This is a guest post by Alissa Amico, Managing Director of GOVERN Center.
ESG (environment, social and governance) investing might well have emerged as the most fashionable acronym in the financial media in the past year. It encapsulates the growing expectations of the institutional investor community regarding the quality of corporate governance frameworks internationally, while demonstrating that investor expectations have in the meantime have also expanded beyond G(overnance).
With the growth of institutional investors - notably developed countries’ pension and insurance funds – these actors have become active not only domestically but also in emerging markets (EMs). Overall, of the almost 14 trillion USD of capital tracking MSCI indices, close to 2 trillion are now allocated specifically to Emerging Markets. In Turkey for instance, foreign institutional investors have until recently have accounted for half of the market capitalization.
This is significant for a number of reasons, including their influence on corporate governance. In many EMs, foreign investors are more active than domestic from a voting perspective since the latter’s participation in the capital market can be limited by law. Equally, many EM institutional investors lack the engagement culture and experience, despite having a better knowledge of the domestic market.
While developed market institutional investors are active in their own domestic markets, the extent of their participation in EMs varies depending on their risk appetite – Canadian institutional investors for instance tend to shy away more from EMs such as the Middle East than their American peers. Importantly, their participation is contingent on their perception of the quality of national ESG regulatory frameworks in individual emerging markets.
As such, Brazil has become a darling of foreign institutional investors due to the introduction a voluntary corporate governance listing segment (BOVESPA). While the success of BOVESPA has proven difficult to replicate, EM capital market regulators and stock exchanges have raised corporate governance requirements over the past decade, often at a faster pace than their developed market peers.
Both for EM regulators and companies this approach has delivered. On a macro-level, higher governance practices have proven to correlate with higher foreign inflows, as highlighted by the World Federation of Exchanges in its recent analysis of EM investing. Markets where a full set of well-established corporate governance requirements was in place received additional foreign inflows as high as USD 756 million over 2006-2018 period.
Indeed, foreign institutional investor participation in emerging markets is fundamentally linked to their appreciation of national corporate governance regimes, which generally include the governance code, listing requirements and any relevant provisions of the corporate law. It is likewise connected to their perception of the quality of oversight and enforcement which generally tends to be more problematic in EMs.
In many instances however, foreign institutional investors are not always aware of the extent of governance regulatory change that has taken place in EMs. Few investors are aware for example that listed companies in Oman are required to have a fully non-executive board. In part to make enforcement easier, the regulatory philosophy adopted by EM regulators tends to lean more on the side of mandatory regulations as opposed to UK-inspired “comply-or-explain” codes.
Furthermore, foreign institutional investors’ understanding of strategy and governance of individual EM companies can be limited. Indeed, smaller companies not included in EM or large cap domestic indices often do not get any research coverage. Our earlier work in Egypt has demonstrated that only 10% of listed companies where followed by analysts whereas close to two-thirds of listed firms had no coverage whatsoever.
Indeed, collecting quality ESG data is frequently cited as the number one challenge by foreign institutional investors in different EM regions. They may not have access to annual reports in foreign languages or fully understand issuer disclosure, which in many cases remains not comparable due to the discrepancies in disclosure frameworks.
While the ESG data reported by EM companies remains patchy, expectations of its disclosure have high-rocketed in recent years. Encouraged by the recent stewardship trends worldwide, developed market institutional investors have introduced voting policies that reflect their specific investing philosophy.
In many cases – and this can indeed be problematic – ESG priorities are not set in a country or region-specific manner. Blackrock, the largest institutional investor globally, has one voting policy for the entire Europe and Middle East region. Nonetheless, voting policies are an instructive read for boards and executives of EM companies wishing to differentiate themselves from the market based on the quality of their governance.
In particular, they may need to understand how foreign institutional investors’ stewardship and voting policies differ from national governance requirements. This can indeed be important especially for mid-cap companies that may not be automatically noticed by passive, index-tracking investors. In examining institutional investor voting policies, understanding their rationale and objectives is primordial.
For instance, in OECD member countries, having a majority independent board is a prevalent requirement whereas many EM regulators have shied away from imposing it as a standard. While EM company practices tend to mirror their domestic standard, expectations of foreign investors remain higher or different. In many instances, large institutional investors expect to have a largely or a majority independent board in listed companies.
Compliance of EM companies with foreign institutional investors’ ESG criteria matters and proxy firms voting their shares are instructed to do so with respect to these policies. For passive investors, lobbying for change may be conducted through a long-term engagement process. For active, stock-picking institutional investors, the approach may be more hands-on since they often take risks in smaller, less known EM companies.
A key question then for EM firms is how to demonstrate their commitment to ESG in order to attract foreign institutional capital. Examining internationally recognised disclosure frameworks such as the IIRC to ensure the comparability of reported information is a critical first step. Too many annual reports of listed companies boast their philanthropic contributions and their positive environmental impact without any connection to company-specific risk factors, strategy or industry comparisons.
Some aspects of investor expectations may actually reflect priorities in their own markets and not necessarily those in EMs. This is perhaps most obvious when we consider the issue of executive remuneration. While executive and board remuneration has emerged as a major regulatory concern following the financial crisis, remuneration in EMs tends to be less of a concern.
As most EM companies are controlled either by the state or a family, board representatives who are often also major shareholders tend to be compensated by dividends, not sitting fees. In addition, board compensation in some EMs such as Saudi Arabia has been capped by law and hence remuneration does not represent a high risk.
The corollary of this for boards and management of EM firms wishing to attract foreign capital, is that they need to report on the information that institutional investors are seeking, even on issues that they may consider material or that are not required by domestic ESG regulations. The flexibility provided by the comply-or-explain (CoE) approach provides a possibility to address these criteria and concerns.
EM companies can use CoE not only as a mechanism for communicating to their own regulator and the local public, but also as a means of explaining to foreign investors why certain global governance standards may not be fully relevant. Explaining how a firm has gone above the national governance regulation can also be of benefit for all investors, as it demonstrates that the board does not take a minimalist, compliance – driven approach to governance.
Likewise, a demonstration by a firms’ reporting of how it has adapted its governance framework to the risks it faces geopolitically, financially and operationally is key. In doing so, EM firms can benefit from drawing a better connection between their strategy and their ESG practices. Boards and management need to stop considering ESG as E & S & G but instead as interconnected pillars of their corporate strategy.
The GOVERN Center works with boards and senior executives of leading EM companies to develop its governance practices in support of better financial performance and investment attraction. For more information: email: email@example.com