The Race for Green Capital in Emerging Markets
Emerging markets (EM) are highly vulnerable to climate change and require significant amounts of foreign capital to fund transition, mitigation, and adaptation measures. Although the green bond market is growing rapidly, EM is not capturing its share of the potential. Our paper describes structural reasons why, without intervention, this will persist.
Unlike developed markets (DM), where there has been a surge in green-dedicated funds, very few such vehicles exist in EM. As such, there is little natural demand for green bonds at present. Moreover, most of the EM fixed income asset class is too volatile, illiquid and risky to attract capital from dedicated DM green managers.
Interviews conducted for this research reveal that EM fund managers are beginning to integrate more holistic environmental, social , and governance (ESG) considerations into their investment process. However, there is a wide range of views on exactly what ESG means in the context of developing countries and to what extent such measures complement credit risk considerations.
Historically, environmental considerations have had very low impact on credit scores. As such, EM managers are most concerned with governance issues as this has immediate, tangible impact on credit risk. Climate risks are more opaque and much further away from day-to-day consideration.
EM fixed income is a highly indexed product. Investors are drawn to the high yields and managers are incentivized to stay close to the benchmark. The rise of passive investing has depleted some of the rigorous credit analysis needed to differentiate long-term transition risks in EM.
The vast majority of EM fixed income assets are in local markets, yet very little issuance has occurred outside of China. Most EM countries do not have a local green framework for issuance and many do not have credible plans outlined to meet their Paris Agreement pledges. Without a concerted effort to educate and incentivize local investors, and to support governments in building out the proper infrastructure and protocols, local green issuance will continue to lag.
Our report highlights the need for deeper and more flexible sources of EM capital. In particular, we note the green bonds framework is unsuited for many EM issuers, and propose transition bonds as an effective way to bridge the gap. We see an expanded role for International Financial Institutions and Sovereign Wealth Funds to provide long-term, patient capital and risk-sharing. And we believe it is vital local markets are given the support and incentives needed to build out a vibrant green market.
Most importantly, EM end investors must move on from the short-termist mindset which often views the asset class as a macro-driven carry trade that falls in or out of favour based on global trends. To facilitate the sustainability transition needed in EM economies, more strategic and long-term thinking is required to support EM managers as they attempt to actively engage issuers