Sustainable investment in emerging markets and developing economies: mobilising institutional capital

Sustainable investment is gaining momentum worldwide, driven by the need to align financial returns with positive outcomes for people and the planet. This shift is not just a trend – it is an essential path forward. The world faces pressing challenges that demand urgent action, from climate change to poverty alleviation and social inequality. Emerging markets and developing economies (EMDEs) must be at the centre of these efforts. These regions are not just financial frontiers offering institutional investors such as pension funds and insurance companies growth and diversification benefits; they are the battlegrounds for climate action, poverty alleviation, and social progress. The potential to leverage growing investor interest in sustainability for the benefit of both people and the planet is immense.

There is a compelling investment case for allocating more capital to EMDEs. Research by ODI Global has found that since 2010, emerging market bonds have consistently outperformed their developed market counterparts. Furthermore, over the past two decades, emerging market equities have delivered returns on a par with, or in some cases exceeding, those of developed markets – excluding the United States. Despite these strong performance indicators, institutional investors continue to under allocate capital to EMDEs, thereby missing out on significant diversification benefits and longterm growth opportunities.

The typical allocation from insurance companies ranges from 0% to 5%, while pension funds allocate between 5% and 15% of their portfolios. One of the key challenges is that EMDE investments are often illiquid, making them less attractive to institutional investors, who prefer liquid, easy-to-exit positions. Additionally, many EMDEs lack well-developed capital markets, which limits the ability of investors to trade securities freely. As a result, most investment in EMDEs is channelled into a handful of more-developed, large emerging markets like China, India, and Brazil, while smaller-, middle- and lower-income economies – where capital could drive the most impact – are largely overlooked.

A recent analysis by Morgan Stanley highlights this underinvestment, revealing that traditional allocation strategies significantly underweight emerging markets. Their models indicate that typical emerging market exposure is just one-sixth of what would be recommended by an optimal allocation strategy. This under allocation means that investors are foregoing substantial potential gains, particularly as EMDEs are projected to drive global growth in the coming decades. These markets currently contribute over 60% of global GDP and represent a rising share of global market capitalisation.

As Europe grapples with an ageing workforce and stagnant productivity growth, institutional investors seeking to meet future pension obligations must look beyond the region’s limited economic prospects. Projections suggest that Europe’s GDP growth will average only 1.45% annually through 2029, compared to 2.29% in the United States and an even more robust 5-6% in EMDEs. The global economic landscape is shifting, and investors who fail to embrace the opportunities presented by EMDEs risk being left behind in an era of rapid transformation.

Institutional investors face a number of EMDE investment hurdles and they can rely on MDBs and DFIs to navigate these. The key role of MDBs and DFIs in enabling access to high-return, transformative investment opportunities is briefly outlined below:

Providing market insights and risk mitigation

Institutional investors often hesitate to enter EMDE markets due to unfamiliarity and an exaggerated perception of risk. But the experience of MDBs and DFIs tells a different story. These institutions have a proven track record in private asset investment across EMDEs. Their deep expertise translates into invaluable credit risk insights, captured in the GEMS dataset - a repository of default and recovery data from 21 MDBs and DFIs. The latest GEMS release (October 2024) challenges common risk misconceptions. It reveals that MDB/DFI private debt loss rates in EMDEs are lower than widely assumed, with an average annual default rate of 3.56% over the past decade – comparable to non-investment-grade firms in advanced economies. Even more compelling, recovery rates stand at a solid 72.2%, outperforming many global benchmarks.

MDBs and DFIs don’t just provide data – they actively de-risk EMDE investments. With unmatched market knowledge, on-the-ground presence, and a suite of risk-mitigation tools – including guarantees, political risk insurance, and blended finance structures – they pave the way for institutional investors to confidently step into EMDEs.

It is time to rethink EMDE risk – backed by data, not perception. MDBs and DFIs must intensify their efforts on data. Investing in robust, transparent and standardised data systems is key to bridging this gap. Two game-changing areas for MDB and DFI improvement include: (1) granular GEMS risk data – essential for accurate risk modelling and pricing; and (2) harmonised ESG and impact metrics – aligning with regulations and investor expectations.

Structuring products to meet the needs of institutional investors

titutional investors seek competitive, risk-adjusted returns when making allocation decisions. To attract capital, EMDE investments must align with these expectations - offering competitive returns while addressing perceived risks. The key? Large-scale, investment-grade products backed by diversified asset pools with robust ESG and impact reporting. MDBs and DFIs play a crucial role in making this happen. By originating and structuring assets—often through collaboration—they create pooled investment vehicles that meet institutional standards, unlocking new opportunities in EMDEs.

Reducing costs and expanding opportunities

Investing in EMDEs is often costly due to higher transaction costs in private markets and limited opportunities in public markets, leading to an over-reliance on private investments. MDBs and DFIs can help lower costs by originating lower cost investment opportunities, pooling assets, and syndicating deals with private asset managers.

Strong ESG and Impact Frameworks

Institutional investors face growing pressure to integrate sustainability into their decision-making. Yet, reliable ESG and impact data in EMDEs remains a major hurdle. This is where MDBs and DFIs step in. With their well-established ESG and impact frameworks, they help ensure that investment opportunities align with global sustainability standards – bridging the data gap and enabling smarter, more responsible capital allocation.

However, to truly unlock investment in EMDEs at scale, we must look beyond MDBs and DFIs and dismantle the systemic barriers – both regulatory and cultural – that are holding capital back. Europe’s regulatory framework unintentionally penalises EMDE investments. Take Solvency II – its capital charges for non-OECD infrastructure debt are misaligned with actual credit risk. Due to data limitations during its 2016 calibration, a blanket 13% charge was applied to unrated 10-year non-OECD infrastructure project loans. Yet, newer Moody’s data suggests that loss rates in Lower- and Middle-Income Countries (LMICs) are comparable to, or even lower than, those in High-Income Countries (HICs). A 2020 recalibration study found that African MICs and HICs warrant a charge as low as 4% – a stark contrast to the outdated 13%. It’s time to revisit these capital requirements.

Another issue is Solvency II’s ‘matching adjustment’, which helps insurers manage liquidity risk but applies only to investment-grade assets. With most EMDE sovereigns rated below BBB, hovering around BB- , this creates an artificial cliff, reinforcing a bias toward Developed markets. EU regulators must reassess this threshold.

On sustainability, new EU finance regulations also tilt the playing field. The Green Asset Ratio (GAR) excludes non-EU green investments from its numerator but includes them in its denominator. This means European DFIs like FMO and others who issue debt but who invest outside the EU – despite extensive sustainable EMDE investments – could register a 0% GAR. Both FMO and EIB have recently raised concerns about the reputational risks associated with this new regulation.

Regulation is not always the issue. In major European pension markets, the bigger challenge is behavioural investor bias and ingrained conservatism. UK pension funds, for example, allocate a mere 0.5% of assets under management to EMDEs, despite no regulatory restrictions. Home-market familiarity and fiduciary caution often lead to a preference for domestic or nearby markets, where investors have easier access to information.

 Change requires political and investor leadership. The Netherlands provides a blueprint – strong government direction and proactive regulatory support have transformed its financial system into a leader in EMDE and impact investing. The UK is now taking steps in that direction, with the Institutional Investor Group on Climate Change new report setting out concrete actions in three key areas:

• Political and Industry Leadership – UK Chancellor, Foreign Secretary, and top asset owners/CEOs must set a clear investment agenda.
• Industry-led steering committee – A dedicated body to drive initiatives, including capacity-building and regulatory assessment.
• Data transparency and standardisation – Regulators and industry players must collaborate to bridge information gaps and facilitate informed investment.

These initiatives set a powerful example. They should spur action worldwide and inspire the preparatory process of the United Nations Fourth International Conference on Financing for Development, which will be held in Seville (June/July 2025). It is important to be pragmatic about what is achievable – but even more so, the agreement must lay the foundation to inspire and drive systemic and behavioural change. Securing broad buy-in from key stakeholders beyond the development finance community will be essential to making real progress.

Mobilising greater investment in EMDEs is essential for achieving the Sustainable Development Goals and fostering global economic resilience. Addressing regulatory barriers, enhancing investor engagement, improving data availability, and leveraging the expertise of MDBs and DFIs will be key to unlocking this potential. With strong leadership and a commitment to innovation, institutional investors can play a transformative role in financing the future of EMDEs, while securing long-term, sustainable returns.