The Power of Transition Finance

Institutional investors need to rethink the risk-return proposition in emerging markets, argues Matt Christ, Portfolio Manager at Ninety One.

Last year, emerging market (EM) economies produced over 75% of the world’s greenhouse gas (GHG) emissions. According to global institutional asset manager Ninety One, they are also on a trajectory to represent 90% of emissions growth by 2030.

The International Energy Agency estimates that US$1 trillion a year to 2050 will need to be spent in developing economies to achieve net-zero GHG emissions. However, only about US$150 billion has been earmarked on the balance sheets of sovereigns or multilateral banks to address this issue – resulting in a US$850 billion annual financing gap.

This presents a compelling addressable market, argued Matt Christ, Portfolio Manager in Fixed Income at Ninety One.

Yet, many institutional investors remain reticent to invest in developing economies. In 2022, only 2% of impact funds were focused on EMs, representing just 0.1% of global assets under management.

A recent Pensions for Purpose report identified several barriers for investors looking to invest in EMs, including governance issues, higher carbon intensity, inconsistent data, political instability and high perceived risk.

Christ argued that institutional investors have a false impression of the risk-return within EMs. Relative to peers in developed markets (DMs), EM investment grade debt is more conservative on fundamental credit metrics, such as leverage, interest coverage, cash balances, and average tenor of a maturity profile, he claimed.

“While EM economies are more prone to volatility – whether currency, commodity price or political – companies based in these countries have responded by crafting conservative balance sheets, which they understand is key to their longevity,” Christ told ESG Investor.

As such, companies with an EM postcode that seems volatile can have much better credit opportunities than a comparable DM company. “A true fundamental investor can identify value in these places. Others might disregard companies in countries like Brazil, Turkey or India, but there are compelling risk-return opportunities in EMs,” he argued.

An important – and ongoing – educational process has been central in addressing global investors’ negative bias. “We’ve spent a lot of time doing missionary work around EMs, explaining how asset owners and managers should reframe their thinking about the risk-return equation,” he added.

Ninety One has been among the first joiners of the World Benchmarking Alliance’s call on asset managers to review their approach to sustainable investing to ensure it does not unintentionally lead to divestment from EMs.

Closing the gap

Both public and private credit will be needed to address financing needs, Christ explained. But to move capital into EMs, asset owners require two things: a commercially attractive risk-adjusted return; and a transparent and quantified metric for measuring progress on impact goals.

Ninety One’s strategy of integrating public and private funding was central to addressing those needs. The asset manager also targeted five sectors that represent more than 90% of global emissions: power, industry, transportation, buildings and agriculture.

“In the industry space, for example, more than 80% of the world’s emissions emanate from EMs, which is not surprising as the production of cement, steel, chemicals and plastics has shifted from DMs to developing economies,” said Christ.

These industrial companies have become the ‘blue chips’ of EMs, he explained. Many have been in the public markets for a long time, are investment grade and have high levels of corporate governance.

“They are best-in-class in their respective industries from a sustainability perspective, with aggressive science-based pathways, and are investing in new technologies and developments that can help decarbonise the sector,” he added.

In addition, many companies from critical but hard-to-abate industries finance themselves in the bond market.

“Therefore, we need to be in the bond market to work with those companies and help them execute their plans,” Christ explained. “But we also need to complement these opportunities with those in the private credit market.”

The latter represents two origination streams: infrastructure lending, such as renewable energy generation projects, sustainable data centres and municipal infrastructure for electric mobility; and corporate finance for growing companies that may not yet have the cashflow to issue a bond.

According to Christ, the private credit market benefits from the “decarbonisation growth tailwind”. For example, a company with an established operating track record in producing electric vehicles components or critical minerals for solar panels can identify opportunities to expand and be a part of the growing decarbonisation market.

Decarbonisation strategy

Ninety One created a portfolio that covers the five sectors and geographies it deems critical for EM decarbonisation, culminating in a strategy that offers 200 basis points of expected return over a growth fixed-income strategy, according to Christ.

“The portfolio picks up incremental value over a US or European high-yield bond markets return stream by adding private credit, tapping into the illiquidity premium of accessing the private market,” he explained. “[We] offer quarterly liquidity, not daily liquidity – there’s no free lunch – but it’s also not a five- to seven-year locked-in private credit fund. That’s how we thought about the return proposition.”

Regarding performance vis-a-vis the impact goals of decarbonising EMs, each asset – whether public bond, infrastructure loan or corporate loan – will have a credible target and plan to either lower or avoid carbon emissions before 2030. Reduction applies to large industrial companies that have relevant plans in place, while avoidance relates to companies engaged in an activity that can displace the use of fossil fuels.

“However, we don’t just buy the bonds of a large cement company with 2030 targets and then wait until 2031 to see the results,” said Christ. “We want to understand their capital expenditure plan and deployment towards areas that are going to help achieve its goals, and then extrapolate reduction targets on an annual basis.”

Ninety One tracks the company’s progress each year-on-year, which is an important tool for engagement.

“This helps us when we report to our investors on how the underlying investments in the portfolio have contributed to avoided or reduced carbon emissions on an annual basis,” he added. “Investors can hold us accountable for how we’re underwriting the impact proposition.”

Global trends

Christ described renewable energy generation in project finance structures as a growing global trend.

“Decarbonising energy grids is important, not only for providing cleaner energy by reducing the use of fossil fuels for energy production – but also for the knock-on effects on companies and households attached to the grid, as well as the Scope 2 emissions related to these enterprises’ activities,” he said.

Christ also pointed to the robust demand for raw ingredients needed for decarbonisation fuelled by the US Inflation Reduction Act – including for batteries, renewable energy infrastructure and electric vehicle production.

But companies should understand where their raw materials are coming from, he emphasised. In the case of a large group like Tesla, for example, the company should be looking at how lithium is being produced downstream in Latin America.

“Buying lithium on the spot market doesn’t indicate whether the metal comes from a conflicted source in terms of the treatment of labour or the environmental impact of lithium mines,” said Christ. He reported that many original equipment manufacturers want to be more vertically integrated.

Another trend is data centre efficiency – especially in light of advancements in artificial intelligence (AI). The amount of electricity consumed by AI is forecast to exceed 85 terawatt hours annually within a couple of years – more than many small countries’ energy consumption.

“In the next few decades, AI models are going to be attributable to much of the world’s emissions if we don’t find a more sustainable way [of producing energy],” said Christ.

Ninety One is working with a company in Asia (ex-China) that has developed a cooling technology for AI-focused data centres. It uses 50% less energy, which results in 50% less emissions.

“This is a cheaper and more sustainable way to offer AI computing power to end users,” Christ said.

Fiduciary duty

Today, pension funds are focused on how they can fulfil their responsibility of delivering attractive returns and capital preservation for their constituents, while also achieving impact.

“It’s about greening their portfolio, but doing it in the real world and in a way that mitigates the risk of greenwashing,” said Christ.

Instead of focusing on a low carbon intensity portfolio, Ninety One identifies companies and projects that are critical to the real economy. “While their carbon intensity may be high today, the underwriting we do gives pensions and us the confidence that there will be a reduction in emissions,” he said.

Christ’s advice to institutional investors looking at impact investing is to go where the carbon is – from both a sectoral and a geographic basis, including in countries with the largest carbon footprint such as India, Turkey, South Africa, and Brazil.

“Investors also need to be in steel, cement and so on,” he added. “That may not feel good because these are carbon-intensive industries, but it’s about rolling up your sleeves and partnering with an asset manager that can articulate a plan for driving carbon emissions down in the near term.”

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