Can ESG ratings shape investor decisions: Insights from emerging markets

Introduction

ESG (Environmental, Social, and Governance) ratings have become an essential tool for evaluating the sustainability and ethical impact of organisations. ESG ratings assess a company’s impact on the environment and society, as well as its exposure to sustainability risks. They also help in analysing a company’s performance across environmental factors (such as resource scarcity, climate change, emissions, and carbon footprint), social responsibility (human rights, labour standards, product quality, community relations, diversity, equity and inclusion, employee health), and governance practices (such as corruption, bribery, supply chain management, and government relations).

Given global challenges like climate change, social inequality, and governance scandals, ESG ratings have gained significant traction, allowing investors to align their portfolios with sustainable and responsible practices. This trend is particularly evident in emerging markets (EMs), where there is a dual opportunity of fostering both economic growth and sustainability. Despite facing challenges such as regulatory gaps and inconsistent data, strong ESG ratings have become critical in assessing risks and unlocking the growth potential of EMs. Companies with strong ESG performance are often seen as less vulnerable to regulatory scrutiny, reputational damage, and operational risks, offering the potential for stable returns. Ultimately, they serve as a transformative tool for mitigating risks, driving sustainable economic development, and catalysing positive change in regions most vulnerable to environmental and socio-economic challenges.

Obstacles hindering ESG ratings effectiveness in emerging markets

ESG ratings are essential for promoting sustainable investing, yet their effectiveness in emerging markets is often limited. Factors like inconsistent regulations, data reliability issues, and market-specific challenges create barriers. Addressing these obstacles is key to enhancing ESG adoption.

Lack of standardisation: The ESG reporting landscape struggles due to the absence of a unified global framework, with companies using different standards like Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), and Task Force on Climate-related Financial Disclosures (TCFD). This fragmentation results in inconsistent reports, making it challenging for investors to compare data across companies. For example, Tata Steel in India uses GRI, while Infosys follows SASB
Data accuracy, costs, and verification: ESG reporting faces significant challenges, particularly in data collection and quality. Many organisations, especially small and medium-sized enterprise (SMEs), rely on manual tracking of key metrics such as emissions, energy use, and workforce diversity, which leads to errors and incomplete data. The absence of clear guidelines on material ESG data further complicates accurate reporting, often resulting in selective or incomplete disclosures that mask a company’s true impact. Additionally, producing ESG reports is resource-intensive and costly, requiring significant time and coordination across business units. The growing need for third-party verification of ESG data adds another layer of complexity, as companies struggle to find qualified auditors or standards, impacting the credibility of the reports.

Greenwashing risks: Greenwashing is the risk where companies exaggerate or misrepresent their sustainability achievements, undermining the credibility of ESG reporting and stakeholder trust. With developing ESG data and insufficient regulatory checks, misleading claims are common. without proper oversight and verification, it becomes difficult to differentiate genuinely sustainable organisations from those using ESG as a marketing tool, such as companies overstating renewable energy usage through questionable offsets. In the case of Starbucks in 2018 “straw-less lid” aimed for sustainability but used more plastic than before critics noted low global recycling rates (9%) and highlighted the U.S. shifting recycling burdens to poorer nations

Stakeholder expectation misalignment: In EMs, different stakeholder groups prioritise ESG aspects differently: investors focus on governance, consumers on sustainability, employees on diversity, and regulators on compliance. This misalignment makes it challenging for companies to balance ESG reporting and meet diverse expectations

Limited focus on social and governance issues: While environmental issues like carbon emissions and climate change often dominate ESG reporting, social and governance factors frequently receive less attention. Companies may favour reporting on measurable environmental metrics rather than tackling more complex social issues such as labour rights, human capital development, and corporate governance. Like Amazon has seen its ESG scores decline in the wake of growing antitrust scrutiny and concern over workplace conditions for its employees

Solutions to enhance ESG ratings’ effectiveness in emerging markets that can bridge gaps:

To address the challenges facing ESG ratings in emerging markets, solutions include strengthening regulatory frameworks, improving data transparency, and fostering collaboration between stakeholders. These measures will create a more reliable, accurate, and impactful ESG assessment system, driving sustainable development:

Improving standardisation and transparency: International bodies such as International Sustainability Standards Board (ISSB) and local regulators need to collaborate to establish standardised ESG reporting frameworks tailored to emerging market contexts. This unified approach would reduce inconsistencies and improve investor confidence

Building ESG capacity and investor awareness: Companies in emerging markets need support to strengthen their ESG tracking and reporting capabilities through technical training, data infrastructure investment, and advisory services. For example, the Johannesburg Stock Exchange offers workshops to enhance ESG compliance for listed firms. Educating investors about ESG investing is also essential to overcome misconceptions and emphasise its long-term value. Collaboration between financial institutions and regulatory bodies is key to providing resources and raising awareness, enabling more informed decision-making

Leveraging technology: Advanced technologies such as artificial intelligence (AI) and blockchain can play a vital role in improving ESG data collection, verification, and dissemination. Brazilian agribusiness firms increasingly use AI tools to monitor deforestation and carbon emissions, providing transparent and verifiable data to investors

Regional ESG benchmarks: Developing region-specific ESG benchmarks can address the unique socio-economic priorities of emerging markets. These benchmarks can complement global frameworks, providing a more nuanced evaluation of company performance as the MSCI Emerging Markets ESG Leaders Index focuses on companies with high ESG performance relative to their sector peers, offering investors a tailored benchmark for these markets

Enhancing regulatory oversight: Strengthening regulatory frameworks to penalise greenwashing and incentivise genuine ESG improvements is crucial. Emerging market governments must play an active role in creating a conducive environment for sustainable investing. Like California’s Third Climate Law required new carbon offset disclosures in an explicit effort to combat greenwashing in October 2023

Conclusion

ESG ratings hold immense potential to shape investor decisions in emerging markets, but their impact depends on overcoming existing challenges. By improving standardisation, enhancing data quality, leveraging technology, and fostering a culture of transparency and accountability, stakeholders can unlock the true value of ESG ratings. For investors, the key lies in adopting a nuanced approach that considers both global frameworks and local contexts. ESG reporting must evolve into a tool for driving real, measurable impact rather than merely serving as a compliance exercise.

As emerging markets continue to integrate ESG principles into their economic fabric, they offer a compelling proposition: high-growth opportunities aligned with sustainable development. By bridging the gap between aspiration and implementation, ESG ratings can transform from a tool of compliance to a driver of meaningful change in global investment strategies.

References

https://www.icsi.edu/media/webmodules/CSJ/October/12.pdf

https://ww2.arb.ca.gov/2023-ab-1305-gabriel-jesse-voluntary-carbon-market-disclosures-chaptered

https://www.msci.com/indexes/group/esg-leaders-indexes

https://tracextech.com/digital-traceability-in-brazil/

https://hbr.org/2020/09/the-challenge-of-rating-esg-performance

https://practicalesg.com/2024/01/starbucks-hit-with-greenwashing-suit/

https://www.jse.co.za/our-business/sustainability/jses-sustainability-and-climate-disclosure-guidance

https://www.clydeco.com/en/insights/2024/08/esg-challenges-in-emerging-markets#:~:text=Emerging%20markets%20face%20governance%20challenges,strict%20adherence%20to%20ESG%20standards.

https://www.morganstanley.com/im/publication/insights/investment-insights/si_diving-below-surface-esg-integration-in-emerging-markets_en.pdf

https://community.nasscom.in/communities/esg-sustainability/esg-ratings-emerging-markets-challenges-and-opportunities-asset

https://www.clydeco.com/en/insights/2024/08/esg-challenges-in-emerging-markets#:~:text=Emerging%20markets%20face%20governance%20challenges,strict%20adherence%20to%20ESG%20standards