ESG Considerations and Fixed Income Investment Opportunities in the Asian Markets
As economies and investment markets have grown and matured around the globe, Asia has grown in lockstep to occupy its own unique position at what are traditionally competing considerations of sustainability and finance. Taken as a whole, Asia is home to almost two-thirds of the world’s population. Two of the region’s countries, China and India, join the United States as the three highest energy-consuming countries. In a relatively short amount of time, Asia has developed a robust trillion-dollar credit market. Notwithstanding unprecedented stresses from geopolitics and the recent global pandemic, the region is responsible for producing almost half the of world’s global gross domestic product.
Despite these features, the one area in which Asia has lagged behind the United States and Europe is in the integration of environmental, social, and governance (ESG) factors into investment processes. Decades of investment experience went by before ESG considerations found their way into the European and US markets, and it is altogether conceivable that the Asian markets are poised for an expansion of those considerations. A fundamental factor that will drive that expansion in Asia is a better understanding of ESG benefits and an appreciation of the commercial motivation driving ESG factors.
One area in which ESG factors have demonstrated a measurable impact is in Asian fixed income considerations such as credit quality, defaults, and spreads. The unprecedented financial stresses of 2020 have forced Asian fixed income fund managers, in part, to use ESG considerations into asset allocations and portfolio balancing as a risk management tool. The more successful funds have generated consistently better returns with active investing that relies on knowledge of local markets and an on-the-ground presence in those markets. That presence has exposed a grassroots demand for ESG considerations and pushed managers and fixed income funds to take a more nuanced approach to identify risks and opportunities. Some practical insights can be distilled out of how that approach has influenced Asian fixed income investment decisions in 2020.
First, it should come as no surprise that regulations and institutional investor demand are the main drivers of ESG factor considerations in Asia. Severe weather patterns and disruptions have brought environmental factors to the forefront in energy, metals and mining, and utilities sectors as investors and regulators have stepped up their demands for better awareness of climate change and sustainable financing. As a prime example of this, for at least two years larger institutional investors have been unloading investments in the Asian palm oil industry, which has faced increasing criticism for alleged deforestation and destruction of wildlife in its sourcing of raw materials.
On the regulatory side, in recent years the Chinese government has emphasized sustainable growth and has imposed stricter environmental regulations with threats of costly fines for companies that fail to comply. Asia, and particularly China and India, have also stepped up investment into renewable energy. Renewable energy-backed bonds, in particular, have benefitted from a supportive Asian regulatory environment. Further, and in sharp contrast to the outflow of institutional investor resources from the Asian palm oil industry, several international long-term investors have provided significant capital to support the continued growth of the Asian renewable energy markets and industries.
Unlike environmental factors, social factors typically have a relatively limited, short-term impact on businesses. The long-term impact of social factors, however, can be far more significant. A company’s strong focus on social factors can offset other weaknesses and offer a stable foundation when markets are otherwise extremely volatile. Institutional investors, for example, have continued to and have expanded their support for one of the largest urban rail systems in China that has an average daily ridership of over 10 million. Many international institutions have previously shied away from investment opportunities funded by Chinese local government financing due to weak financial profiles and inexperienced management. Yet with the urban rail system, those same investors have focused on the company’s efforts to keep ticket prices low and its emphasis on its mandate of providing transportation services. The company also has a strong safety record and favorable employee relationships. These considerations give this company a high ESG score, which is reflected in the performance of its bonds on the public markets.
Governance factors are, perhaps, the most difficult element to assess across Asian industries. Many of the region’s corporate entities are owned by governments, political entities, or private families. For historical reasons, many Asian corporations are part of intricate cross-shareholding structures. As more institutional investment money comes into the region, that money will force greater transparency of ownership structures as investors demand more information to better assess ownership implications for default risk. State-owned entities might have resisted that transparency in the past, arguing that state backing offers implicit guarantees against financial downturns or defaults. Those entities have used similar arguments to price bonds at a tighter spread.
On the positive side, investor demands for more transparency in governance have the potential to save Asian bondholders from losses due to fraud or mismanagement. Some of those bondholders are still reeling from losses in a Hong Kong-listed Chinese timber company. Following a default three months after the company issued a US dollar-denominated bond, the company’s management admitted to fabricating assets and revenues and its CEO was determined to have embezzled millions of dollars from its treasury. Presumably, increased investor scrutiny into governance issues among Asian companies will prevent a repeat of that debacle.
Many advisors that are active in the Asian markets have developed ESG scoring mechanisms to give their clients a clearer picture of ESG factors. Those mechanisms generally measure quantitative risk at the country, sector, and issuer levels based on certain defined categories. The final score may be adjusted by input from a team of analysts.
While there is little question that Asia has been lacking in consideration of ESG factors, both industry participants, and regulators are making strong efforts to narrow the gap versus other regions in ESG integration. Various industry and trade associations are increasingly incorporating ESG factors into their presentations. Market regulators and securities exchanges have established a variety of requirements for ESG disclosures for listed companies. China and Hong Kong have demonstrated strong support for green financing, and China now boasts that it is one of the largest green bond markets in the world.
Analysts are now watching to see if the region will develop a uniform approach to assigning and assessing ESG scores among rating agencies and independent ESG index providers. The region will turn a corner when it incorporates a direct linkage between ESG ratings, credit spreads, and credit ratings.
ESG factors in investment considerations are more than just a fad. Growing investor interest in sustainable investing in Asia and pressure from institutional investors will continue to drive a greater focus on ESG factors and will boost the case for alpha from ESG in Asia fixed income investments.