Environmental, social and governance (ESG) factors are material to sovereign creditworthiness and investment performance, according to the Principles for Responsible Investment (PRI).
PRI has released a discussion paper exploring the link between ESG factors and credit risk in the US%47 trillion sovereign debt market. Asset owner such as pension funds invest in sovereign debt because of a perceived lower risk profile – the PRI cites a 2013 study by Towers Watson that found the average pension fund has 34% of its portfolio in fixed income.
“While ESG analysis has been applied increasingly to equities, few have put it to the test in fixed income until now,” said James Gifford, executive director of the PRI in a statement. “Stung by market volatility during the euro crisis, institutional investors are now applying ESG analysis to their sovereign bond portfolios and using it in their selection criteria to appoint asset managers. Given the sheer size of the sovereign bond market and compelling evidence that these factors are material to both creditworthiness and investment performance, the challenge is now on others to act.”
The PRI Sovereign Fixed Income Working Group (SFIWG) examined research and discussed issues among themselves, concluding that there is a correlation between ESG factors and credit risk. In the discussion paper, the working group outlines a framework to explore the links between ESG factors and how they should feed into economic factors influencing creditworthiness, and how those economic factors impact on credit risk indicators.
The working group then explored environmental, social and governance issues in recent credit events, such as how governance failings contributed to the euro crisis. The group concluded that while the big three credit rating companies – Moody’s Investors Service, Standard & Poors Financial Services and Fitch Ratings do consider corruption in gauging political risk, those risks were underestimated.
“The working group felt that Moody’s, S&P and Fitch, which together control about 95% of the global market for credit ratings, underestimated or overlooked the importance of corruption,” the paper said. “Under ESG analysis, corruption would probably be given much more attention, analysed as a separate category rather than being subsumed under political risk, and assessed with a variety of data and qualitative information.”
The paper also examined how social factors can play into evaluating credit worthiness – for example, when countries have low levels of political freedom combined with a high degree of social development, countries tend to have greater unrest, according to an analysis done by Maplecroft.
“A strong legal and regulatory environment, high standards of health and education, respect for labour rights and access to quality infrastructure all contribute to economic growth, which promotes stability,” the paper said. “Control over corruption and good governance tend to translate into fewer risks of social and political unrest, and this stability in turn provides a fertile ground for economic growth. Countries displaying poor ESG indicators are often more prone to shocks from natural, social or economic events, leading to greater credit risk. This leaves growth markets including China, India and Russia at high risk of being downgraded. Conversely, improvement in these ESG factors enhances the outlook for long-term growth, which in turn reduces risk.”
The report concluded that environmental factors had the weakest correlations with sovereign bond performance, and that there is difficulty in agreeing what indicators should be sued to measure environmental risks in the context of sovereign fixed income.
The working group also want the credit rating agencies to use ESG analysis to inform sovereign debt ratings in a more systematic way, taking into account quantitative and qualitative criteria.
“Whatever any individual investor does to determine creditworthiness by using traditional financial and ESG analysis, the market as a whole will continue to be influenced by credit ratings agencies,” the report said. “Members of the working group expressed concern that Moody’s, S&P and Fitch, which together control almost the entire credit rating market, failed to see the risks that led to the 2008-09 global credit crunch. Is there any reason to trust their ratings and assessments now?
“Working group members suggested engaging with the credit rating companies to convince them to incorporate ESG factors into their assessment criteria, even though they are not expecting instant results. The reply from the credit rating companies suggests they are not about to pour resources into areas that would to some extent mean departing from an approach that has served them for decades.”
The PRI Sovereign Fixed Income Working Group included representatives from AEGON Asset Management, AllianceBernstein L.P. Allianz Global Investors, Allianz SE, ASR Nederland N.V., ATP, AXA Investment Managers, Bank J. Safra Sarasin AG, Bloomberg L.P., BlueBay Asset Management LLP, Breckinridge Capital Advisors, Danske Bankm Deutsche Bank Advisors, Generation Investment Management LLP, Global Evolution, Hermes Fund Managers Limited, HSBC Global Asset Management, Maplecroft, MN, MSCI, oekom research AG, Pension Protection Fund, PIMCO, Skandinaviska Enskilda Banken (SEB) AB, SNS Asset Management, Stichting Philips Pensioenfonds, Sustainalytics, Trucost, UNEP Finance Initiative, Union Investment, Unipension Fondsmaeglerselskab A/S, University of St. Andrews, and Vigeo.