We thought it would be interesting to share the common approach to integrating corporate governance (CG)  into investment decisions that 34 DFIs have adopted. DFIs cover emerging markets around the world, including Africa, Latin America, the Caribbean, Asia, Middle East, North Africa, Europe and Central Asia, with total assets of more than $850 billion. DFIs investin equity, debt and mezzanine deals.

What does it provide?

The corporate governance framework establishes a common approach for evaluating governance practices in the due diligence phase of a deal and subsequently improving the corporate governance of investee companies.

While not designed as a one-size fits all approach that can easily result in undesired tick-the-boxes behavior, a unified approach makes it more predictable for investee companies what to anticipate in terms of corporate governance expectations by investors. By signing on to the framework, the DFIs hold themselves accountable to actively implement the common approach. In addition, the framework initiative provides a set of corporate governance tools such as corporate governance assessment methodology and guidebooks that are ready to be used. It also establishes incentives for investee companies to embark on governance reforms.

The signatories of the framework undertake to:

1. Integrate Corporate Governance (“CG”) in its investment operation

a. Adopt CG procedures and tools in line with the Framework’s methodology;

b. Where considered appropriate, conduct CG assessments of investee companies and develop CG action plans;

c. Monitor progress of the implementation of CG action plans.

2. Ensure internal responsibility

Identify and assign an internal function that is responsible for the implementation of the Framework.

3. Provide or procure training

Ensure capacity building and knowledge transfer to staff for the implementation and further development of the Framework.

4. Collaborate with other signatories

a. Share experience and resources in training and implementation

b. Contribute to developing case studies and progress reports on the above.

5. Report on implementation

Report annually to the other signatories on the internal implementation of the Framework.

What can private investors in emerging markets learn?

The take-away for private investors is at least two-fold.

1. Coordination of efforts can be effective.

We don’t expect private investors to share their evaluation methodologies any time soon, but the increasing focus big private investors such as Black Rock put on governance and sustainability issues can ha e a significant impact on company behavior and efforts. Coordination efforts by pension funds in some emerging markets such as Chile, where the Administradoras de Fondos de Pensiones (AFP), the country’s private pension funds, operate a shared data base for independent directors show that cooperation can take many different and fruitful forms.

2. Emerging market companies want to improve their governance.

The DFI experience over the last decade shows that there is appetite by emerging market companies to implement corporate governance reforms. If investors provide additional incentives to their investee companies, governance reforms are even more likely to be initiated.

This brief defines the responsible investment approach and differentiates it from standard investing practices. It also discusses the key debate whether it is profitable in the long or short term to align societal and investment values.

Highlights the motive for investors to engage in public policy debates since it decisively influences their long-term financial interests.

Discusses imminent shifts in the interpretation of fiduciary duties imposed on trustees and other fiduciaries away from being solely focused on maximizing return on investment in the short term.

Elaborates on the rationale for being an active owner and debates the effectiveness of active ownership.

The last brief focuses on the critical question whether ESG issues are relevant for investors, i.e. whether they are financially significant.

Emerging markets have been lagging in the development of ESG investment and investment products though. However, it seems that the time has come for the systematic incorporation of ESG risk assessments into emerging market investment decisions.  Three major trends are responsible for bringing emerging markets and ESG investing together, until recently separate investment specialty areas, although two of the fastest growing:

1. Emerging markets growth is diversifying and is not predominantly based on infrastructure investments anymore. In addition, a rising middle class represents a new class of consumers increasingly paying attention to sustainability concerns. Both developments lead to an increasing role for sustainability considerations in emerging markets.

2. Many emerging market companies are entering their mature growth phase, consolidating and affording the ability to focus more on management quality and corporate responsibility. These companies also are also facing increasing challenges such as resource constraints, demand for more corporate accountability and compliance with global best practices such as labor standards and reporting guidelines. Companies that embrace the challenge can truly differentiate themselves from companies that do not and offer attractive investment opportunities.

3. Information on ESG practices of emerging markets companies was very difficult to obtain only a few years back. This has changed significantly in a short time span. An increasing number of emerging market companies today publish sustainability reports, a growing number of them in compliance with the guidelines of the Global Reporting Initiative. In addition, for investors willing to purchase rating reports, GMIRatings has increased its ESG rating service for emerging market companies from 688 in June 2012 to 998 as of April 2013.

Indeed, underlining these developments, two commercial emerging market ESG indices have been launched in the past two months.

In February, RobecoSAM, a sustainable investment specialist and S&P Dow Jones Indices launched the Dow Jones Sustainability Emerging Markets Index with 69 companies. The companies are selected based on RobecoSAM’s annual corporate sustainability assessment, which evaluates companies’ sustainability performance based on economic, environmental and social criteria.

In March, asset manager Northern Trust announced the first emerging markets custom index based on MSCI ESG Research and Institutional Shareholder Services’ (ISS) governance screens. The design of the fund applies three screens to the MSCI Emerging Market (EM) Index universe, followed by a sequence of checks on governance and executive independence. The first screen eliminates constituent companies of the MSCI EM Index that have been found to be in breach of the UN Global Compact’s ten principles. The second screen removes manufacturers of controversial weapons ant he third tobacco manufacturers. Following these exclusions a filter is applied targeting companies lacking sufficient independence across ownership, board representation, key corporate committees and audit and remuneration committees.

In addition to these indices representing select companies from a variety of emerging markets, stock exchanges in a number of emerging markets had already launched ESG indices over the past decade. Prominent examples are the Johannesburg Stock Exchange Socially Responsible Investment Index and Sao Paulo’s BM&FBOVESPA’s Corporate Sustainability Index, launched in 2004 and 2005 respectively.

While these are encouraging signs, much work still needs to be done. Two reports published late last year, EIRIS’ “Evolving markets: what’s driving ESG in emerging economies?”, and the Forum for Sustainable and Responsible Investment “Lessons Learned: The Emerging Markets Disclosure Project, 2008 – 2012” found that poor corporate environmental and social governance disclosure remains the number one challenge to investing in emerging markets. The reports also highlighted that knowledge of sustainability reporting practices and international norms varied widely between markets.

As investors are integrating ESG risk factors into their investment decisions in emerging markets, it is clearly time for emerging market companies to take the sustainability challenge serious.

Participants in the forum identified as the critical issue that both sides rarely speak the same language. A typical analyst will not necessarily ask questions about sustainability but is certainly interested in issues concerning succession planning, regulatory compliance, energy efficiency or customer relations. All of these issues of course about corporate sustainability, when defined by a company’s triple bottom line of social, environmental and economic performance, but it might not be apparent to the investor. While a company with a strong sustainability strategy and record shows superior risk management and long-term growth prospects, the terminology used to describe sustainability practices may alienate investors. Eric J. Hespenheide, global leader of Deloitte’s Sustainability Audit and Enterprise Risk Services is quoted in the article as raising the question: Is the disconnect “all a grand misunderstanding? It sounds like analysts are actually interested in this but not getting through because of the language.”

And, at least in the US and Europe, the language is clearly the problem, since there is no shortage of disclosure on nonfinancial performance data anymore. On the contrary, as one senior investor pointed out, there is lots of bad and irrelevant data released, essentially creating noise, preventing investors from seeing the real CSR picture of a company.

To allow companies to remedy this communication gap, Mehallow summarized five steps suggested by participants at the forum.

1. Investors need industry-specific data. While companies can and need to produce the data, it is difficult to know what exactly individual investors are looking for. The work of the Sustainability Accounting Standards Board (SASB), which is developing standards for ten sectors and 88 industries and is set to release standards in 2015, will facilitate bridging this barrier.
2. Avoid loaded language. The term CSR is a good example in itself, as its terminology suggests that there is no economic benefit for the company and investors involved. Communicating that a company’s sustainability engagement is really about integrating social, environmental and economic performance to create lasting value is more accurate and certainly more appealing from an investor perspective.
3. Talk to the right players. Issues of sustainability should be a routine and integral part of an investors’ assessment of companies and part of the conversation with management, not just a company’s sustainability officer.
4. Provide useable data. Where sustainability performance can be measured and standardized, companies need to go ahead and provide such data as easily digestible as possible to investors, so it can be fed into models. Examples include carbon emissions, human capital, natural resources and other sustainability performance metrics.
5. Explain the meaning behind the data. Companies need to explain why their sustainability performance is good for its bottom line. 

In a recent article in Pensions & Investment, Anne Simpson, senior portfolio manager and director, corporate governance of CaLPERS was cited as explaining that under the new initiative, CaLPERS will buy additional shares of companies it owns already under its indexed equity portfolio. The additional investment will go into companies that CaLPERS views as underperforming but displaying growth potential with CaLPERS engagement. The names of companies it engages are not normally disclosed, but CaLPERS makes exceptions when it files shareholder resolutions to force governance changes. Last year’s examples of such companies included Chesapeake Energy Corp. and Nabors Industries Inc. . According to Ms. Simpson, CalPERS has about 10 other companies also under engagement.

Another CaLPERS official said the funds allocated to the concentrated portfolio would be US$50 million indefinitely for five to 10 companies each year with the potential to grow significantly if successful. According to Ms. Simpson the new initiative is “an important signal to the market that we believe in this, we have conviction.” She also called the strategy “monetizing our company focus list”.

Lev Janashvili, managing director of corporate governance research firm GMI Ratings, is quoted in the article as believing that CaLPERS is the first pension fund to build a separate portfolio of companies it has engaged in.

Since CaLPERS has been a pioneer in incorporating financial standards, corporate governance and broader ESG issues into its portfolio allocation decisions, it seems only fitting that the fund would be the first to build a separate portfolio of companies it is actively engaging on such issues. Depending on its success, one can expect more institutional investors with comparable clout to enter such strategies.

The first report  is called “Integrated Analysis”. It utilizes almost 20 case studies from brokers and research providers, including Citi, Société Générale, UBS and West LB to show different aspect of how understanding the impact of ESG factors on sales, costs and long-term return on capital can enhance investment decisions.

The structure of the review followed what the reports calls a “stylised stock review.”  It used five stages from the analysis of the economies in which a company operates, through the industries in which it operates, the way it conducts its operations, the financial impacts of those operations and finally the valuation tools used.  The document then goes on to highlight innovative research in each of these five stages.

Overall, the report finds,

advanced use of integrated analysis in all aspects of fundamental equity valuation, particularly in industry analysis, forecasting earnings and adjusting discount rates. These integrated approaches to estimating fair value point towards significantly improved valuation models that account for scarcity of resources, future regulatory directions and timeframe tensions.

However, challenges remain. The main challenges the report identifies are:

• Short-term valuation tools cannot always capture ESG issues that will impact companies over longer timeframes;
• Acquiring consistent, comparable, audited information remains an obstacle to integrated analysis, making it more resource intensive than traditional analysis relying on audited financial information;
• Since there are different regulatory regimes around the world in terms of disclosure requirements ,raw ESG data without context can be misleading.

The second report, “Aligning Expectations” is intended to serve as guidance for asset owners on incorporating ESG factors into manager selection, appointment and monitoring. The report shows that asset owners featured in the report are becoming more advanced in ensuring that their asset managers meet ESG guidelines. It also shows that investment managers are rising to the challenge of integrating ESG factors into their investment decision-making.

The report also offers guidance on a number of issues in order to enable asset owners to include ESG expectations in their processes. Examples in the report include requests for proposals, questionnaires, and monitoring and discussions with managers.

The report finds that, globally, at least US$ 13.6 trillion worth of professionally managed assets incorporate environmental, social and governance (ESG) concerns into their investment selection and management. This represents 21.8 percent of the total assets managed professionally in the regions covered by the report. And these figures represent a growing trend. From 2009 to 2011, the sustainable investment sector in Europe grew by 35 percent; in the United States by 22 percent and, from 2005 to 2012, the sector grew overall by a staggering 486 percent.

What is really interesting though is the regional and strategy split up of these numbers.

Regionally, ESG investing is dominated by Europe, the US and Canada, which combine for 96 percent of assets under management incorporating ESG factors. Amongst these three, Europe accounts for a whopping 64 percent, followed by the US with 27.6 percent. The other regions hardly play a significant role. Latin American, which does not yet have a sustainable investment forum, was not even part of the survey. This underlines that clearly, ESG investing does not yet play a strong role in emerging markets, but on the flipside it means that there is tremendous potential for growth in the years to come.

With respect to investment strategies, the most common strategies used for ESG investing identified in the report are as follows:

• negative screening, defined as exclusion from a fund or portfolio of certain sectors, companies or practices based on specific ESG criteria, accounts for US$ 8.3 trillion;
• integration, the systematic and explicit inclusion by investment managers of ESG factors into traditional financial analysis, accounts for US$ 6.2 trillion;
• corporate engagement and shareholder action, defined as a strategy that employs shareholder power to influence corporate behavior including through direct corporate engagement (i.e. communicating with senior management and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided by comprehensive ESG guidelines, accounts for US$ 4.7 trillion;
• norm-based screening, the benchmarking of investments against minimum standards of business practice based on international norms, is valued at US$ 3 trillion;
• positive/best in class screening, the investment in sectors, companies or projects selected for positive ESG performance relative to industry peers, stands at US$ 1 trillion;
• and impact/community investing (Targeted investments, typically made in private markets, aimed at solving social or environmental problems) and sustainability themed investing (Investment in themes or assets specifically related to sustainability) account for US$ 89 and 83 billion respectively.

Negative screening is obviously the most basic form of including ESG factors into investment decisions, and it currently accounts for the biggest chunk of investment. However, other more sophisticated strategies also play a significant role and can be expected to grow further in importance in the future.

Sergei Sinkevich, Primary Market Department and Globalisation Managing Director of the Moscow Exchange formulated the motivation for the launch in an interview with FTSE Global markets:

“We are introducing this segment for two reasons: on the one hand we are planning to attract long-term investors who are ready to invest in “high-quality’’ issuers. On the other, we want to attract issuers that want to establish reputational capital and who expect to enjoy market premia, added to the price of their shares, which clearly demonstrate their exemplary practice of corporate governance and transparency.”

In essence, the rationale is the same that led to the launch of the “Novo Mercado” in Brazil 12 years ago: the stock exchange introduces a set of special listing rules, in particular concerning shareholder rights, that go beyond the host jurisdiction’s rather weak protection offered to investors. The Novo Mercado, consisting of three different tiers with increasingly stringent corporate governance requirements, has been a resounding success: virtually all new listings in Brazil occur in the special corporate governance segment and the index based on the segments has soundly outperformed the BOVESPA benchmark since its inception. Given this success story, the “Novy Rynok” is directly modeled after the Novo Mercado.

A November 2012 presentation by the Moscow Stock Exchange, available on the Russian Investor Protection Association website, lays out the details of the planned segment. The basic principles and some of the specific criteria addressing these principles are:

1. Procedures and obligations associated with public offerings to protect new shareholders. Provisions targeting this principle include the obligation that public placements must target dispersion and a 6-month lock-up period following an IPO.

2. Additional provisions for the protection of existing shareholders: Tag-along rights, a minimum of 3 independent directors on the board and a majority independent Audit Committee.

3. Transparency and disclosure: IFRS based quarterly statements in Russian and English; ongoing disclosure in English; detailed disclosure of related-party transactions and of the ultimate controlling shareholder, annual shareholder meeting material to be published in English and Russian 20 days in advance.

According to the presentation, internal approval procedures within the Moscow Stock Exchange for Novy Rynok are supposed to be finalized in the first and second quarter of 2013. The project is to be launched in the third quarter, with the first issuers joining the segment. The stated goal is to have at least 5 companies listed in the new market in 3 years. This seems overly modest. Brazil’s Novo Mercado started out with 18 back in 2001.

So how do ESG issues factor into the decisions of the mainstream investor, if at all? The SustAinability survey sheds some light on this question:

• Among the ESG factors, governance gets most consideration. 59 percent of respondents often or always consider governance issues in their investment decision, followed by social issues (40 percent) and the environment (34 percent).
• Within social issues, customer relationship management (74 percent) and employee training and development (68 percent) outweigh other issues such as diversity (49 percent).
• Over 60 percent of respondents say they are using ESG data and information more today than they were three years ago, while 63 percent say they will use such data and information more three years from today.

The survey concludes that the biggest challenge to make sustainable investing more widespread is to change the time horizon of investment managers, from rewarding short-term performance to a time horizon where the risk and opportunities stemming from ESG issues play out.

Ian Aylward, Co-Head of Multi-Manager at Aviva Investors, said:

“Aviva Investors’ multi-manager team integrates environmental, social and governance considerations into its fund selection process. We are increasingly seeing these issues crossing over into ‘mainstream’ fund management, with ESG performance starting to be assessed in actively managed funds. We wanted to know just how far the global investment community has come in doing this.”

Clearly, quite far. These numbers would certainly have been a lot lower only a few years back, and probably closer to zero a decade ago. In fact, Mercer published a study for the IFC in 2009 titled “Gaining Ground – Sustainable Investment Rising in Emerging Markets”. At this point a survey of 177 fund managers with investments in emerging markets showed that ESG issues were taken into account in roughly 50% of the emerging market equities products offered by the managers. It stands to reason that this percentage, in particular for investments in emerging markets would be significantly higher today.