Our monitoring process is a crucial aspect of how we integrate ESG
Fundamental research has always been at the heart of our investment approach, The Capital SystemTM.1 We believe that analysing material environmental, social and governance (ESG) issues can help us better understand long-term risks and opportunities.
Monitoring is a key aspect of our ESG integration approach for equity, corporate debt and sovereign issuers.2 For these asset classes, we complement in-house research and analysis with monitoring of third-party ESG data, where available. Our goal for monitoring is to surface external views of potentially material ESG risks.
Importantly, investment decisions are made based on a long-term view, engagement and analysis — never solely on monitoring results. The data is often a catalyst for deeper research, debate and collaboration among investment professionals.
Why integrate ESG considerations when investing in government bonds?
The ability of a government to repay bond investors can be affected by “E,” “S” and “G” risks that may not be fully reflected in traditional financial analysis. For example, low levels of corruption, social cohesion, the rule of law and effective government can set the stage for economic resilience and potentially reduce the risk of financial, political and social upheaval. Conversely, from a bond investor’s perspective, less favourable ESG indicators could suggest greater risk that a government borrower struggles to meet its obligations regarding coupon payments and return of principal.
There are challenges in assessing “E,” “S” and “G” risks for sovereigns, compared to other asset classes. Difficulty in obtaining and analysing ESG data and lack of consistency in defining material issues have been cited as barriers for more widespread adoption.3 In addition, some sovereign ESG risks can evolve slowly. Depletion of natural resources, rising inequality and shifting political trends are examples of changes which occur and have impacts that can unfold over many years or decades.
Despite these challenges, there seems to be broader recognition among bond investors that ESG risks have the potential to affect default risk and investment outcomes. Recent academic and industry studies support this claim and demonstrate that ESG scores and sovereign credit ratings are highly correlated.4 In particular, governance and social scores show positive correlations with credit ratings — above 0.81, according to a recent World Bank calculation.5
Our sovereign ESG monitoring methodology: Focused on material risks, recognizing nuance
Capital Group’s monitoring methodology for sovereigns was developed through a partnership between our ESG team and our investment professionals who have experience analysing sovereigns. In addition to in-house collaboration, we reviewed academic research and assessed competitor methodologies to help find the right approach for us.
Sovereign monitoring methodology
Our monitoring process for sovereigns leverages raw scores from three data sources as detailed below.
Capital Group’s proprietary methodology blends these third-party scores and adjusts for gross national income (GNI). Issuers with the lowest scores — either on a GNI-adjusted basis or in absolute terms — are flagged for additional research and review.
The GNI adjustment allows us to assess an issuer’s performance relative to peers with similar wealth. We find this distinction to be increasingly important in addressing the income bias ingrained in ESG scores for sovereigns. According to research from the World Bank,6 average sovereign ESG scores across data providers are highly correlated with GNI per capita, which overly penalizes poorer countries based on their level of development and resources. Improvements in ESG-related metrics are often a natural part of a country’s economic development process; and as such, we believe it is important to evaluate the strength of an issuer’s ESG metrics given their level of economic development.
Our monitoring process is built into Ethos, Capital Group’s proprietary ESG data platform, where investment analysts can view and resolve monitoring flags. For flagged issuers in Ethos, investment analysts share information and perspectives on material ESG risks and how those affect their investment thesis.
We also integrate ESG into our sovereign investment process through our proprietary data analytics platform, EM Live, which is used for exploring relative value and other traditional financial metrics for sovereign issuers. In EM Live, our investment professionals are able to track and analyse the underlying ESG indicators used in our sovereign monitoring process. In addition, in periodic portfolio reviews, our investment analysts review and analyse updates to ESG metrics for issuers in their coverage.
Outside markers indicate stronger governance scores in percentile rank terms from 0 to 100. Inside markers indicate weaker governance scores.
These findings prompted a discussion between our ESG analysts, an equity portfolio manager and members of the company’s board. Specifically, we wanted to understand the reasons behind the decline in employee sentiment and also gain insight into plans to expand the board of directors.
We believe it is important to acknowledge the limitations of these datasets, which are backward looking in many cases and may not cover all sovereign issuers in our coverage universe. Our investment professionals therefore aim to identify forward-looking risks in their proprietary research and to discuss risks and concerns with issuers where possible. Data is not considered in isolation — it’s used to help inform our long-term view and dialogue with issuers.
Why we view the ‘G’ as typically more material for sovereigns
Our proprietary ESG scoring is currently most heavily weighted towards governance metrics for sovereigns. Countries that pursue best practices in “G” standards often have easier access to new financing and lower cost of capital, as governance indicators can directly relate to a sovereign’s ability to repay its financial obligations.7
A multi-country analysis on the impact governance indicators can have on development and growth suggests good governance, such as goverment effectiveness and control of corruption, as measured by the World Bank’s governance indicators, is associated with a higher level of per capita GDP and higher overall rates of GDP over time.8
Monitoring is just one piece of the puzzle
“Monitoring is just one step in our overall ESG integration process, and flags are merely guideposts,“ says fixed income investment analyst Holger Siebrecht. “Improvements or declines are not necessarily linear.” For example, a country’s improving governance data may coincide with deteriorating environmental data. Countries may not progress equally across all areas at once.
Alongside fundamental research and analysis, our investment professionals' local experience is, in our view, critical for developing well-rounded and differentiated investment perspectives. Our commitment to meeting with government officials (in person or virtually) is a distinctive aspect of our research and engagement process. Rather than solely relying on roadshows, our experienced sovereign bond investment analysts and portfolio managers will often visit the countries in their coverage.
“When our investment professionals engage with governments via meetings and roadshows, they will often emphasize the importance of transparency, good governance and adopting international standards,” explains fixed income portfolio manager Kirstie Spence. “Governments that pursue best practices can improve their access to financing and lower their cost of capital.”
For emerging markets, ESG can sometimes be a thorny issue, according to Kirstie: “Because they are often in the earlier stages of industrialization, these countries may, in some cases, struggle with the economic and societal changes that are a necessary part of improving their ESG profile.”
That’s why, in certain instances, our analysts engage directly with sovereigns to gain a better understanding of these ESG indicators. After a flag is raised, our starting point is further research, debate and, in some cases, engagement with the issuer. “Bringing ESG issues to the forefront of discussions enhances our dialogue with issuers and helps us fine-tune our valuations,” says Kirstie.
ESG monitoring in action: three country case studies
As noted, a flag in our monitoring process generally prompts deeper research and analysis by our investment professionals.
Here are three instances where our monitoring process helped inform our sovereign research and analysis:
Angola: Improvements in underlying governance indicators support our investment analyst’s positive outlook for an issuer.
In our review of this country in 2022, our monitoring process indicated that this country was no longer flagged, owing to an improvement in three of the World Bank’s Worldwide Governance Indicators:
- Government effectiveness
- Regulatory quality
- Control of corruption
This prompted one of our investment analysts to conduct additional research to assess these improvements and upon further due diligence determined the following:
- Government effectiveness: The effectiveness of the country’s public finances apparatus appears to be materially better than that of comparable countries.
- Regulatory quality: Improvements around transparency (including data transparency) and the privatization of large parts of the non-core state businesses support stronger regulation.
- Control of corruption: There has been notable improvement in control of corruption since a new political administration came to power.
Following engagement with the sovereign, continuous monitoring and in-depth research and analysis, our investment analyst maintained their positive outlook on the issuer.
Guatemala: Social and governance issues flagged by our monitoring process contributed to a cautious outlook on the issuer.
This country was flagged during our monitoring process due to scoring below our GNI-adjusted target threshold on two primary governance and social indicators:
- Governance: In 2019, the country removed a United Nations-backed anti-corruption body and, as a result, dropped to the 12th percentile for control of corruption, according to the World Bank’s Worldwide Governance Indicators.
- Social: Due to a decline in life expectancy, the country slid to the 34th percentile for this metric, according to the UN Human Development Index.
Our investment analyst conducted in-depth analysis into these issues and believes that:
Potential for corruption may heighten geopolitical risk and hinder the sovereign’s ability to secure funding from the International Monetary Fund (IMF) or multilateral institutions.
The decline in life expectancy was primarily driven by COVID-19; however, social metrics are unlikely to improve in the near-to-medium term due to a lack of funding in public services.
Our investment analyst concluded that the sovereign valuations did not fully compensate bond investors for the overall deterioration in the country’s credit risk, which is due in part to heightened ESG concerns.
Pakistan: Environmental, social and governance issues flagged by our monitoring process support prudent outlook on the issuer.
Our monitoring process indicated that this country has traditionally had low scores across several environmental, social and governance indicators, including:
- Water scarcity
- Weak education system
- Poor governance across several metrics
As a result, the issuer was flagged during our monitoring process and escalated to one of our investment analysts for review.
The investment analyst conducted further due diligence on the issues flagged and determined that these risks were likely to weigh on the country’s future growth prospects.
The investment analyst acknowledged that although there had been some positive reform efforts in recent years, implementation thus far had been poor. In addition, upcoming elections were likely to further hinder the government’s ability to implement improvement measures, in our analyst’s view.
The investment analyst determined that the potential for positive reforms and significant external financial support may support the case for investing, though a high risk premium would be required to make the investment attractive.9
Case study examples are shown for illustrative purposes only. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein.
Monitoring of relevant third-party data is a key aspect of how we integrate ESG into our investment approach. However, investment decisions are always made based on a long-term view, engagement and analysis — never solely on monitoring results.
We are continuing to enhance the ways in which we embed ESG in our overall sovereign investment approach. The ESG data we consider as a part of our sovereign monitoring process may evolve as sources improve.
What won’t change is the reason that we’re making this effort: It is our belief that, by incorporating information on material ESG risks and opportunities into investment research and analysis, we can help to improve long-term outcomes for investors.
1 Fundamental research is a method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors.
2 A sovereign bond is a debt security issued by a national government (the sovereign issuer) for the purpose of financing spending programs.
3 UN Principles for Responsible Investment. "A practical guide to ESG integration in sovereign debt," August 29, 2019.
4 Credit rating: typically ranging from AAA/Aaa (highest) to D (lowest), these are assigned by credit rating agencies such as Standard & Poor’s, Moody’s and/or Fitch, as an indication of an issuer’s creditworthiness.
5 World Bank. "Credit Worthy: ESG Factors and Sovereign Credit Ratings," 2022. Correlation is a statistical measure, which evaluates the strength of a relationship between two variables. The value ranges between -1.0 and +1.0, with +1.0 being a perfect positive direct relationship.
6 World Bank Group. "A New Dawn — Rethinking Sovereign ESG," pp. 18-19. 2021.
7 UN Principles for Responsible Investment. “Shifting Perceptions: ESG, Credit Risk and Ratings.” S&P Global Ratings analysis of 147 sovereigns, local and regional governments, insurers and banks in the two years to July 31, 2018.
8 Xuehui Han, Haider Khan and Juzhong Zhuang. “Do Governance Indicators Explain Development Performance? A Cross-Country Analysis.” ADB Economics Working Paper Series. November 2014.
9 Risk Premium: A risk premium is the extra return that an investor might expect to earn from investing in an asset deemed to be of higher risk.