ESG integration in sovereigns: insights on institutional strength

By 5 minute read

ESG criteria introduces a whole new set of variables that help identify investment opportunities across asset classes. In the case of sovereign debt, ESG metrics facilitate asset selection, as substantial differences can be found between countries with similar credit profiles.

In a world dominated more and more by being able to process large quantities of information, knowledge is worth as much as the quality of your data and how much sense can be made from it. At the same time, sustainability is challenging governments, corporations and individuals to recognize positive and negative behaviours, in an attempt to reward the first and discourage the latter. The topic of ESG integration in investments sets strong roots in a landscape like this.

In "ESG Integration in Sovereign Portfolios" we explain our approach to ESG integration in more detail. However, having a methodology in place is not enough for an ESG-driven investment process. Once a rating score system is in place, how difficult is it to find relevant indicators that can potentially drive portfolio allocation? Can prospect ESG champions be identified today, and how will that affect their financial profile in the coming years?

Introducing institutional strength

A variable that could offer some insight on future economic developments is institutional strength. In our model, institutional strength is one of the main pillars of governance, along with sustainable policies.

Figure 1: ESG pillars and scores composition. Source: Aegon Asset Management

Institutional strength facilitates better governance and steady structures based on the rule of law, which results in higher reliability, independence and, usually, an accommodative business environment. Besides, improving governance systems ripple through to environmental and social factors, reinforcing policy sustainability. In figure 2 financial credit ratings of a country versus its institutional strength score are shown.

Figure 2: Financial credit rating of a country vs its Institutional Strength score. Size of the bubble represents how high the country spread is versus its benchmark. Benchmark are US Treasury securities in case of USD denominated bonds and German bonds in case of European countries. Source: Aegon Asset Management

A few insights can be highlighted at this point:

  1. As expected, countries with a higher financial credit rating tend to show higher institutional strength scores, a relationship that is well known.
  2. Within credit rating peers, significant differences arise between the highest and the lowest score in this category. Those tend to increase as the credit fundamentals are lower.
  3. And within credit rating peers, spreads versus their benchmark is not at all homogeneous for this category.

Naturally, no single number can describe the reality of a whole economic environment, but it does help to identify inconsistencies from fundamental and valuation points of view.

ESG should not be about how good you are but how hard you are trying

Together with a static score, the development over time is also relevant. In that respect, we define ESG momentum as the average improvement in the ESG score of a certain country during the last 5 years. This metric can be traced back to the specific sub indicator that might be leading or dragging the overall score of an issuer, and thus it is helpful to identify trends in the different aspects of the sustainable agenda of a country.
Following the same logic as we did for institutional strength, we can cross our calculated ESG momentum with the credit rating profile of a country (see figure 3).

Figure 3: Financial credit rating of a country vs its ESG momentum rate. Size of the bubble represents how high the country spread is versus its benchmark. Source: Aegon Asset Management

As can be seen in figure 3, the average per rating peer group tends to gravitate around zero. Within those groups, however, significant differences in the developments of their sustainable agenda are observed. Those differences tend to amplify if we move towards lower ratings, reaching a maximum in the B rating area. Additionally, similar spreads can be observed in countries with both positive and negative ESG momentum, which again facilitates issuer selection.

Integrating ESG criteria into mainstream funds requires complementing a traditional fundamental analysis skillset with a broad range of variables that relate to long term sustainability. Some of those have been a structural part of sovereign analysis (for example, related to governance) while some others offer a fresh new angle when assessing an issuer (like environmental parameters). We expect these themes to become an even more central part of the global discussion, and as such investment professionals will need to understand what its impact is on portfolios.

Jesús Martinez

About Jesús Martinez

Investment manager