioning of sovereign debt.
• At the same time, innovative strategies are facilitating the flow of funds toward climate change adaptation and mitigation efforts in EMs.

Events of 2022 - including Russia’s invasion of Ukraine and the associated energy crisis in Europe; extreme weather conditions globally; and the political polarization of environmental, social, and governance ((ESG)) factors in advanced economies, most notably the United States - could have a lasting effect on emerging markets ((EM)) debt investing.

For example, Russia’s aggression toward Ukraine led us to ask: what happens when a country becomes “univestable”?

Innovative strategies are facilitating the flow of funds toward climate change adaptation and mitigation efforts in EMs.

In a rare event since the emergence of EMs as an asset class (which most would argue was in 1994), a meaningful market was severed from global financial markets through the sanctioning of sovereign debt. Russia joined the ranks of just a few other countries - Iran, Syria, North Korea, Venezuela, Myanmar, and Cuba - and is now the most sanctioned country in the world. At the same time, Russian authorities imposed restrictive measures, such as capital controls, on investors.

The combination of sanctions and restrictive measures led to the exclusion of Russia from conventional fixed-income and equity indices. These events demonstrate the extent to which geopolitical tensions and the adherence to international law and terrestrial agreements remain central considerations in investment decisions. Along those lines, we, along with the markets, will continue to closely watch relations between China and Taiwan in 2023.

At the same time, innovative strategies are facilitating the flow of funds toward climate change adaptation and mitigation efforts in EMs.

Loss and Damage Finance Facility On the Table

EMs were not spared extreme weather conditions in 2022, with catastrophic flooding in Pakistan and Nigeria and the Horn of Africa facing its fifth consecutive year of extremely dry conditions. To ensure a comprehensive approach to climate impacts, developing countries called for the establishment of a loss and damage finance facility at the UN Climate Change Conference in Glasgow (COP26) last year. Some progress was made in getting this topic on the agenda, with at least signs that financial support to climate-vulnerable countries may be coming.

Adaptation Bonds Bridge the Finance Gap

In EMs, the adaptation finance gap - the gap between actual and required adaptation financing - is widening, with adaptation cost estimates increasing continually. This might encourage innovation in climate finance. One example is adaptation bonds - bonds that will fund climate resilience - in EMs. We also see other examples of innovative efforts in emerging markets to raise financing for transition and mitigation efforts.

Another innovative strategy for assisting the energy transition in developing economies is the Just Energy Transition Partnership between South Africa and Indonesia.

Carbon Credits Incentivize Green Practices

Gabon, a net absorber of carbon emissions, has moved to sell carbon credits, allowing it to at least partly monetize the value of its forest conservation efforts. Although carbon credits are not consistent with the UN’s path to net zero, they can incentivize forest protection and rehabilitation.

Partnership Drives Clean Energy Investments

Another innovative strategy for assisting the energy transition in developing economies is the Just Energy Transition Partnership (JETP) between South Africa and Indonesia. By encouraging the flow of investments in clean energy while addressing accompanying societal issues, such as job relocation, the project seeks to hasten the phaseout of coal-fired power generation.

GSS Bond Market Expands

Bond markets - the largest and most liquid sources of capital for EMs - should continue to play an important role in channeling funds toward endeavors such as those mentioned above. And the market for green, social, and sustainability ((GSS)) bonds is expanding quickly. While issuance is highly concentrated by country (Korea, India, China, Brazil) and sector (financials and utilities), we expect it to grow and diversify.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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