ESG in Emerging Market Sovereign Debt: What Investors Should Watch

Investing with attention to environmental, social, and governance (ESG) objectives has historically been more common in developed market credit strategies, but more recently, investor focus has shifted toward the crucial role that emerging markets will play in achieving global sustainability goals. And while the analysis of ESG risk is universal and well understood for corporate issuers, it’s less clear how investors should quantify the ESG risk of sovereign bonds and how they can engage with sovereign issuers on ESG issues – and how asset owners can best allocate capital to sovereign bonds in line with their sustainable investment objectives.

Understanding sovereign ESG risk

Within the PineBridge Emerging Markets Fixed Income team we have long integrated ESG risk within our fundamental credit analysis and have formally assigned ESG scores to all emerging market (EM) issuers under our coverage for more than five years. Corporate bond markets are supported by standard ESG reporting requirements and by several dedicated ESG research firms, which provide investors with the data necessary to perform in-depth risk analysis and enable their investment decisions. For sovereign bond issuers, those metrics have historically been harder to define and collate. Yet while few ESG research providers cover or specialize in sovereign issuers, there is a wealth of ESG-related analysis generated by multinational organizations, think tanks, and universities. 

One of the primary challenges when considering the myriad analyses, indices, and rankings of country-level risks is in identifying which indicators are the most informative and predictive. Investors look for indicators that influence economic growth as well as external and fiscal balances over the near, medium, and long term. 

Environmental factors. PineBridge’s Emerging Markets Debt team aims to identify near-term risks from weather hazards, medium-term risks associated with the carbon transition, and the longer-term health and productivity implications of environmental risks. To do so, we reference fossil carbon dioxide emissions data, oil rents (the difference between crude oil production value and the total cost of production) as a percentage of GDP, and the sovereign’s exposure and vulnerability to natural hazards, along with its biocapacity reserves or deficits (referring to the ability to regenerate what the population demands).

Social factors. Social conditions have an impact on a country’s labor force and the stability of its institutions. Income inequality feeds discontent, which can evolve into protest movements that may impede productivity and make a country’s economic growth more volatile. The status of labor rights can have a similar impact on the productivity and sustainability of that country’s workforce. Inequalities and labor rights deficiencies can point to potential near-term risks, while education indices and average years of schooling help indicate the future productivity and skill level of a country’s workforce. The age dependency ratio – the percentage of a country’s working-age population – also helps set expectations for how the aging of a population might affect fiscal balances. Lastly, safe and secure societies are more productive, and the World Justice Project indices help quantify order and security.

Governance factors. Strong economies are built on a foundation of stable institutions, sound policies, and regulation – all areas that rule-of-law and economic freedom indices help to quantify. The stability and predictability of government have a direct impact on sovereign creditworthiness, and Transparency International’s Corruption Perceptions Index provides a view of governmental corruption around the world. Investment is a key building block of sustainable economic growth in emerging markets, and low corruption coupled with good-quality institutions and governance work together to give investors comfort in the relative safety of their assets, which in turn encourages higher rates of investment.

Taking a balanced view across the various risk data and indices allows investors to better understand the current state of risk and to take a forward-looking approach to the impact these factors will have on both economic growth and external and fiscal balances over the near, medium, and long term. 

Engaging with governments on ESG

Engagement with sovereign issuers can pose challenges, as investors do not have the same recourse to the decision-makers as they do in the corporate debt or equity markets, and government interests are not always aligned with those of sustainability-focused investors. However, the investment management industry has been addressing the need for greater leverage by, in many cases, formally organizing and approaching governments as a collective group rather than as individual investors.

The ability to effect change may rely on the sovereign’s dependence on external financing, particularly for smaller or poorer countries. Yet by presenting ESG issues as potential economic risks or paths to more robust, sustainable economic development, the market finds governments are more willing to engage and take investor recommendations into consideration on matters of policy. A powerful example can be found in Brazil, where a coordinated effort among active investors to communicate the risks to future funding and benefits of stronger regulation contributed to policy changes regarding deforestation and protection of the Amazon in 2020.

Investor engagement can also shine a light on important ESG issues that might otherwise go unaddressed in parts of the world where access to information or freedom of the press may be limited. Furthermore, consistently engaging officials on key ESG issues helps inform those governments on how ESG risks impact their cost of capital and their support in the investor community, which should aid in their journey to improved creditworthiness.

Putting sovereign ESG investment into practice

For many investors, the sovereign bond market remains the primary access point to EM debt. This is particularly true for the growing subset of EM debt funds focused on sustainable investment objectives, most of which have a sovereign investment benchmark. To meet growing demand from asset owners and asset managers for sustainable investment strategies, many index providers now offer ESG indices. 

JP Morgan’s suite of EM bond indices are among the most widely used benchmarks, and in 2018 JP Morgan launched the ESG version of its flagship EM Bond Global Diversified Index, which is designed to provide a benchmark for sustainable sovereign bond investment strategies. While the intent is clear, the screening methodology may be more opaque; ESG integration is defined simply as being based on a scoring framework that utilizes Sustainalytics and RepRisk data, where better-scoring issuers are given a larger weight within the ESG index than in the standard EMBI Global Diversified index. Of the 71 countries within the standard index, only twelve – Angola, Ethiopia, Honduras, India, Iraq, Lebanon, Maldives, Mozambique, Nigeria, Papua New Guinea, and Tunisia – are excluded from the ESG index (see table).

Standard Versus ESG-Focused Sovereign Index Weights

Source: JP Morgan as of 31 January 2022. JP Morgan EMBI Global Diversified Index (left column.) JP Morgan JESG EMBI Global Diversified Index (right column.)

Whereas investors in corporate bonds or equities can analyze uniform data with respect to environmental objectives, such as climate change mitigation or adaptation, sovereign investment strategies rely on the discretion of investment managers to decide which governments are best aligned with their clients’ sustainable investment objectives. Looking across the ESG index universe, we believe several countries with meaningful index weights are likely not aligned with such objectives, given concerns regarding environmental and social impact of general governance risks 

Among EM sovereign bond issuers, the strong links between ESG risk and creditworthiness suggest that forward-looking ESG analysis can help identify credits that are improving and offer opportunities for attractive returns. Reform efforts and improvements in risk factors for specific companies and industries may be ahead of official government efforts, including changes to fiscal or regulatory policy, that would improve weaker ESG rankings, and tapping into these misalignments may provide ESG-driven alpha opportunities for portfolios. We believe it’s important for investors to consider, not only on the current state of sustainability risks but also on the trajectory of those risks over the medium to long term, in their ESG analysis of sovereign bond issuers

When it comes to the way that the Emerging Markets Debt Team views ESG risk, where we aim to promote climate change mitigation and adaptation with a careful analysis of ESG risks, we find it challenging to manage a consistent portfolio against the ESG sovereign index universe. We believe investment in sovereign bonds within sustainable investment strategies should be more country-specific in the context of a global portfolio, where investments can span the breadth of EM fixed income markets, both sovereign and corporate. In short, sovereign investment should be focused on countries that are truly aligned with our investment objectives, rather than managed against an index that may itself introduce concerns for sustainability-focused investors. This view enables us to maintain the integrity of our sustainable investment objectives in our sovereign bond allocations, rather than make exceptions to align with the index-defined universe of sustainable sovereign bonds.