Why investing in emerging markets is so difficult for institutional investors, and how this challenge can be overcome: The story on the disparity of the international capital market with a focus on emerging markets.
Background
The world is currently overshooting the 1.5 degree celsius goal stated in the 2015 Paris Agreement significantly and if we continue at the same pace, scientists predict a 3-4 degree celsius increase compared to pre-industrial levels - a temperature increase that would have catastrophic consequences for humans and nature alike.
While many companies have already presented net-zero commitments and countries are outlining their Nationally Determined Contributions (NDC’s), reaching the goals outlined in the Paris Agreement will prove a great challenge, requiring all sectors and countries to contribute their fair share. Emerging markets, a group of 27 countries (MSCI) representing 60% of the world population, are bound to play an important role in driving the green transition. Meanwhile, these economies are experiencing steadily increasing emissions rates due to an enormous intake of outsourced production and increasing living standards.
Reaching the goals in the Paris Agreement will undoubtedly prove one of mankind’s largest challenges, but as proven by the COVID-19 pandemic and particularly by the rapid development of vaccines, humanity has the capability to address difficult challenges. Achieving the green transition is in a completely different league and will require massive investments and support from high-income countries.
Emerging markets have in recent years attracted large investments from investors from high-income economies, particularly due to high growth rates and growing middle classes in China and India. However, investments into emerging markets and developing economies are nowhere near the level of investments in high-income economies and many investors are struggling to achieve successful investments into emerging markets. So, what makes it so difficult to invest in emerging and developing markets?
The challenges
Certain approaches from high-income market investors (both public sector and financial investors) into emerging markets have failed in some regions, whilst being more successful in others. To improve the quality and success of these investments, we must confront some of the challenges and apply new solutions. Investors looking to invest in emerging markets are faced with a series of market-specific challenges. While risks differ between countries, there is a set of existing challenges related to emerging markets: immature markets, different types of risk and emerging green investments.
Immature markets: emerging markets are a relatively new area for investors, and while these markets have developed at unprecedented rates over the past 10-20 years, they still experience a large gap when compared to advanced economies. This is primarily visible through insufficient access to data and knowledge (e.g., the MSCI does not have all frontier markets categorised). Investors simply do not have access to data that is required for investments in emerging markets and developing economies. Emerging markets also often lack adequate regulatory frameworks for reporting, transparency and long-term investment prospects, making investments in emerging markets riskier than in high-income economies.
Different types of risk: Investors in high-income economies often also benefit from stable political and economic frameworks and a deep understanding of the markets in which they invest. Through access to data and knowledge, investors have profound knowledge on the various investment risks and can hedge accordingly. This is not always the case in emerging markets and it can prove difficult to fully understand the present risks and even harder to rely on public institutions and organisations to minimise these risks.
The most fundamental risk is not having full knowledge of the market. This is often related to political and regulatory risks. Emerging markets are often characterised by unpredictable political systems, which can be followed by an array of issues including corruption and sudden changes in the political landscape (e.g., the public sector can stand still for months in the months leading up to and following an election).
Financial risks are another challenge for investors. First, hedging can prove extremely difficult for investors in emerging markets due limited access to large Fiat currencies. This is further exacerbated by volatile currencies, local inflation and debt and a lack of transparency, which can prove fatal for an investment. Additionally, emerging markets and projects can often be too small for institutional investors to make successful investments.
Finally, operational risks are easier to handle, but are still a challenge to many investors. One of the most challenging factors for investors is the need to be physically present. Without knowledge of the local market it is very difficult for an investor placed in Europe or North America to run a successful project. Here, it is vital for the managing fund to have a local team responsible for running the project. For most investors the only way to achieve success is through trial and error.
Green investments: One thing is the relative immaturity of emerging markets and another is that green investments are also a relatively emerging field, with green investments only having grown significantly in the last 10 years. When combined with the other investment risks, a green investment project in an emerging market can prove an extremely difficult investment to make without risk surpassing possible returns.
Solutions
The challenges outlined above can make it seem extremely challenging to succeed in emerging markets and developing economies. However, it is important not to forget that a growing number of investors have proved it is possible to succeed in emerging markets, even when adding green investments to the calculation. So what are the solutions behind successful investments in emerging markets?
Achieving success with emerging markets investments involves solutions on both macro and micro levels. At the macro level looking into governance, regulations and political environment and the micro level looking into the investor’s individual approach.
Regulatory systems and political environments are not only a serious risk for the investor environment, they can also be part of the solution. Increasing the flow of investment and finance into emerging markets requires strong governance, policy and currency stability, increased market access and innovation in business models and financial vehicles.
For the emerging and developing markets, it is crucial to prepare convincing plans to deal with and secure the green transition. These markets should prioritise their National Determined Commitments (NDCs) to ensure attractive market terms and to prove the local government has a true interest in attracting investments in the long term. Together with improved NCDs, emerging markets can also actively focus on identifying risks and thereby establish a transparent and accessible investor environment.
At the micro level, success also depends on the individual investor's approach to the market. Investors have to allocate a greater amount of internal resources towards the right set of data, information and knowledge. Most investors do not recognise the actual need of resources when looking into new markets to minimise risks. That is why it becomes a risk, however, it can also be converted into a solution to achieve success when the due diligence is prioritised internally.
To improve the quality of high-income market investments in and value of finance to e.g. In Africa, parts of the Middle East and South America, investors need to adjust their best practices to the local market and business culture and not copy investment strategies from Europe and North America. Respect and understanding of the importance of the local human factor, including the different cultures and traditions, must be integrated into an investment approach.
It is furthermore crucial that all levels in the organisation consider the risk and opportunities emerging market investments can bring. The decision needs to be actively included in the investor’s strategy and clearly reflect that it is not only a priority from the C-level or a senior analyst, but permeates a common decision in the organisation.
Although investors are suggested to further prioritise their efforts on due diligence, external partners are equally important. External partners can help minimise risk through knowledge, network and experience which the investors might not possess. A higher rate of success is often achieved if a number of partners are commonly involved.
The role of partnerships
Partnerships can prove particularly valuable when looking at investment in emerging markets and developing economies. Not only can different partners contribute with a wider range of knowledge and share the investment risks, investors new to emerging markets can also team up with other actors already present in the specific country to avoid startup mistakes. This can be done through partnerships with other institutional investors, development banks or development funds. Partnerships can also be used to aggregate investment opportunities, technological solutions, funding and communications through development of vehicles like the Partnership for Green Growth, P4G. In some emerging markets, particularly African countries, ownership and strong hierarchy is often more important and requires one of the partners to take the lead.
Investors prefer to invest where others have had success and so, partnering with national/international development banks or funds is an extremely strong strategy. Not only are these funds good at working with blended finance, they are also on the forefront of hedging against downside risks, as they have the network and reach to influence local political or economical decisions and will usually have first-loss guarantees covered by the state.
A key to ensuring there is local representation and therefore, local knowledge, is to have ownership locally where the investment activity is taking place. There is a long tradition of partnerships in Europe, however to succeed with a partnership in some developing economies, such as in Africa, you need to have a strong and centralised financial ownership, so projects do not end up lost.
Denmark has a long and successful history of public-private partnerships, the Danish Foreign Ministry and The Danish Investment Fund for Developing Countries have worked with the private sector and private capital for the last 10 years and provided investors with a competitive advantage through their knowledge of both state and private finance.
Another strong and impactful example is the Climate Investment Coalition (CIC), which is a public-private partnership between the Danish Ministry of Climate, Energy & Utilities, Insurance & Pension Denmark, Institutional Investors Group on Climate Change (IIGCC) and World Climate Foundation. This partnership structure has proven successful in accelerating the green transition through engagement with the private sector to mobilising financial commitments for green investments by 2030.
Future outlook
Many investors have proven to have a strong bias towards their home-country or well-known countries and policy systems and thus miss out on long-term investment opportunities. It is simply too risky and complicated to explore new markets, while ensuring continuous high returns to members. However, a lot will happen in the coming years and decades in emerging markets, which is why it is time to act. It is time to actively take a part in the green transition through emerging markets and ensure investors' portfolio's return goes hand in hand with our climate. The acceleration of green solutions through investments is seriously needed.
As mentioned, emerging markets are home to 60% of the world population, however, they only represent 13% of financial markets. This needs to change if emerging markets are to play their pivotal role in driving the green transition. To do so requires them to actively identify risks and provide better access to data, increase transparency and to continue strengthening partnerships to attract more impactful investments. While today’s investing into emerging markets requires governmental influence, these markets will likely develop to a degree where they become so transparent that institutional investors can invest single handedly.
While emerging markets might prove difficult to institutional investors, there is no doubt that it is still easier to make a difference in those markets as compared to high-income economies. Some of the most successful emerging markets; China, India and Vietnam, have taken 20-25 years to reach their current levels. With this in mind, it is very likely that we will see investors who learn to successfully invest in emerging markets in the next 20-20 years, be among future winners.
Peter Damgaard Jensen is Co-Chair of the Climate Investment Coalition, board member of the World Climate Foundation and Chairman of AIP, one of the two large energy infrastructure investment companies in Denmark. He was previously chairman of the Institutional Investors Group on Climate Change (IIGCC) and CEO of PKA and has been instrumental in setting up the Climate Investment Fund and the SDG Fund with the Government of Denmark and IFU, Denmark’s development finance institution.
Anders Engel Christensen is part of the World Climate Foundation and has had a career in international corporate finance advisory, mergers and acquisitions, including engagement in the major transactions in the Danish Wind Turbine Industry for the past 25 years. He co-founded a leading Danish corporate finance advisory firm for small and medium sized businesses, and he has been CEO of a British family office for nine years including operating companies in Kenya, Jamaica, Barbados, Trinidad, Tobago and the UK, as well as global and emerging markets private equity investments.
Reports Tracking SDG 7: The Energy Progress Report released by the International Energy Agency (IEA), International Renewable Energy Agency (IRENA), the UN Department of Economic and Social Affairs (UN DESA), the World Bank, and the World Health Organization (WHO).
Financing Clean Energy Transitions in Emerging Markets and Developing Economies, released by the IEA, in partnership with the World Bank and World Economic Forum.
The 2021 G7 communicated their intention to reaffirm the collective developed country goal to jointly mobilise USD $100 billion per year from public and private sources, through to 2025 in the context of meaningful mitigation actions and transparency on implementation.