Sovereign debt is one of the largest and most liquid markets in the world, with over USD 60 trillion outstanding.1 Yet implementing an environmental, social and governance (ESG) framework within the space brings a unique set of challenges. We propose three common principles to help investors assess the ESG characteristics of sovereigns with a holistic and data-oriented approach.
1. ESG factors are important drivers for economic performance and impact financial risk and return.
We strongly believe that integrating ESG factors is critical for better investment outcomes. Good governance, strong institutions and low levels of corruption have been long identified as drivers of economic growth and lower financing costs.2 Intuitively and empirically, we understand that countries that provide better social conditions tend to see better economic outcomes. Income equality, gender balance, human development and demographics all play a role in a country’s long-term growth.3 And, even before tracking carbon emissions became commonplace, we understood that countries reliant on commodity exports tended to be vulnerable to cyclical commodity prices and rent-seeking behaviour. ESG factors supplement conventional credit analysis, picking up information that is not captured by traditional credit risk analysis, with a long-term focus.
Even if one is sceptical about the relevance of ESG factors today, their importance is only growing. Governments are broadly adopting policies that will require greater disclosure on ESG metrics and penalise poor ESG practices (for example, carbon emissions taxes). Investors are reallocating capital toward issuers with stronger ESG characteristics, and demanding progress.
While it’s been widely demonstrated in the equity space that ESG approaches do not come at the cost of returns,4 fixed income investors have been more sceptical as credits with lower ESG scores tend to have higher yields. Specifically for sovereigns, we can look at the example of J.P. Morgan’s suite of ESG indices compared to its traditional emerging market debt indices (Exhibit 1). The ESG versions of the indices have been able to demonstrate similar returns, with incrementally lower volatility. In developed markets, higher ESG scores have historically been correlated with lower drawdowns in times of market stress (Exhibit 2).
Exhibit 1: EM ESG indices have been able to demonstrate similar returns to traditional indices with lower volatility over the long run
Source: J.P. Morgan; data as of 30 June 2021. Return and volatility calculations from 31 December 2012 to 30 June 2021. EM Local Sovereign Index = GBI-EM Global Diversified. EM USD Sovereign Index = EMBI Global Diversified. ESG Index created by J.P. Morgan excludes certain sectors, low scoring ESG names and UN Global Compact violators, and increases weights to green bonds. More details provided here: https://www.jpmorgan.com/content/dam/jpm/cib/complex/content/markets/composition-docs/pdf-30.pdf
Exhibit 2: Incorporating ESG considerations for DM sovereigns helps to protect against drawdowns
Source: J.P. Morgan, Bank of America Merrill Lynch, J.P. Morgan Asset Management; data as of August 2021. Drawdown calculated based on J.P. Morgan and Bank of America Merrill Lynch country sovereign debt index.
2. Using a holistic array of internationally regarded data sources helps guard against bias.
When investing in sovereigns, it is impossible not to consider politics, which often involves bias. We believe considering a variety of perspectives and looking at a wide array of reputable, internationally regarded data sources is a good start to forming an objective view.
A common complaint about ESG analysis is that data can be difficult to source. Some sovereign data is in fact more readily available than corporate data given the multitude of multinational organisations and NGOs – including the World Bank, the IMF and the United Nations – that have been tracking country level data for decades. However, just because the data is available does not mean it is easy to use and interpret, or that it is accurate or unbiased. Timeliness is a common issue as most ESG data is updated at best annually and often with multi-year lags. This can make assessing progress in some areas, such as climate change policy, particularly difficult. Qualitative assessments of policy translated into quantitative rankings, such as the World Bank’s Governance Indicators or Germanwatch’s Climate Change Performance Index, can help.
Despite the shortcomings of the data available today, we believe there is enough information for sovereign investors to assess general trends and make some cross-country comparisons.
3. Scoring is only one part of any approach – investors also need to take into account trajectory and engagement.
Scoring frameworks serve an important purpose: they provide a simple understanding of issuers as “better” or “worse”. Third-party scores also provide an independent assessment for investors, similar to the role of a credit rating agency. Yet third-party scores can differ widely and, as yet, there is no industry standardisation. Scores may also lack transparency and may not be aligned to a specific investor’s values and objectives.
A qualitative assessment can complement a score-based approach and incorporate higher frequency views and other considerations not well captured by data. Many sovereign ESG scores exhibit an income bias (richer countries tend to have higher ESG scores).5 While this may be a desirable feature as sustainable investors are likely to want to invest in countries that provide a better standard of living, it can also have the harmful effect of diverting financial flows away from countries that may need it the most. Income bias can be addressed by comparing countries within their peer income groups or by looking at trajectory and momentum, not just current levels.
As with corporates, engagement is critical, but it can be more nuanced in the sovereign space. Engagement can take a variety of forms, including helping governments finance specific sustainable projects; meeting with government officials regularly to review progress on climate goals; and participating in industry groups to collectively advocate for better disclosure and improved practices from state-owned companies.
Although a wide range of sovereign ESG data is available, it can be patchy, biased and challenging to interpret. Third-party scoring can help to provide a simple understanding of a country’s ESG characteristics, but may lack transparency – and there is, as yet, no industry standard. We believe a proprietary approach that includes trajectory analysis and engagement, as well as scoring, is required to gain a more complete picture.
This is a short version of a longer paper examining the challenges of ESG analysis in the sovereign debt space, looking at ways to overcome those challenges and introducing J.P. Morgan Asset Management’s proprietary sovereign ESG scoring framework.
1 ICMA, August 2020. https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Secondary-Markets/bond-market-size/
2 Governance, Corruption & Economic Performance. George T. Abed and Sanjeev Gupta. https://www.researchgate.net/profile/Sanjeev-Gupta-9/publication/234791577_Governance_Corruption_Economic_Performance/links/00b7d520d3e3c53a2a000000/Governance-Corruption-Economic-Performance.pdf
3 Trends in income inequality and its impact on economic growth. https://www.oecd.org/newsroom/inequality-hurts-economic-growth.htm
5 World Bank, A New Dawn Rethinking Sovereign ESG. https://documents1.worldbank.org/curated/en/694901623100755591/pdf/A-New-Dawn-Rethinking-Sovereign-ESG.pdf
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