Despite its size and importance, the sovereign debt market has been the subject of less systematic environmental, social and governance (ESG) consideration than other investment asset classes. However, appetite for ESG integration is growing among investors, with a rising number appreciating that ESG factors can and do affect sovereign debt valuations[1]. At Colchester we believe that traditional sovereign balance sheet analysis should be supplemented with a systematic integration of ESG factors to allow us to fully assess the financial stability of those developed and developing markets in which we may invest.
We assign countries a proprietary Financial Stability Score that combines an assessment of their overall balance sheet strength and ESG factors. We have separate bond and currency scores for each market which range from +4 to –8. A country may be excluded from the investment universe, where it has an inappropriate level of financial stability for the relevant asset class, or there are some other factors that suggest it is inappropriate for us to put our client’s money at risk there. We believe that countries with stronger governance, healthier and more educated workforces, and higher environmental standards tend to produce better economic outcomes. Typically, this leads to more stable debt and currency paths and ultimately better risk-adjusted returns.
There are clear differences when it comes to engagement as a sovereign investor compared to other asset classes such as equities. Unlike those asset classes where shareholders can use annual general meetings and their voting rights to engage and challenge corporate management, sovereign bond investors do not have “votes” and can only make an impact through engagement or, at an extreme, by withholding capital. The latter is only effective if there is collective commitment to do so. Accordingly, Colchester puts great emphasis on engaging with sovereign issuers in an effort to encourage best practices.
While a sovereign investor may wield less direct influence, we believe we can still play an important role in driving change through encouraging more targeted action to progress the country’s ESG agenda, discussing funding needs for ESG-related reforms, and offering our opinions on how issuers can address balance sheet and ESG concerns.
Integrating the E, S, G
Governance
As sovereign investors, we have long recognised the importance of how markets are governed and the impact this has for financial stability. Unlike a company, where governance can be considered by the actions of a board of directors, sovereign governance is broad reaching, and the economic management is often undertaken by several institutions. The assessment of sovereign governance therefore requires a broad assessment of factors to build the overall picture of how a market is being managed.
The quality of governance is indicated by factors such as government effectiveness, credibility of institutions, the rule of law and control of corruption, and has a direct bearing on the government’s ability and willingness to repay its financial obligations. Strong governance also promotes stronger economic and social outcomes. The corollary to good governance is fiscal transparency and ultimately how decisions relate back to the financial balance sheet of a market. Fiscal transparency helps to foster better overall economic governance by providing legislatures, markets and citizens with the information they need to hold governments accountable.
Governance factors differ between markets. They take on additional importance in countries with considerable resources that may generate significant wealth, such as fossil fuel, minerals, etc. Resource governance, for example, can be an important consideration for countries such as Norway, Mexico and Russia.
Turkey is a prime example of governance concerns overriding macroeconomic considerations. It may be surprising to some investors that the government financial position for Turkey is in a relatively good standing for an emerging market country, albeit certain metrics are now also weakening. The healthy domestic balance sheet position is marked with a relatively low level of debt compared to the size of the economy (in April 2021 the IMF estimated that net government debt to GDP is likely to be 34% at the end of this year). Fiscal spending has increased over the last few years, with the aim of aiding economic growth. Our external balance sheet assessment for the country has been more negative over recent years given the negative current account position is largely supported by portfolio investment flows, which creates a vulnerability for the currency. However, the rise of power from incumbent President Erdogan over the last several years has brought significant governance and other policy concerns. We have witnessed the slow but steady unwinding of the independence of many Turkish official institutions, including the Judicial System, the imposition of emergency measures, limits placed on reporting, and the influence over the central bank. This led to progressively negative Financial Stability Scores over the last several years for Turkey.
Environmental
Colchester recognises that climate change will have a profound impact on the global economy. As average temperatures around the globe continue to rise, the consensus across the scientific community is that human activity is the cause of long-term changes to temperatures and weather patterns – largely due to greenhouse gas emissions. In our view, climate-related risks are significant, as are the costs to transition to a low-carbon or more sustainable future. As sovereign bond investors, we need to be cognisant of these risks and seek to incorporate them into our investment analysis, recognising that different economies are likely to be impacted in different ways, and that policymakers can influence and mitigate the negative impacts through well-considered policy choices today. Some of the environmental factors we look at in our assessment include both transition factors such as CO2 emissions, energy intensity of GDP and renewable energy generation and physical factors such as those measured by the World Risk Index[1], Yale Environmental Performance[2], and Resource Governance.
Green bond issuance has been one of the themes of our issuer engagements this year. For example, we discussed in our interaction with the New Zealand Local Government Funding Agency (LGFA) the challenges they faced in building a sustainable bond framework given that LGFA is a conduit for local council funding (and proceeds are unlikely to be earmarked specifically for one project). We shared our insights on some of the frameworks we have seen with Nordic LGFA green bonds and green bond issuance from the European Bank for Reconstruction and Development (EBRD).
Social
Social factors and the quality of human capital are key determinants of a country’s long-term economic growth. Measures of a country’s demographic, education, income inequality and social cohesion can inform its potential for economic progress. In particular, education is a core feature of any country’s ability to progress. Education provides knowledge and skills to the population; it is also an effective tool for reducing poverty and fostering broad socio-economic development.
The quality of education has been a constant issue discussed in our engagements with the sovereign, multilateral organisations and local institutions. In a recent meeting with a large multilateral organisation, we discussed the structural constraint the quality of education was placing on an economy. Consistent with our thinking and efforts, the organisation noted their concerns and discussed their own direct engagement with the sovereign on this matter. Examples of other social factors we look at in our assessment include indicators such as the Gini income inequality, labour standards, quality of education, life expectancy and demographics.
To sum up, Colchester strongly believes engagement can help drive positive outcomes and we take this responsibility seriously on behalf of our investors. Furthermore, we holistically integrate ESG factors into our valuations and hence into portfolio construction through the Financial Stability Score.
As a government bond investor, our engagement necessarily differs from that with a company. We recognise the “sovereignty” of the issuers we are engaging with and are sensitive to the different cultural and economic conditions of each country. The focus therefore is often on having a dialogue with a country to better understand their national priorities and to seek greater transparency in their sustainability efforts.
This article should not be relied on as a recommendation or investment advice. Colchester Global Investors Limited is regulated by the UK Financial Conduct Authority, and only deals with professional clients. https://www.colchesterglobal.com for more information and disclaimers.
[1] The World Risk Index is the product of a close cooperation between scientists and practitioners, it was developed by Birkmann and Welle for the Bündnis Entwicklung Hilft (The Alliance Development Works). For further informatiom, please see https://www.ireus.uni-stuttgart.de/en/institute/world_risk_index/
[2] The Environmental Performance Index (EPI) is constructed through the calculation and aggregation of 20 indicators reflecting national-level environmental data. For further information, please see https://epi.envirocenter.yale.edu/
[1] Please see PRI – A Practical Guide to ESG Integration in Sovereign Debt. A practical guide to ESG integration in sovereign debt | Technical guide | PRI (unpri.org)
For Alicia Miguel Serrano