Net zero in emerging markets: a challenge

According to a recent study by Standard Chartered, $94.8 trillion – an amount greater than annual global GDP – is needed to help emerging markets make the transition to a net zero economy by 2060. Without help from developed countries, this is virtually impossible. And even if they could manage to finance it themselves, this would reduce the disposable wealth of households in these countries by about 5% between now and 2060. This is anything but desirable.

Of course, that contribution from developed countries was also a major topic at COP27 in Sharm el-Sheikh early last month. Already on the second day of this 12-day climate summit, our Prime Minister Mark Rutte made a commitment to increase the annual climate finance contribution for developing countries by 1.8 billion euros. An increase of more than 50% compared to 2021. In addition, an extra donation was made to the Africa Adaptation Acceleration Program (AAAP). Other countries followed suit.

This seems like a generous offer, but is this not repaying debt incurred? Indeed, a common argument is that the historically largest contributors to greenhouse gas emissions are also the ones who should be the largest contributors to solving this crisis. According to data from the Our World in Data platform, the cumulative CO2 emissions of all countries combined is 1.5 trillion tons of CO2. Of these emissions, 25% come from the United States, more than any other country and almost as much as the entire continent of Asia. Conveniently add the entire European Union and one concludes that nearly half of all historical CO2 emissions come from the U.S. and Europe alone. In fact, the countries that have contributed the least to emissions do get hit first. No more than logical, then, this contribution.

Emerging Markets in the portfolio

The challenge within emerging markets of becoming a Net Zero economy is at the same time also an opportunity. This asset class is already becoming an increasing part of the investable universe and this will only accelerate with all the investments needed. That the interest in sustainable investment in emerging markets is increasing can also be seen in capital flows. According to IMF publications, issuance of ESG-linked finance tripled to $190 billion by 2021, and ESG-related equity funds saw total invested assets increase by 20% to total assets of over 150 billion euros. ESG-linked financing now constitutes about 18% of foreign financing for emerging markets (excluding China). This is a fourfold increase from the average of recent years and shows a positive trend for sustainable financing in emerging markets.

Investing in companies that contribute to the transition to a Net Zero economy is also becoming increasingly easy. Although data availability and quality is certainly not yet at the level of developed markets, there are an increasing number of data providers and index providers that also focus on emerging markets. For example, MSCI recently launched a full Climate Index Range specifically targeting companies that contribute to solutions to the climate problem or companies that, for example, are themselves in the process of transitioning to a net zero carbon economy.

The most progressive methodology used in constructing these indices is to incorporate the recommendations of the Task Force on Climate-Related Financial Disclosures, the TCFD. These recommendations are used to determine the extent to which companies are in line with the Paris Climate Agreement, and de facto the 2 and 1.5 degree warming scenarios. What is immediately noticeable is that this index excludes many companies compared to the regular emerging markets index. Only 34% of all companies remain. Not unexpectedly, the entire energy sector is excluded and only a third of the companies operating in the materials sector remain.

Does following such an index now actually help the transition for emerging markets toward net zero? That remains the question. But it does provide a more focused steering of capital to companies that are working on the transition. In addition, it is a matter of mitigating risk. Investing in these companies efficiently reduces transition and physical equity portfolio risks.