Environmental, social, and governance (ESG) factors are increasingly influencing asset allocation strategies, with many investors actively seeking out companies with strong ESG ratings. A growing number of rating agencies and investment firms specialise in tracking the ESG performance of companies. These ratings employ specialised metrics and frameworks to help investors identify and evaluate the ESG risks and opportunities of businesses, allowing them to align their investments with their values and objectives. But the lens of ESG analysis isn't solely focused on corporations. In recent years, investors have increasingly scrutinised sovereign bond issuers, which are national governments issuing debt securities.
Sovereign bonds are one of the largest and most important asset classes in the world, with approximately $64tn1 in bonds backed by governments across the world. The issuance of green, social and sustainability (GSS) bonds by sovereigns has seen a significant uptake over the last few years, especially after the COVID pandemic2.
Several sovereign ESG indices exist. For example, the World Bank has a sovereign ESG data portal capturing 135 indicators for 211 countries. This exhaustive database mainly consists of quantitative indicators such as country-level CO2 emissions or child mortality rate. Additionally, several financial service providers have their own ESG indices that specifically cater to investors by focusing on ESG factors’ impact on the creditworthiness of a sovereign.
Building a sovereign ESG index is a complex undertaking that requires expertise in index building. We highlight a few issues:
Incomplete and inconsistent country-level ESG data: The dearth and inadequacy of ESG data for sovereign issuers, particularly in emerging markets, pose a significant challenge to comprehensive and accurate assessments. Inconsistency, incompleteness, and unreliability of data are pervasive issues, further compounded by inconsistencies in definitions, data sources, methodologies, and temporal coverage. This diversity makes comparisons of apparently similar ESG indicators very difficult. For example, several sovereign ESG indicators might be based on nation-wide household surveys that are expensive to run, leading to some nations running them irregularly, or not running them at all, which leads to data incompleteness or a lack of temporal coverage. Moreover, some of the decisions are taken at sub-regional levels so national level data may not fully reflect the situation. An example is California, which is much more advanced on ESG issues than the United States on average.
There are no standardised frameworks: The approach and structure for ESG rating on sovereign bonds currently lack a standardised and universally agreed-upon process. Instead, it remains a subjective and qualitative exercise, influenced by the assumptions, judgments, and preferences of each provider and user. An example of this subjectivity is the notable correlation between sovereign ESG scores and a country's GDP per capita. This correlation frequently leads to emerging countries receiving disproportionate penalties for lower ESG scores compared to high-income countries. This occurs even though some of these emerging nations demonstrate strong performance in ESG metrics relative to their income levels.
Contextual materiality matters: ESG ratings for sovereign bonds may not adequately account for the materiality and relevance of ESG indicators for each sovereign issuer, as these indicators can vary based on the context, perspective, and the scope of analysis. Unique circumstances and distinct ESG challenges faced by countries often defy a one-size-fits-all approach. For instance, a country heavily reliant on fossil fuels may prioritize concerns related to air and water pollution, carbon emissions, and the transition to renewable energy sources. Similarly, in a nation marked by high income inequality, social materiality may revolve around issues like access to education, healthcare, and social safety nets.
Overcoming these challenges requires a thoughtful and comprehensive approach. Let's explore key factors to consider when building a sovereign ESG index that not only navigates the pitfalls highlighted earlier but also offers a more nuanced and accurate reflection of a country's commitment to sustainable and responsible practices.
The Need for Policy Indicators:
Traditional quantitative metrics may not sufficiently capture the complexities of sovereign ESG performance as these do not assess a government’s actual commitment to ESG principles. Instead, policy indicators provide a more comprehensive assessment of a country's commitment to sustainable and responsible practices. By evaluating government ESG policies, the index can capture the broader context in which ESG issues are addressed. Additionally, policies often have a more lasting impact than short-term initiatives. Assessing policy indicators allows for a focus on long-term sustainability, as governments are likely to prioritize and commit resources to policies with lasting effects. Moreover, policy commitment is key to future returns on ESG-related investments and measuring this requires a dedicated approach, which we discussed during a session at Building Bridges. At Horizon Group, we specialise in formulating and assessing policy indicators that allow us to craft indices that go beyond traditional indices with only quantitative indicators.
An example of ESG policy indicator
Integrating ESG Controversies:
While quantitative data forms the backbone of sovereign ESG ratings, it has some inherent limitations. One key limitation is that quantitative data is mostly self-reported and hence ESG indices relying solely on quantitative data take an inside-out approach to rating a country’s ESG performance, an approach that fails to capture the nuances and complexities of a country’s ESG performance. To address this limitation, it is essential to integrate an outside-in approach with the conventional inside-out method, and a key step in this direction is the inclusion of ESG controversies in the index. These controversies bring in the perspective of stakeholders external to the government. They can uncover hidden vulnerabilities or trade-offs, highlight policy gaps, and amplify the voices of marginalised stakeholders, giving a more complete understanding of a country's ESG trajectory.
Leveraging Surveys:
Engaging with a diverse range of stakeholders, including businesses, NGOs, and local communities, is critical to understanding the diverse interests and concerns that shape ESG dynamics in a country. Surveys function to systematically collect firsthand perspectives, ensuring that the sovereign ESG index captures the collective voice of those directly or indirectly affected by policy decisions. Unlike quantitative indicators that might not be up-to-date, surveys can be used to gauge the pulse of various stakeholders, including the public, investors, and experts, regarding a country's ESG efforts.
Horizon Group specialises in designing and implementing country-level surveys that offer a comprehensive view of stakeholder sentiments on a variety of matters.
Sovereign ESG ratings face complexities, but the solutions offer immense potential. Integrating policy indicators, stakeholder voices, and ESG controversies can rewrite the sovereign ESG narrative. The need of the hour is to move beyond mere numbers to a world where nuanced ESG assessments guide governments, empower citizens, and drive responsible progress for all.
References
[1] International Capital Market Association data (as of August 2020)
[2] Gong Cheng & Torsten Ehlers & FrankPacker, 2022. "Sovereigns and sustainable bonds: challenges and new options," BIS Quarterly Review, Bank for International Settlements, September.
