Islamic investment screens may provide a way to overcome ESG data limitations in emerging markets

In the absence of solid ESG data, investors will be looking for other types of ‘low-cost mechanisms’ that include Shariah screens so they can narrow their investment options and find companies that are likely to have lower financial and ESG risks.

• Unsophisticated application of ESG screening that excludes entire countries or applies developed market ESG standards to emerging & frontier markets may constrain the new funding needed to achieve the Sustainable Development Goals
• Alternative investment screening methods, including some that are a product of the Shariah screening process, can help investors to narrow their investable universe in the absence of ESG data
• Over time, the growth of green, social, sustainable and sustainability-linked (GSSS) bond & sukuk issuance will improve and incentivize ESG data generation at the same time as ‘baseline’ international sustainability standards come into force to address the underlying data gaps

A new report carried out for the UK government has found that many emerging & frontier investors see ESG being used as a ‘headline risk’ measure, with investors excluding countries and companies based either on broad country-level metrics, or skewed against emerging & frontier market companies where an absence of data on ESG leads investors to rule them out.

Emerging & frontier markets are already sharply under-resourced in addressing the Sustainable Development Goals. Annual investment reaches $1.4 trillion annually, but emerging & developing countries need $2.5 trillion over and above what they currently see, and they need it every year this decade to achieve the SDGs.

Investors’ ability to support these investment flows could be hamstrung if they can’t move past divestment-oriented ESG strategies, and their screening approaches a lack of ESG data as poor ESG. The report for the UK government’s Foreign, Commonwealth and Development Office (UK FCDO) explained:

“There is clearly a risk that ESG in its screening mode will serve to systematically bias capital away from poorer regions.” The report noted that although these “regions have the greatest need for investment to fund development […] if the outcome is to bias capital away from the poorest regions it arguably will be failing, at least while emerging and frontier markets are unable to meet the standards used for ESG screening.”

Taken at face value, these conclusions seem to imply that investors relying on ESG are at best misguided and at worst creating barriers where they didn’t exist before using ESG as an excuse. Headlines about how “ESG hurts emerging markets” do little to address the issues raised, allocating blame instead of finding solutions, some of which are contained in the report itself.

From the interviews of investors, consultants and fund managers quoted in the report, the picture becomes much more nuanced, although it does highlight some clear challenges associated with more limited ESG data accessibility in emerging markets. These challenges are compounded by investor decisions that may be guided more by limited experience investing in emerging and frontier markets.

One example would be the application of ESG criteria too broadly (at a country level), or too rigidly applying similar ESG screening thresholds to emerging markets as have been applied in developed markets without adjusting for differences. For example, there may be more data on environmental issues than on social issues, so excluding companies purely on data availability grounds (particularly relating to social impact) rather than on coherent ESG rationale would choke off investment to companies that could have acceptable ‘S’ scores.

One of the researchers’ conclusions after conducting the interviews with market participants was that “in many markets these failures are simply because of a lack of capacity to develop efficient digital interventions [to improve ESG data]. Further research should be undertaken on how to develop simple low-cost mechanisms to gather data from frontier markets and make it easily available to global investors.”

The RFI Foundation has found one such ‘low-hanging fruit’ for investors in emerging markets through our research into the impact of Shariah compliance on ESG integration. Together with INCEIF, the RFI Foundation produced quantitative research looking at the impact of overlaying Shariah screens on ESG screens for four geographical regions, one of which was Emerging Markets.

Across Emerging Markets stocks, between 2001 and 2020, companies with better ESG scores (especially those in the top 50%, but also those in the top 75%) outperformed other stocks in lower quartiles. For companies without enough data to have an ESG score, the investing performance was more mixed. However, those that qualified as Shariah-compliant (about one-sixth of the universe of emerging markets stocks without an ESG score) outperformed those that didn’t pass the Shariah screening process.

One of the screens that accounts for a significant reduction in the universe of Shariah stocks is the limits that Shariah screens place on the ability of companies to have high levels of interest-based debt. It is a simple way to divide a universe of companies into high- and low-leverage. But, as we have shown, it could offer a simple way to narrow the universe of limited ESG data companies so as to identify promising investments and seek more data to evaluate whether a company is more likely to be a ‘high’ or ‘low’ ESG-scoring company, supplementing other metrics in making investment decisions.

This is an example of how concerns about the effect of adding ESG screening in the context of emerging markets can be mitigated using simple metrics even without additional ESG data. It provides a starting point for investors to continue and even expand their investments in emerging markets and helps to mitigate risks that ESG could curtail needed investment flows into emerging markets.

As existing investors in emerging markets find innovative ways to distinguish between companies likely to have good ESG from those with weaker scores, their work will become easier over time. New investors in emerging markets will see increased issuance of green, social, sustainability and sustainability-linked (GSSS) bonds and sukuk.

This issuance will come with embedded ESG information and use of proceeds. Increased issuance by companies will provide financing needed to first refinance and later to expand investment that will be supportive of ‘additionality’ in service of longer-term goals such as the SDGs. Over time, it will also maintain investor flows into emerging markets and provide the support for increasing flows while over time, other forces, such as heightened stock exchange disclosure regulations, embed ESG disclosures under the new ISSB standards.

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