In a world of anticipated resource scarcity and rapid population growth in which it believes sustainable companies will deliver greater value, First State Investments is preparing to launch a emerging markets sustainability fund into the Australian institutional market.

More companies in the emerging world would be pressured to implement sustainable business models as their economies march into an era of resource shortages, burgeoning population growth and global warming, according to David Gait, senior portfolio manager with First State. “Emerging markets are realising that they have to do things differently. A decade ago, their idea was to get rich first and then get green. The US, UK and Australia have done this, but now it seems that the emerging markets might not be able to,” Gait said.

Up to 75 per cent of the new product, slated for a prospective launch in November, would be comprised of holdings in the existing Asia ex-Japan sustainability fund, which is near capacity. Gait argued that global warming was primarily an emerging markets concern as agricultural production in these economies would be most threatened and the risks of natural disaster more acute than in the developed world if climate change occurred. This scenario would be exacerbated by the projected increases in the populations of emerging economies, which would demand more food from an increasingly urbanised and polluted landscape.

Companies operating in a sustainable way would be the most profitable, Gait said. But many companies in emerging markets were still guilty of causing environmental and social degradation, and putting shareholder capital at risk, in the course of business. On top of this list were resource companies. Gait said there were rarely any shades of grey in First State’s appraisals of these businesses: the good were very good, and the bad were terrible. Since many of the companies were owned or controlled by governments, “there is a question mark about whether the companies are run in the interests of minority shareholders,” Gait said.

The manager is further reluctant to invest in resources companies as a rule since the value of these stocks can be heavily influenced by the market price of the commodities they produce, irrespective of the quality of management. “Cheaper prices are outside management’s control.” First State engages companies that are committing, in its view, infringements of environmental, social and governance standards conveyed by the United Nations Principles of Responsible Investment, to which it is a signatory. It is in the process of redeeming an investment in its Asia-Pacific fund with an energy company in the Philippines that has caused environmental damage.

In the past, the manager has engaged an Indian manufacturer following the suicide of one of its employees; a Chinese business that cleared what was perceived to be an excessive amount of forest; and resources companies who continued to operate in Burma during and after the 2007 protests led by Buddhist monks. “Just to sell a share and run away isn’t a responsible thing to do,” Gaits said.

In India, sustainability investors should be wary of corruption and violations of social justice sometimes committed by businesses operating in rural lands. Companies operating in these areas have been known to bribe local officials, or pay sums far less than those set by the market, in order to buy land occupied by farmers, Gait said. “The ‘official’ rate goes back for decades and doesn’t reflect the current market.”

But even the more pedestrian route into emerging markets encounters sustainability risks: many of the big names in emerging markets indices are major offenders against sustainability, Gait said. “If you’re constrained by the index it’s hard to integrate sustainable analysis into your decision making process.” Investors should be mindful of the ‘Kodak Count’ – meaning the number of photos of smiling children – in the annual reports of companies.

Anecdotally, according to Gait, the reports showcasing more happy kids in between blocks of text are often published by companies most neglectful of sustainability risks. But the news concerning extra-financial risks in emerging markets is not always so bleak. For example, the Chinese government has reformed its policies guiding the domestic cement industry. Vertical kilns, which were deemed to be energy inefficient and damaging to the environment, are being phased out in preference for dry rotary kilns. Up to 280 million tonnes of old cement works are scheduled to be decommissioned and replaced with the new kilns by 2010. Given the old kilns account for up to 30 per cent of China’s production, 7.4 per cent of the nation’s total energy use, and 15 per cent of its emissions from gas waste while generating just 1.5 per cent of its gross domestic product, Gait supported their demolition.

However the theme dominating the manager’s Asia-Pacific portfolio is an expected demand for natural gas from China and, later, India. “It’s very important for China to move away from coal, and gas is an important next step,” Gaits said. According to First State, in per head of population terms, China and India use hardly any natural gas compared to the United Arab Emirates, Russia, Canada and the US. A move towards gas would help alleviate some of the pollution problems caused by coal as alternative energy sources and clean coal technologies are developed and commoditised, Gait said.

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