Missing Pieces

A Better Approach to Sovereign ESG Analysis

09 November 2020
2 Minute Read

What You Need to Know

ESG integration has built considerable momentum in recent years, but the case for incorporating ESG in sovereign-credit analysis isn’t always clearly articulated. In developing a more rigorous ESG model, we’ve created a framework that enhances traditional sovereign-credit analysis and provides fresh insights into the drivers of long-run economic performance.

Environmental
Pillar is missing from many sovereign ESG proxy measurements,
making them less comprehensive
50%
Weighting for governance pillar
in AB’s enhanced sovereign ESG scoring framework
0.5
Value for R2 between AB’s social score and a GDP-per-capita proxy,
indicating the broader information span of AB’s sovereign ESG model
Authors

A SHORTFALL IN ESG ANALYSIS

Responsible investing has built considerable momentum in recent years, as investors have recognized that environmental, social and governance (ESG) considerations can help them meet their social responsibility goals and have a meaningful financial impact on their investments.

The case for integrating ESG considerations into equity and corporate-credit research is well understood. However, the important role that ESG factors play in driving sovereign-debt performance and broader economic and financial outcomes has not been articulated as clearly.

To address this shortfall, we set out to develop a framework that could measure and monitor sovereign ESG characteristics more effectively. In the process, it became clear that the ESG pillars are more important than we initially thought. Put simply, they capture all the factors likely to determine long-run macroeconomic performance.

HURDLES IN APPLYING SOVEREIGN ESG ANALYSIS

Before discussing AB’s approach to macro and sovereign ESG, it’s worth providing a brief description of the conventional approach.

It’s widely agreed that incorporating ESG factors helps improve sovereign-credit analysis. But there’s a clear pecking order: governance is widely regarded as being the most important factor, followed by social, and environmental considerations receive less attention—though that’s starting to change. As a result, sovereign rating agencies and fixed-income managers can rightly claim that they’ve been applying a primitive version of ESG in their sovereign-credit analysis for many years.

But is this enough, or can we move the needle further? Is there a more robust approach that can enhance traditional sovereign-credit analysis and provide a better assessment of potential financial outcomes? Those are the questions we sought to answer.

ESG PILLARS: THE BUILDING BLOCKS OF GROWTH

In conducting our research, we started with different questions: Why do we need to monitor ESG factors when we already use a wide range of higher-frequency indicators that do much the same job? Wouldn’t that be double counting? After all, many social factors are highly correlated with GDP per capita. And strong governance is likely to influence better economic performance, including more sustainable external and fiscal balances.

We quickly resolved this conflict when we realized that ESG isn’t an alternative approach to traditional economic or sovereign-credit analysis. Instead, it’s actually the foundation upon which long-run economic performance is built. To understand why, we first need to go back to the basics and the economic factors of production: natural resources, labor and factors governing the efficiency with which they are used.

The United Nations Principles for Responsible Investment (PRI) laid out a framework mapping economic growth factors to ESG pillars in its 2013 white paper, Sovereign Bonds: Spotlight on ESG Risks (Display 1).

A table illustrating how economic growth factors connect to environmental, social and governance pillars.

The environmental pillar is a list of natural resources and, more frequently these days, natural barriers to growth. The social pillar includes factors such as demographics, education and employment: in other words, factors that determine the quantity and quality of labor. And the governance pillar focuses on factors that are likely to determine how efficiently the other two pillars are used.

In short, the ESG pillars contain just about every factor likely to affect a country’s longer-term prospects. It would therefore be hugely surprising if ESG scores weren’t highly correlated with economic outcomes.

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