Can net zero superfunds expand their emerging markets footprint?

When it comes to addressing the climate crisis, emerging markets are a tough nut to crack. 

On the one hand, they are the strongest source of growth in the global economy. In 2023, the IMF expects real GDP growth of about 3.9% in emerging economies, compared to 1.3% in advanced economies. On the other hand, this growth comes with a cost: rising emissions.

Research has shown that growth in emerging economies is a significant driver of carbon dioxide emissions. Primarily owing to increasing energy demand which is met with carbon-intensive supply. A study conducted in 2020 found that when energy consumption increases by 1%, emissions in developing economies tend to rise by about 2.16%.

However, cutting down emissions in emerging markets is expensive – estimates of the transition finance gap place the cost at about $94 trillion.

It is therefore logical to conclude that any meaningful progress by institutional capital on the net zero agenda cannot exclude emissions reduction in EMs. Yet, these economies tend to occupy relatively narrow portions of portfolios. Changing the status quo is therefore critical.

New research from down under suggests a way forward:

Australian institutional capital

Australia is home to a significant pool of institutional capital. There are 145 superannuation funds with a combined assets under management of over $3.4 trillion. Over 60% of these are attempting to reduce emissions intensity of their portfolios.

However, surveys have repeatedly found that far more climate capital is invested in advanced economies compared to emerging markets. In 2022, only 4 funds reported investing in climate solutions in Africa, for example.

A new report has outlined a strategy to fund climate solutions in emerging markets.

The research was conducted by the Investor Group on Climate Change (IGCC), a coalition of institutional investors from Australia and New Zealand.

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Blended finance

The intersection of public and private finance has often been deified as the harbinger of climate finance in the developing world. In mitigation for instance, blended finance has emerged as a powerful financing structure.

A 2022 report from Convergence, a blended finance network found that “blended mitigation deals also consistently represent the largest transactions in climate blended finance – the historical median deal size of mitigation deals is $92.7 million”.

IGCC’s findings reconfirm the superannuation fund industry’s faith in blended finance tools. Interviewees reported substantial interest in structures such as debt funds with concessional lending and bond issuance with priced guarantees.

What attracts institutional capital according to IGCC is the first loss principle – the idea that if public finance assumes the first loss position, the reduction in risk would attract super funds:

“Many interviewees felt that structuring investment so that public finance took a ‘first loss’ position would attract superannuation investors”, the report says.

As an example, the report cites the rapid increase in India’s renewable energy capacity. A feat, the IGCC claims is attributable to blended finance structures in solar and wind that attracted Canadian and Norwegian pension funds.

Nurture expertise

Expertise is a key constraint in emerging market climate investing. Securing risk-adjusted returns in these markets requires a deep familiarity with domestic conditions. 

To some extent, one might argue, that the expertise can be outsourced - asset management companies invest heavily in their emerging markets experts hoping to attract institutional capital.

However, outsourcing does not eliminate the need for in-house capacity, according to the study. 

“Pension funds will still need to have sufficient internal knowledge about deal flow, market level characteristics, risk return dynamics, and specific asset classes or industries, in order to assign a mandate for an emerging markets strategy to an investment manager”.

IGCC’s recommendation is that capacity development within asset owners might accrue through peer-to-peer learning as well as collaboration with development finance institutions.

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Green flags

Climate policy environments in emerging markets also affect the investment outlook. Within the emerging markets, there is significant climate policy variation – Ghana and Argentina might have different approaches to renewables. India and Turkey could have a very different appetite for fossil fuels.

This in turn depends on many factors – level of development, renewables capacity, political support for decarbonisation and so on.

According to the IGCC, investors should look for a set of green flags in a country’s climate policy environment: (i) 2030 national emissions reduction targets backed by political support, (ii) a net zero target of 2050 or sooner, (iii) commitments to phase out fossil fuel generation, (iv) consistent policy at multiple levels of government and (v) sectoral strategies aligned with the national commitment.

The climate investing milieu has always known the urgency of scaling up investments in emerging markets. Speaking at COP26, the CEO of Mastercard Michael Miebach, said “emerging markets serve as a daily, constant reminder that we won’t win unless everybody wins”.

Miebach’s words ring true today more than ever. IGCC’s research offers a blueprint to act on them.