Those in advanced and developed industrial countries may be tempted to view emerging markets as irresponsible producers of pollution and a culprit for much of the world’s global warming. But new research on South America, "Sustainability Indices in Latin America: Can Financial Markets Push for CSR?" by professor Adrian Zicari, reveals a surge in local-specific sustainability indexes for investors seeking a clearer picture of firms’ responsible business practices.
Why investors need sustainability indexes
It’s a fact – things are getting better. Doom-laden prime-time TV reports of industrial pollution and global warming apart, social responsible investing and sustainability indexing are two clear examples of a tangible effort to make things go in the right direction. Across the world, they are surging. Socially responsible investing (SRI), sometimes known as green or ethical investing, is all about gaining financial return while seeking to invest in firms demonstrating a conscious effort to improve their impact on business, society and the environment. For an investor to make that decision to place his money wisely – and responsibly – he needs to know what a firm is actually doing in terms of responsible business practice and how it performs. This is where the sustainability index comes in – stocks quoted in terms of environmental, social or governance (ESG) criteria.
Such indexes have been around for some time in industrialised and developed economies, encouraged by the UN Global Impact initiative of 1999. The US Dow Jones Sustainability Index (DJSI) or the London-based FTSEGood index, respectively launched in 1999 and 2001, are good examples that some make use of to point a condemning finger at stock markets in developing or emerging economies without such indexes. Such moralising from the world’s richest may not be entirely justified – firstly because their own emergence tended to occur at a mature stage of the market. And secondly because, in a global context of increasing reference to sustainability indexes for investor decisions, some developing markets are attempting to make good. They are doing this via the launch of indexes that tailor to local contexts as well as solving the challenges of their comparative low market liquidity and the high cost to the potential investor of obtaining correct and proven information needed for their investment decisions. Such an example is Latin America, and more specifically Brazil, Mexico and Chile, the focus of my research on SRI.
A novel approach in Latin America
SRI is developing in Latin America in a different way from those of developed markets, with Brazil, Mexico and Chile providing an approach that could prove interesting for other emerging countries either in the region or elsewhere in the world. This ongoing surge of Sustainability Indexes in three Latin American countries is remarkable. SRI is still quite new in the region, the situation largely contrasting with that of developed markets where SRI has become a common investment practice. One sixth of funds invested by professional managers in the United States, for example, is related to some approach of SRI (US SIF, 2014).
What sets the Latin American approach apart is the direct participation of local stock exchanges that aim to gather a critical mass of highly respected stakeholders. This has mainly come about through a combination of two factors – the limited nature of stock exchanges in South America and the cost of obtaining ESG data.
In developed markets, this assessment data is collected by investment funds or by social rating agencies which makes the cost of obtaining it high for investors in developing countries. By using indexes created by their local stock markets and whose composition is freely distributed so that any investor can use the information at no cost, Brazil, Mexico and Chile have creatively detoured this onerous aspect.
Does it work?
In Brazil, the Sao Paulo stock exchange created the ISE corporate sustainability index as far back as 2005 – the fourth in the world and the second in an emerging market. Data is collected on a voluntary basis and corresponds to seven different criteria: general, product nature, corporate governance, economic and finance, environmental, social, and climate change. Both a good score and a minimum liquidity are required before selection is made. All in all, the index does not seem to have better returns compared to a classical investment portfolio. However, it can be argued that SRI investors may still prefer to invest in companies with better ESG performance even if financial results remain similar.Moreover, it can be said that the ISE directly influences corporate practice, appearing attractive to firms wishing to make their reputations visible, gain knowledge and exert influence on competitors and suppliers via their presence in the index.
Mexico has the IPC Sustentable, created by the Mexican stock exchange in 2011 with the involvement of the European ESG rating agency, Eiris. Here too, a requirement is minimum liquidity and companies are assessed on three criteria – environmental (50% of the score), social (40%), and governance (10%). As with the Brazilian ISE, the IPC Sustentable changes its list of companies yearly.
The latest newcomer is the Chilean Sustainability Index jointly launched in 2015 by the stock exchange and S&P Dow Jones. Known as the Dow Jones Sustainability Index Chile, it follows a best-in-class approach – cherry-picking the best companies and with no exclusion of sector – with assessment made on the basis of information submitted by listed companies. If a company decides not to answer the questionnaire, the evaluators can use publicly available data. The biggest difference from the Brazilian and Mexican indexes is the use of the Dow Jones name. It will be interesting to see in the next few years if this choice of launching a sustainability index with a widely known brand will accelerate the international awareness for this Index.
Helping responsible investors make their decisions
For investors, the most valuable information is not the Index composition itself but the methodology for assessing ESG performance. This is where the Dow Jones Sustainability Index Chile “best-in-class” approach may prove difficult for the socially responsible investor to swallow. Controversial businesses such as oil and tobacco can be included and, given that only the very best firms are selected, many firms with very good responsible business reputations may remain off the radar screen. As a result, Sustainability Indexes cannot perfectly replace the lack of ESG rating agencies. Indeed, both serve different purposes: the former are meant for reference or benchmark for SRI portfolios while ESG rating agencies evaluate the ESG performance of particular firms. This said, information from Sustainability Indexes in the context of Latin America can still help SRI investors to make their decisions. And for responsible investors, where there is no index to glean there are always corporate reports to read, announcements to hear – or the doom-laden prime-time TV news to watch.