When it rains in Pakistan, investors who hold shares of Sweden’s apparel chain H&M might need umbrellas — no matter where they are.
In 2011, the resulting floods coupled with drought in China destroyed cotton crops and caused prices to rise to record levels. The apparel maker posted a 30% drop in net profits, and investors took a hit.
Emerging market funds and the stocks of multinationals forging ahead in those markets have been among the hottest investments in the past decade. But as H&M’s experience shows, doing business in emerging markets can be full of unanticipated shocks, especially on the environmental front. Some of the recent pullback in emerging markets investments — which fell from $162 trillion in March to $85 trillion in April, according to EPFR Global — is likely attributable to investors’ growing realization of the risks, said experts.
“Part of the issue is that investors are starting to recognize the inherent risk in the markets — political, cultural, and economic — that makes it very difficult for foreign investors to understand these markets,” said Robert Salomon, associate professor of management and organisations at New York University’s Stern School of Business. “They underestimate the cost and overestimate the benefits associated with investing in foreign countries.”
Environmental risks — from pollution, to extreme weather, to changing government regulations and more — are among the most difficult to quantify because they are so broad and diffuse, but they are also some of the most crucial to understand. Investors aware of the effect of environmental problems on emerging markets funds will have a better sense of the volatility they can expect from those investments.
“The investor who’s able to incorporate environmental information into their analysis before it becomes evident in a company’s financials is ahead of the game,” wrote Steven Soranno, senior equities analyst at Calvert Investments in Bethesda, Maryland, in an email. It’s not an easy task, in part because companies themselves have only begun to grapple with environmental risks, especially as they affect their complex supply chains.
What do the risks look like?
Companies operating in developed markets face environmental risks, too, from hurricanes to oil spills. But such issues are magnified in emerging markets, wrote Loic Dujardin, director of Research Products at sustainability research and analysis firm Sustainalytics in Singapore, in an email. “A lack of adequate infrastructures and institutions amplify the impacts of extreme weather events such as droughts and floods.”
For instance, in an emerging market, droughts causing water scarcity can close power plants that use water for cooling purposes, reducing power to factories. Floods can also temporarily close factories, as the monsoons in Thailand did when flooded plants were closed, and a shortage of hard drives in 2011 affected PC inventories.
Along with water scarcity issues, pollution and deforestation are major issues. Companies that generate “externalities,” as they are called, may be fined or lose their license to operate in some countries, wrote Dujardin. “A chemical plant that discharges its wastes in a nearby water stream may be shut down by local authorities... [any] downstream companies impacted by polluted water may lose their competitiveness.”
Researchers at London-based Trucost, an environmental data company, analyzed the affect of limited to no available natural capital, such as clean air, water and land, which implies costs down the road, and industries’ ability to absorb those costs. It reported that the industries most vulnerable to environmental risk were: coal power generation in Eastern Asia, cattle ranching and farming in South America, iron and steel mills in Eastern Asia and wheat farming in southern Asia.
The bottom line?
Companies that examine supply chain risks in their analyses early on are ahead of the game, experts said. Many do not — but that’s something any investor can try to assess, too.
“A lot of companies fall short on having robust assessments of their supply chain risk profile — this is where an informed investor can add value,” said Soranno.
Shally Venugopal, project manager of Climate Finance & the Private Sector at the World Resources Institute in Washington, DC, suggests investors look through annual reports and sustainability reports to see whether a company is proactively addressing environmental risks, and if their competitors are doing it better. Rankings and sustainability reports from Global 100, Bloomberg New Energy Finance or Trucost, can be good sources.
Within the supply chain, companies can find the most efficient use of resources and minimizing waste. Partnering with suppliers to use environmentally friendly technologies is another sign a company takes risks seriously, especially with exclusive suppliers that provide a key commodity. When expanding or planning a supply chain, companies can locate and design facilities to be sustainable and “green” as well as avoiding flood areas. Look for these things in a firm’s annual report to get a sense of how much they’ve considered the risks — and the reward — of environmental issues in emerging markets.
Libby Bernick, senior vice president of North America at Trucost, considers whether a company measures and manages environmental risks to be a sign of good management overall.
Companies’ analyses of risk should also show they are aware of the long-term implications of environmental problems. For instance, multinationals in China might eventually have to relocate if air pollution keeps them from attracting or retaining personnel. If a manufacturer in China points to this risk in its sustainability reports, that’s one sign of a solid assessment of environmental risk.
Another example: the cost of polluting is low until a company is caught depleting or contaminating water tables, burning down forests or opening factories in environmental zones. The resulting headlines and fines are bad – but they’re just the beginning.
“The issue is the long-term liability of the cleanup and the accumulation of the pollution in the ground.” said Karl Russek, senior vice president of Environmental at ACE Overseas General, based in Philadelphia.
Investors should look though sustainability and corporate social responsibility reports for how a company operates within emerging markets. Social media and local newspapers can help investors better understand environmental issues within an emerging market.
(This story has been corrected to show that Trucost is based in London, not Philadelphia)