December 12, 2022
This year the disruption caused by the war in Ukraine and aggressive US monetary tightening have set back sustainable finance, but we expect higher flows to resume over the medium and longer term.
Financial inflows to ESG bonds and equity surged in 2019-21 as investors sought higher returns, but there has been a downturn in 2022, in line with the global economic outlook. Moreover, there are signs of a growing backlash among investors as many grapple with fundamental issues with the ESG phenomenon and its purpose, most of which arise from the lack of a common global taxonomy. Proponents’ inability to prove that ESG equity portfolios outperform their non-ESG counterparts has compounded these difficulties.
Challenges to sustainable finance
The broader sector of sustainable finance is expanding across different segments and across EM regions. Green bonds dominate, but social and sustainability-linked bonds are growing faster than other bonds. China has been the leader from the start, but there has been growth in other regions, notably in Latin America, led by Mexico, Peru, Chile and Uruguay, partly owing to innovative financing mechanisms and their focus on climate change issues.
EMs face a number of similar issues to developed markets in attracting sustainable finance, including the lack of clear frameworks, and difficulties harmonising ESG regulations and reporting standards. EMs also face some unique challenges; for many countries, these include a greater economic reliance on environmentally harmful industries and weaker climate frameworks as per the Paris Agreement, which complicate energy transition objectives. High levels of dependence on foreign funding, poor availability of ESG data compared with developed markets, and weaker corporate governance and social indicators are other constraining factors.
Other EMs are starting to catch up with China on issuance
The year 2021 could well come to be seen as a watershed year for sustainable finance in EMs, as inflows to both ESG-related bonds and equities surged; ESG bond issuance was particularly high, reaching US$190bn, which was triple the amount of issuance in 2020 and accounted for 40% of the entire cumulative issuance of US$500bn since 2015. This acceleration followed the mainstreaming of sustainable financing strategies in EMs, fuelled in part by pandemic-induced demand, as well as the deployment of green borrowing strategies in Latin America. Flows into equities were more modest, at US$25bn in 2021, but this was still marginally higher than 2020 inflows, bringing total sustainable assets under management in EMs to US$150bn.
The number of EMs issuing ESG debt rose from five in 2015 to more than 30 in 2021, but the market remains concentrated, with 80% of total issuance accounted for by the top five countries. China is the dominant EM participant, accounting for US$110bn in ESG bond issuance in 2021 (similar to levels in large developed economies, including the US, France and Germany). Furthermore, China, which predominantly issues green bonds, is the world’s second-largest issuer in this category, behind only the US. ESG issuance in EMs outside China is also increasing, reaching US$90bn in 2021, up from an annual average of US$25bn in 2016-20. This lifted non-China EMs’ share of overall EM bond issuance to 46% in 2021, compared with only 32% in 2016-18. Chile, Peru and Mexico are leaders in non-China EMs, having issued sustainable debt amounting to the equivalent of 12% and 2% of their local GDPs respectively.
Social and sustainability-linked finance is rising
Partly reflecting China’s large footprint, green bonds are the core of the EM ESG market, but social, sustainability and sustainability-linked bonds and loans are gaining ground after accounting for almost half of new issuance in 2021 from non-China EMs. About 80% of ESG issuance by Brazil, Mexico, Chile and India was not directly tied to green investments; this is particularly attractive for corporate issuers, as it gives them greater leeway to spend the proceeds on a range of business projects. However, this flexibility opens the door to greenwashing concerns, which will continue to plague green bonds in the absence of clearer standards.
What next?
The global stockmarket downturn in 2022 has hit investor returns in ESG equity funds, many of which were weighted in favour of tech stocks that were more vulnerable to higher interest rates. Nonetheless, inflows to ESG funds have held up; according to Morningstar, a data firm, US$139bn had flowed into global sustainable funds by the end of September, but this compared with US$643bn of net outflows from the broader market. This also comes despite a political backlash by the political right wing in the US over “woke” investments, which appeared to feed into broader questions among investors on the basis for ESG equity investment. Efforts to improve reporting standards should boost investor confidence that ESG financial tools can meet their environmental and social objectives, but this will take time.
The recent growth of ESG markets provides opportunities for EM sovereigns and firms to secure access to funding sources to help countries to meet their climate-related and energy-transition challenges. The popularity of sustainable bonds, which aim to fund the energy transition, indicates that financial instruments with a clear use case may come to define the sustainable finance arena. To benefit the most from these opportunities, policymakers will need to address a myriad of issues to develop the ESG ecosystem in EMs.
Source: Economist Intelligence Unit (EIU)
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