Institutional investors, with their vast holdings in retirement funds, operate under a fiduciary duty to ensure sustainable returns for their beneficiaries. The looming threat of climate change, if not addressed, poses systemic risks to these returns. One of the paramount challenges in the finance sector is channelling funds towards the transition to net-zero emissions in emerging markets and developing economies (EMDEs). These regions are at the nexus of needing to decarbonise while ensuring socio-economic growth. The global pension market, with its staggering valuation of USD$56 trillion in 2022, is a potential reservoir for climate mitigation investment. However, the capital allocation towards EMDEs remains suboptimal. This underinvestment can be attributed to various financial barriers, including unfavourable risk-return profiles, high capital costs, and the absence of standardised ESG metrics. Yet, the potential for alpha returns in these markets, coupled with the diversification benefits they offer, makes them an attractive proposition for astute investors.

Investment Rationale in EMDEs:

EMDEs present a compelling investment thesis. They are significant contributors to global emissions and are concurrently vulnerable to the adverse impacts of climate change. From a portfolio management perspective, investments in EMDEs can offer diversification benefits, given their low correlation with developed markets. Moreover, sectors like renewable energy, sustainable transport, and climate-resilient infrastructure in these regions are in their nascent stages, offering growth potential. Leading global pension funds, in their pursuit of uncorrelated returns, are already scouting for opportunities in EMDEs. For superannuation funds, the integration of EMDE investments can be achieved through strategic asset allocation, clear target setting, and risk management through blended finance structures.

Barriers and opportunities

The investment landscape in EMDEs is riddled with challenges. The risk profiles, encompassing currency fluctuations, governance issues, and geopolitical risks, can lead to high volatility in returns. Additionally, the lack of robust climate and energy policies in some EMDEs can deter investors seeking stable cash flows. From a financial modelling perspective, the absence of standardised ESG data makes it challenging to price risk accurately. However, these barriers also present arbitrage opportunities for informed investors. Blended finance, which combines public and private capital, can act as a risk-mitigating tool, offering a cushion against potential downside. Offtake agreements, like power purchase agreements in the renewable energy sector, can provide predictable revenue streams, enhancing the net present value (NPV) of projects. Furthermore, debt instruments or pooled funds can be structured to minimise default risk.

Conclusions and recommendations

For the finance sector to truly harness the potential of EMDEs, collaboration is key. Superannuation funds can forge alliances with development finance institutions to tap into their expertise and local market knowledge. Upskilling investment teams in climate and EMDE investing will also be pivotal. This can be achieved through workshops, certifications, and partnerships with financial think tanks. Lastly, transparency is paramount. Superannuation funds should consider adopting reporting standards that track their investments in climate solutions and EMDEs, providing stakeholders with a clear view of their commitment to sustainable investing.