The challenges of the past 18 months or so have highlighted the potential for environmental, social, and governance (ESG) factors to become even more relevant to asset management and have underscored the ever-increasing importance of stewardship by fiduciaries and active investors alike. ESG has quickly become one of the defining investment criteria of this decade — a trend we have little doubt will endure in 2022 and beyond.
We have long believed that mounting sovereign debt burdens pose a risk to investors, even in developed markets. At the very least, investors are not being adequately compensated for investing in the most heavily indebted countries. Given the sharp rise in government debt levels in response to the global COVID-19 crisis, it’s an opportune time for sovereign bond investors to refresh their investment frameworks, the particular metrics to be applied, and their country selection methodologies, including the ESG factors underlying investment decision making.
Sovereign risk framework at a glance
Our sovereign risk framework (SRF) incorporates ESG factors, which we see as indicators of a country’s structural stability or long-term ability to generate economic growth and meet its debt obligations. (Notably, as discussed below, we recently elevated the already important role of ESG factors in our SRF framework.)
ESG/structural stability remains one of four pillars of the overall framework (Figure 1), with the other three being the country’s: 1) fiscal and monetary flexibility; 2) economic imbalances; and 3) total public debt outstanding. The primary output of the framework is a ranking system, which allows to us exclude from consideration those countries deemed to have the weakest sovereign fundamentals.
Why we elevated ESG factors
While ESG encompasses a wide range of concepts, we worked through a long list of components to identify those metrics that have historically exhibited the strongest correlations with a country’s long-term economic performance.
- ESG is now equally weighted along with the other three pillars of our framework (see above) to create what we think is a more robust, comprehensive view of sovereign risk. The main goal is to identify countries with stable to improving credit characteristics for potential investment. In this context, we believe increased emphasis on ESG makes sense given its power to influence a country’s longer-term growth potential and future liabilities.
- We believe climate change risk will put significant pressure on sovereign balance sheets over the medium term if it is not dealt with effectively in the coming years. With that in mind, we are able to leverage our unique partnership with Woodwell Climate Research Center to help optimize our climate risk metrics. This adds analytical depth and rigor to our SRF and also greatly informs more productive interactions with ESG standard setters and regulators.
Inside our ESG variables
- Environmental (“E”): Environmental factors have gained prominence in our investment process as we acknowledge climate change to be a material risk and a contingent liability. Environmental factors include both physical climate risks (e.g., population displacement, pollution-induced health problems) and climate transition risks (e.g., non-compliance with the Paris Agreement).
- Social (“S”): Social metrics relate most appropriately to the downward pressures supply-side dynamics can exert on a country’s ability to generate economic growth over the long term. These factors take into account the stability of the country’s future income tax base and revenues, as determined chiefly by demographics (e.g., female/male and dependency ratios).
- Governance (“G”): We believe governance metrics correlate with a country’s GDP over time, especially for emerging markets. It stands to reason that a weaker governance backdrop will likely make the growth environment more challenging. Our indicators here include a country’s rule of law and its degree of political stability.
Final thoughts on sovereign bond ESG risks
Overall, we firmly believe that a more complete integration of ESG factors into our sovereign debt investment approach can deliver meaningful benefits to clients in the coming years. With respect to climate risks specifically, given their critical importance to investors and regulators, we will continue to seek new ways to proactively implement the findings of our ongoing research efforts.