By Elena Ilkova, Research Analyst at Rand Merchant Bank.
Environmental, social and governance (ESG) have become well-established themes in investing, but the main focus has been strongly around the environmental factor. Environmental concerns tend to dominate again as the world still deals with the impact of the upheaval in energy markets following Russia’s war on Ukraine.
While addressing environmental concerns is critical in the long run for the world, in the here and now Africa has a broad spectrum of pressing social challenges that must be addressed. Many investors are also starting to recognise the link between environmental and social outcomes, especially in emerging markets, and appreciate the complex ways in which tracked indicators can interconnect and influence each other.
One challenge in Africa is the fact that a significant proportion of economic activity involves fossil fuel production or carbon- and water-intensive production, such as mining, agriculture and heavy industry. Accelerated development of the African sustainable financing market is critical in managing the trade-offs between short-term growth and social stability imperatives versus long-term environmental protection. Capital allocation based on integrating ESG considerations into the investment decision-making process can be the balancing force.
Sustainability in Africa: social, with an environmental add-on
In emerging and frontier markets, especially in Africa, government commitments to achieve carbon neutrality (net-zero) are intrinsically linked to broader socio-economic development aspirations. However, while the ultimate objectives are the same, the starting points for transition journeys are very different, since they are determined not only by the current structure of each economy but the policy priorities of governments.
Examining the approaches taken by two of the continent’s biggest economies – South Africa and Nigeria – highlights this difference.
South Africa’s initial focus is on the facilitation of a just and equitable transition towards a low-emissions and climate-resilient economy. A five-year draft investment plan has key proposals focusing on re-purposing old coal power stations; grid strengthening; reorienting the local auto industry to the production of electric vehicles; and support for the development of a green hydrogen industry.
In Nigeria, the 2060 Energy Transition Plan (ETP) has strong emphasis on reducing energy poverty, critical not only for development, but for industrialisation and economic growth (close to 60% of the population in Nigeria has access to electricity, compared to 85% in South Africa). The five critical energy sectors on which the ETP focuses on are power, clean cooking, oil and gas, transport and industry.
Taking advantage of ESG investment opportunities in Africa requires a more comprehensive approach than concentrating on the climate change component alone. The need to reduce carbon emissions has focused much of the developed world’s attention on green issues and incorporating environmental considerations into a company’s business strategy, operations and investors’ decision-making has become essential. However, in an African context, environmental considerations exacerbate the social impact and need to be embedded in governance structures.
Beyond traditional social considerations
The Covid-19 pandemic shifted global attention to the social component of ESG. In most advanced economies, the disruption of economic activity drew attention to business practices predominantly related to the management of human capital. Social issues such as employee benefits, paid sick and family responsibility leave, pay reductions and retrenchment practices became key investor concerns.
In contrast, in Africa food security was the top social concern. The loss of the opportunity to earn income, combined with the typically very low savings rates, exposed the fragility of the existing socio-economic systems. The solution is rapid economic development and industrialisation, which require energy, but the challenge is to enable growth while keeping the carbon footprint low.
Green finance can help facilitate the production of clean energy, but considering the social impact, such investments have a direct social component embedded, which is potentially a natural extension in many green projects. For investors in Africa, projects that fall into green investment categories such as renewable energy, energy efficiency, sustainable water management, sustainable land use, clean transport, and pollution prevention and control, also frequently qualify under the eligible social investment categories such as affordable basic infrastructure, access to essential services, socio-economic advancement and empowerment, employment generation, and food security and sustainable food systems.
Sustainable finance: investment opportunities with de-risking measures
A combination of environmental and social considerations is often integral to the success of business ventures in African countries and can help to identify more resilient and profitable investment opportunities. An intentional focus on social factors is also better risk management. Effective and consistent integration of social criteria in investment processes helps de-risk investments by acknowledging that the challenges in Africa are both climate change and inequality. In this context, the financial materiality of social performance can be just as critical as the environmental performance.
In addition, understanding and addressing the social issues that affect corporate supply chains protects against potential reputational risks when dealing with a variety of issues. Identifying the specific social issues that are material to the geography or jurisdiction in which a company operates is a starting point, and further analysis of sectors or industries allows for early identification of issues that can become material in time. The materiality of social risks differs between countries and industries, which adds a layer of complexity to financial analysis, but the structured approach associated with explicitly targeting social outcomes helps reduce the complexity. Failure to consider the social dimension in supply chains can present significant risk to operations, as in many cases a social compact with local communities is necessary to ensure stability of operations.
In the context of African economies, assessing social performance and integrating social criteria into investment decisions allows investors to play a part in creating more resilient and equitable economies. The focus on sustainability is a strategy that has the potential to enhance returns and reduce risk in investors’ total portfolio — both in public and private markets, as well as in equity and debt.