ESG in emerging markets sovereign debt

May 2, 2024  
By Alex Kozhemiakin, Cathy Elmore

Executive summary

This is an update of our ESG in Emerging Markets Sovereign Debt paper (the Paper), originally published in December 2019, in which we made the case for a more nuanced approach to the consideration of environmental, social, and governance (ESG) factors in sovereign analysis. Since then, a study by a group of World Bank researchers has broadly supported our argument.¹

Practitioner approaches to sovereign ESG tend to extrapolate from the more established corporate ESG analysis by identifying sovereign analogues to corporate ESG factors and then using them to rate countries. This approach overlooks the fact that sovereigns differ from corporate entities on at least two dimensions: factual and our definition of ethical standards. 

From a factual standpoint, social and governance scores for sovereigns correlate with credit quality, whereas corporate ESG scores do not. From an ethical viewpoint, we believe it is acceptable (in fact necessary) for corporates to go out of business. In contrast, sovereign states are generally protected because when states fail, the socioeconomic costs can be very high and ethically undesirable. 

The factual and ethical differences detailed in the Paper demand a more nuanced approach to sovereign ESG, which we reflect in our EMD ESG model for sovereigns:

• Social (S) and governance (G) scores for sovereigns resulting from a ranking approach using ESG credentials should be adjusted for their level of development before an exclusion approach is applied.
• Changes in income-adjusted ESG scores should be considered a reflection of effort
• Poor countries should not be punished as much as rich countries for low environmental (E) scores.

In sum, we believe that a more thoughtful approach to sovereign ESG provides better investment insights and results in more ethical portfolios. For Macquarie’s ESG-oriented, global investment performance standards (GIPS)-compliant emerging markets debt strategies, such as Macquarie Emerging Markets Debt (EMD) Select Opportunities and Macquarie EMD Sovereign ESG (both are available as SICAVs and classified as Article 8 under the European Union’s Sustainable Finance Disclosure Regulation (SFDR)), as well as Macquarie EMD Green Opportunities classified as Article 9, we exclude the bottom quartile of countries in our EMD “universe” via their income-adjusted scores in our proprietary model, based on any of the E, S, and G categories.

Introduction

Over the past 30 years, the consideration of ESG factors in portfolio investment decisions has moved from the fringes of finance to the mainstream. Starting exclusively in the realm of equity investing, ESG has gradually spread to corporate debt analysis. As a result, many companies trying to obtain financing today, regardless of whether it is equity or debt, are forced to consider how they are faring with respect to ESG. 

Unlike companies, sovereign entities are not for sale, but they do borrow. Widespread attempts are now being made to apply ESG principles to sovereigns, specifically emerging market (EM) countries, which are normally facing higher borrowing costs than their developed counterparts. In 2019, for example, United Nations Principles for Responsible Investing (PRI) – the most prominent global organisation dedicated to ESG – published “A Practical Guide to ESG Integration in Sovereign Debt” designed to help PRI signatories integrate ESG factors into the analysis of sovereign debt issuers. Similarly, the World Bank launched an online portal to simplify access to sovereign ESG data for bond buyers. As shown by their publicly available marketing literature, many EMD managers, ostensibly spurred by the regulatory changes in the EU and the perceived market demand, are also jumping on the ESG bandwagon. But the World Bank’s “Demystifying Sovereign ESG” research paper notes that while sovereign ESG scores are converging, there remains a wide divergence, and asset managers are pursuing different objectives for integrating sovereign ESG into their investment decisions. While these objectives are attracting increased scrutiny – accusations of “greenwashing” are becoming louder, for instance – vigilance is still warranted.

Practitioner approaches to sovereign ESG tend to extrapolate from the more established corporate ESG analysis by identifying sovereign analogues to corporate ESG factors and then using them to rate countries. For example, the World Bank’s sovereign ESG dataset includes, among other useful information, country data on emissions and pollution, natural capital management, and energy use to help make an informed assessment of E; data on education, health, and poverty for S; and data on human rights, gender equality, and the rule of law for G. We believe the mechanical application of this data, however, ignores important differences between sovereigns and corporates. 

With respect to ESG, sovereigns are distinct from corporate entities on at least two dimensions: factual and our definition of ethical standards. We explain these differences below. The consideration of these differences leads us to conclude that sovereign ESG requires a more nuanced approach than what currently prevails.

Different facts

While the ESG characteristics of corporates normally show no strong correlation with their credit rating quality, the social and governance (SG) attributes of sovereigns correlate strongly with their credit because countries with higher income (gross domestic product (GDP) per capita) have better SG characteristics as illustrated in Figure 1.

Causality runs both ways. Richer countries have more impressive social and institutional characteristics. For example, their populations are healthier, they take fuller advantage of the contributions of women, and they are more democratic, with a stronger rule of law. There is an extensive body of literature in social sciences (known as the “theory of modernization” pioneered by Seymour Martin Lipset in 1959) arguing that economic growth promotes democracy. Yet, it is true that it is exactly these characteristics that also enable countries to grow richer. According to the more recent academic studies (for example, Robert J. Barro’s “Determinants of Economic Growth: A Cross-Country Empirical Study,” MIT Press Books, 1998), for a given starting level of real GDP per capita, economic growth is enhanced by higher education, lower fertility, and better rule of law, among other variables.

The outliers in this relationship of causal endogeneity between GDP per capita and SG characteristics are oil and gas producers. These are shown in Figure 1. Simply put, the energy-exporting countries are rich not because of their social and institutional characteristics but because they have been graced with an exceptional natural endowment.

In turn, for sovereigns, the GDP per capita is the best single predictor of their credit quality. As a result, higher-rated sovereigns score better on SG and vice versa. This is why some veteran emerging market sovereign analysts (including us at Macquarie who started in the mid-1990s) say that they focused on SG long before ESG became popular.

We should note that this factual difference is potentially problematic as the structural preference for countries with better SG characteristics would mean, in practical terms, having less exposure to lower credit quality, higher-yielding sovereign issuers. This is likely to lead to subpar investment results over the market cycle.

Different ethics

Ethical investing is an investment approach that seeks to generate returns while also considering the ESG attributes of issuers. The logical result of wider and more consistent consideration of ESG factors in portfolio investment decisions is that it makes it more difficult (expensive) for corporate entities with less favourable ESG characteristics to obtain financing. Applying the brute-force logic of finance to advance broader objectives of society via implementation of ESG is ultimately based on the premise that it is ethically acceptable for corporates that do not adapt to shrink or entirely go out of business. The premise clearly does not apply to sovereigns.

In the market economy, it is acceptable (in fact necessary) for corporates to go out of business. In contrast, the modern international system (dating back to the Westphalian Treaties of 1648) is designed to protect sovereign states. When states fail, the socioeconomic costs can be very high and ethically undesirable. When companies close down, their employees can potentially find jobs elsewhere in their country, though barriers to this are higher for older and less mobile workers. When states fail, they produce refugees who are the true outcasts of the modern international system

Hypothetically, we would run into a similar ethical problem if we started using ESG-inspired principles in personal finance. In our view, it would be ethically questionable to restrict financing to individuals with less education, who are in poor health, and who cannot afford electric cars.

Our solution

These factual and ethical differences between sovereigns and corporates necessitate a more nuanced approach to sovereign ESG, so we offer the following three principles:

1. SG scores for sovereigns should be adjusted for level of development.

We believe that we should not punish poor countries for their SG characteristics. Instead, we consider SG in relation to the country’s level of development, captured by GDP per capita. We hold richer countries to a higher standard. Operationally, we regress SG scores of countries on GDP per capita (which we consider separately in our sovereign assessment) and focus on the residuals.

2. Changes in income-adjusted ESG scores should be considered as a reflection of effort.

We believe that, given the ethical differences between sovereigns and corporates, changes in income-adjusted sovereign ESG scores should be considered in addition to their levels. The changes reflect their effort, and we believe it is important to acknowledge the countries that take steps in the right direction (and highlight those that do not).

3. Poor countries should not be punished as much as rich countries for low E scores.

In contrast to SG, E scores for sovereigns exhibit no correlation with the credit quality as illustrated in Figure 2

In our view, the environment is not just a “first world” problem but, again, richer countries, whose basic socioeconomic needs are already met, should be held to a higher standard.

Investment insights

In addition to accounting for the differences between sovereigns and corporates, we believe our approach to sovereign ESG offers greater analytical clarity and therefore has the potential to provide better investment insights compared with an approach that doesn’t necessarily account for these differences. For example, it is useful to understand how much of a country’s SG profile is due to its level of development and how much of it is due to the “unjustified” improvement or detraction relative to where it should be (that is, relative to the “universe”). If there is a large negative residual (for example, Russia, Turkey, or Saudi Arabia), what does that tell us about the institutional characteristics of the country? Similarly, improvements in the ESG scores can be signs of prudent, competent policy making, which is an important component of sovereign assessment. In a sense, considering changes in ESG and to the income-adjusted levels is similar to how the International Monetary Fund (IMF) focuses on primary fiscal surplus (which strips out the interest cost of debt that has already been accumulated) in its country lending programs, as an indication of policy effort.

Implementing our ESG approach

We rank the emerging market debt (EMD) universe – all countries in the industry standard EMD J.P. Morgan benchmarks and others for which we can access data – across each of the E, S, and G components using 20 variables, all publicly available (see Figure 3). 

As shown in Figure 3, we use both the latest data and five-year changes, and we adjust for income. From the resulting ranking, the bottom quartile of the list is excluded from mandates. Triggers can come from any of the three categories (see Figure 4 for the 2024 update). To reduce volatility from countries that are on the cusp, oscillating in and out of the exclusion list, we adjust it annually and allow a six-month buffer to implement portfolio changes so that we minimize the impact on portfolio performance. 

It is worth noting that Russia scores badly across two of the three ESG metrics; poor practices predated the recent war with Ukraine, although this seems to have been a wake-up call to other organisations’ ESG monitoring. As a result of the war (and an example of how our methodology is evolving over time), we have included a new binary “land grab” variable in the S category, which results in automatic exclusion.

Given that many of the countries in Figure 4 have significant external bond issuance, excluding these countries removes 35% of the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified market capitalisation. While this can increase the concentration of resulting portfolios somewhat, it does so to a lesser extent than might be envisaged due to our approach to emerging markets corporates. Where there are privately owned corporate issuers (that is, not controlled by the government) that score well on our (separate) corporate ESG metrics in a country that is on the excluded list (for example, a telecom provider in Turkey), we can add these to the ESG-oriented portfolios. At the same time, we consider quasi-sovereigns (i.e. entities with more than 50% ownership by the state) as sovereign “alter egos” and therefore exclude them if their respective sovereigns are excluded. As an additional prudent step, in line with our corporate ESG assessment, we screen quasi-sovereigns for any severe ESG controversies, as the ESG characteristics of certain state-owned entities can be worse than the more general ESG attributes of their sovereigns. If we find that relevant severe controversies are present and have not been adequately addressed, we exclude these quasi-sovereigns from the portfolio, even if their respective sovereigns are not excluded.

Yield – an unintended consequence

A positive but unintended consequence of our income-adjusted approach to sovereign ESG is that the exclusions do not necessarily lower the portfolio yield. This is because the income-adjusted approach does not indiscriminately punish poorer countries, which tend to have a lower credit quality and higher yields. Our sovereign exclusions include highyielders (Argentina, Mongolia, and Iraq) as well as low-yielders (Kuwait, Qatar, and Saudi Arabia).

Our ESG commitment

In sum, we believe that the thoughtful approach to sovereign ESG articulated here provides strong investment insights and results in more ethical portfolios. 

The use of publicly available, consistent data, with a clear methodology that is purely quantitative adds rigour. The income adjustment allows some leeway for countries earlier on their development path.

The field of sovereign ESG continues to develop, and we acknowledge that more accurate data are becoming available over time. We consistently review our sources and methodology to ensure we are best capturing this important approach.

Appendix – the EMD ESG model

The ESG model is used to rank countries according to their ESG credentials. For our ESG portfolios under Article 8 or Article 9, the bottom quartile of countries (including majority-owned quasi-sovereigns from these countries) in the model are excluded as appropriate holdings. 

How the model works:

•  We include the broadest universe of EMD sovereigns for which we can collect sufficient data points across the chosen variables. 
• For each variable, the countries are ranked from best to worst in terms of both the latest data point and five years ago to capture the current situation and the change over time. A simple average score is produced for each of the E, S, and G variables per country.
• Each E, S, and G score is income-adjusted to penalise richer countries for having the means but not doing more and benefit poorer countries that have a more limited capability.  
  • For the income-adjusted E score, if the E score and the GDP per capita at purchasing power parity (PPP) exchange rates are below the average, we give an uplift to the score. 
  • Given the high correlation of S and G with GDP per capita, we calibrate where the S and G scores “should” be with respect to each country’s GDP per capita at PPP and use the difference with the actual score.
• To create the final scores, the latest score and the five-year change are combined. 
• To produce the exclusion list, an iterative process is used to exclude the bottom quartile based on poor scores in each of the categories (we do not presume to favour any of E, S, or G).

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The Emissions Database for Global Atmospheric Research (EDGAR) is a joint project of the European Commission Joint Research Centre and the Netherlands Environmental Assessment Agency which estimates emissions of all greenhouse gases, air pollutants and aerosols.

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