As financial markets experience significant headwinds in 2022, environmental, social and governance (ESG) funds saw their first net outflow since 2011. However, the energy transition, climate-related threats to food security and the search for long-term value could prompt a resurgence of sustainable investment in emerging markets.

After global ESG funds enjoyed a record run from 2019 to 2021, growing by 98% and seeing net inflows of $25bn in 2020 and $35bn in 2021, net outflow from ESG funds in 2022 tallied $13.2bn by November. The 10-largest ESG funds posted double-digit losses during this period, with eight of them underperforming the S&P 500, which was down 14.8%.

It is important to note, however, that non-ESG funds also experienced a net outflow of $420bn over this period.

Nevertheless, political and regulatory hurdles continue to cloud the outlook for ESG funds. A Bloomberg News survey in November found that 65% of 691 respondents expected ESG funds to trail the broader market in 2023, with 38% expecting them to “slightly underperform” and 27% predicting they will “significantly underperform”.

This negative sentiment could scare off short-term investors, but the long-term case for ESG projects remains robust, especially as emerging markets continue to embrace them.

Undervalued assets

Several major investment houses, including US investment bank Goldman Sachs, have grown notably more sanguine in recent months about making targeted investment in ESG companies in emerging markets unlisted on the stock exchanges of developed markets due to the relative lack of available data, which can cause the ratings and valuations of such companies to suffer.

Companies in emerging markets tend to have lower ESG ratings than their developed market peers, according to MSCI, one of the world’s largest providers of ESG ratings.

In early January Goldman Sachs invested $1.6bn of client capital in the Horizon Environment & Climate Solutions I private equity fund, which is listed as an Article 9 product, meaning that it complies with the EU’s toughest ESG standards.

Another reason for optimism about ESG investment is the general rebound in emerging markets equities, fuelled by optimism about slowing US inflation and a coming rebound from China, which experienced an economic slowdown in 2022 due to its zero-Covid-19 policy.

Two weeks ago emerging market stocks hit six-month highs after enjoying eight straight days of positive performance, the longest since November 2021, buoyed by the announcement on Thursday that US inflation had slowed.

Energy and climate imperatives

As Russia’s ongoing invasion of Ukraine and disruptions to global supply chains are expected to continue into 2023, many countries around the world have shifted to hydrocarbons or coal to ease energy supply shortages.

In 2022 hydrocarbons-producing countries reaped record revenue on the back of high oil and gas prices.

However, the case for shifting to cleaner energy sources has only grown more urgent amid what the International Energy Agency has deemed a global energy crisis.

As governments adopt new policies to boost investment in clean energy and efficiency, there are tremendous opportunities for emerging markets that embrace the technologies and sources that will shape the future energy mix, enhancing the case for ESG investment.

From a strictly emissions-reduction perspective, national oil companies have perhaps the largest role to play due to their dominance in production, ample reserves and cost advantages.

In the Gulf, Saudi Arabia’s Aramco, the Abu Dhabi National Oil Company (ADNOC) and the Kuwait National Petroleum Company produced 19.3% of global oil and held 28.7% of proven oil reserves in 2021, while QatarEnergy produced 4.4% of the world’s gas and held 13.1% of proven gas reserves.

By focusing on reducing emissions and adhering to stricter ESG guidelines, these energy giants could help their countries meet their respective climate goals.

Both Aramco and ADNOC are already deploying artificial intelligence to make their operations more efficient, monitor and reduce CO2 emissions, and integrate green energy resources.

Meanwhile, the spike in climate change-driven drought and flooding in 2022 has led to food shortages in some emerging markets, making it imperative to adopt climate-change resilient food and agricultural systems.

Sub-Saharan Africa alone will require $15bn in annual investment to support climate change-resilient food and agriculture systems, according to a 2021 report by the Global Centre on Adaptation, which estimates the cost of inaction could be as high as $201bn per annum.

Long-term outlook

Beyond relying on third-party ESG ratings, investors should bear in mind that emerging markets have different reasons for investing in sustainable projects than developed countries.

Emerging markets approach ESG as a method to address social priorities such as reducing poverty, accelerating economic development and providing affordable energy supply, while more developed countries often have narrower goals such as meeting emissions targets.

This can lead to inconsistency about what ESG means in emerging markets, but also presents opportunities, especially in tandem with improved data reporting and a more holistic approach to assessing emerging market companies unlisted in developed markets.

Prioritising ESG activities across numerous sectors aligns with government sustainability objectives and consumer demand, but also has the potential to improve business operations and create a virtuous cycle of investment.

The question for ESG funds ultimately remains whether investors will recognise that emerging markets are moving in this direction. Niko Safavi, president director of Mowilex Indonesia, recently told OBG how paint and coatings manufacturers in Indonesia are promoting environmental and social protection through their activities and seeking new business opportunities in the space. “There is a real business opportunity attached to the ESG activities, and the sooner companies embrace that, the better,” he said.