Investors should allocate capital based on direction of travel, rather than static ESG scores – otherwise some emerging countries will be left behind on the journey to net-zero, writes Gustavo Medeiros
The energy transition is maturing, and a year dominated by global elections and bookended by COP29 has naturally sharpened the scrutiny levelled at policymakers on climate.
Particularly for emerging markets, the concept of a 'just transition' has become an important element of the net-zero conversation, thanks in part to endorsement by many global organisations and initiatives. The International Labour Organisation describes the term, as it relates to the energy transition as 'greening the economy in a way that is as fair and inclusive as possible to everyone concerned', a definition which the United Nations Development Programme recognises as a 'sound basis' for the concept.
ESG scores are punishing EM countries
It is well-documented that a key bottleneck to the energy transition is the lack of available capital, particularly within emerging market (EM) countries. Several deep-pocketed institutions stand ready to be part of the solution to this bottleneck. But many investment vehicles focusing on environmental, social and governance (ESG) metrics are led by a scoring system that limits or excludes investment to countries on absolute levels of emissions, environmental practices and governance policies.
These scores have a strong correlation with GDP per capita. A 2020 World Bank paper suggested that "about 90% of a country sovereign ESG score is explained by the country's level of development". This means asset managers with ESG mandates often have a bias to allocate capital away from EM.
"About 90% of a country sovereign ESG score is explained by the country's level of development. This means asset managers with ESG mandates often have a bias to allocate capital away from EM"
Herein lies an important paradox in the energy transition challenge that must be solved within the context of a 'just transition'.
Instead of punishing countries that are not fully aligned to the goals of the Paris Agreement, investors should reward those that move towards alignment. For example, Brazil earned a bad environmental reputation largely due to actions from its previous government, but deforestation rates have declined significantly under President Lula, and the country now has the capacity to generate more than 85% of its electricity through renewables.
Another consideration within the 'just transition' is accepting the reality that, for some EM countries, fossil fuels will remain crucial during the energy transition. For example, Indonesia produces nearly half of the world's nickel, a critical metal in electric vehicle batteries. However, many vital nickel mines are in remote areas that are not connected to the country's grid and can only be explored today relying on local coal plants. Overlooking countries like Indonesia and Brazil as investment opportunities can have real-world consequences for both the success of the energy transition.
Finding a solution
There are several levers that can be pulled by ESG rating agencies to level the playing field between emerging and developed markets. Measuring emissions on a consumption basis could be a starting point. A large portion of European and US emission reduction has been achieved in the process of diversifying production away to EM countries, particularly in Asia. This does not reduce emissions, but just shifts the burden on to other countries' shoulders.
Overlooking the obvious is also a habit that needs to be addressed. By definition, most historic pollution and environmental damage was caused by today's 'developed markets'. Therefore, penalising EM countries that have little choice but to undertake their own (more climate-conscious) industrial revolutions many years later does not constitute an appropriate or 'just transition'.
Creative financing mechanisms will be necessary to incentivise EM countries to continue transitioning away from fossil fuels, rather than punishing them for using them when needed. The developing sustainable bond market is evidence of this, and we are witnessing EM countries embrace the issuance of these debt instruments.
Uruguay exemplifies innovation through its sovereign sustainability-linked bonds, which aim to keep the government accountable for environmental policies through providing greater financing optionality via step-up and step-down features tied to environmental KPIs. KPI-1, for instance, requires the government to achieve a 50% reduction in 'aggregate gross greenhouse gas emissions' by 2025. The bonds' spread over US Treasuries can widen or tighten depending on whether such KPIs are met.
Globally, countries and corporations are working towards ESG programmes that need funding. More capital allocated to EM-dedicated ESG funds will not only increase the demand for such product structures but also directly support the energy transition efforts in EM countries. The private sector has a key role to play in supporting this transition – one that will only be truly realised once it looks beyond some of the unjust negative screening approaches currently in place.
Gustavo Medeiros, Head of Research at Ashmore Group plc.