Sovereign ESG: Breaking Investment Biases

By Lazar Karapandza, SI Research Senior Analyst

Climate change, the evolving financial landscape, and better data have pushed sustainability into the investment spotlight, amid a global recognition that a broader perspective in investments brings benefits. Sustainability is not just mainstream for investors – it’s expected to be embedded in risk models.

Initiatives that have helped to usher in that transformation on a global level include:

1. The industry-led Taskforce on Climate-Related Financial Disclosures (TCFD), launched by the Financial Stability Board (FSB)
2. The EU High-Level Expert Group (EC-HLEG) on Sustainable Finance, established by the European Commission
3. The Network of Central Banks and Supervisors for Greening the Financial System (NGFS)

In the process, financial institutions and market participants have focused on integrating Environmental, Social, and Governance Pillars (ESG) in risk analysis. As a result, they now request and expect investors to consider and integrate ESG in all major asset classes.

Coming under the global spotlight has also resulted in more scrutiny and more questions being asked. How models are constructed, how data is collected, why certain countries rank better, etc. have all become justified and important questions. Despite all the benefits and wide use, the methodologies adopted so far could respond more efficiently to some of the most pressing questions and concerns.

Changing the approach could be key, and three problems have been identified as the most critical ones.

First issue is the so-called Ingrained Income Bias (IIB).[1] Studies have found that countries with high ESG scores also rank high in income and development levels. While not entirely surprising, there is nonetheless an expectation that ESG scores might capture some aspects of sustainability distinct from countries’ economic development levels.[2]

Second one is Data Lag/Timeliness. While the models are frequently updated, timely data collection still presents a challenge. Most providers rely on national sources and international organizations to obtain the data, however, those sources’ reporting lags. Although there is some inertia in ESG data, some shocks could occur and would not be properly reflected in due course.

Last, investment horizons are a challenge as well. Normal business cycles are measured over a few years, the political cycle is a four to five-year period, and regulators or central banks often look out two or three years ahead. All of those timespans are considerably shorter than the horizon over which the impacts of climate change and ESG constraints will manifest, resulting in the now famous Tragedy of the horizons.[3]

These issues lead to a question: “How can Sovereign ESG transform and respond more fittingly to the main concerns raised by the key stakeholders?”

First to be tackled is Ingrained Income Bias. Our in-house developed model, Sovereign Risk Monitor (SRM), currently uses IMF country classification based on their level of development. However, Gross National Income (GNI) is a more accurate metric and should be used as a measurement of an overall economic condition of a sovereign. That assumption is made because GNI encapsulates an economy’s total income, including one derived from investments in foreign business.

Second, Data Lag and Timeliness need to be properly addressed. Within the current SRM methodology, data points missing due to a lag are replaced with the values from the last quarter for which the data exists. However, for some indicators data lags up to three years, and the consensus is that within that timeframe sovereigns can go through a considerable transformation. ESG indicators and raw data can appear static at times and not show the real rate of improvement or worsening. Therefore, incorporating a momentum factor is the key, and looking at the overall trend is crucial in observing the holistic picture of how sovereigns are performing.

Last, in dealing with the Tragedy of the Horizons it is important to recognize that E, S, and G do not have the same importance short, medium, and long-term. Currently, the weights of each pillar are equivalent, regardless of the time horizon. However, in the short-term, Governance is the most important driver of success. In the medium-term, Social factors become more important, and in the long-term, it is the Environment that takes the lead. Such an assumption is based on the fact that the horizon of technocratic authorities is typically two to three years, the horizon of the decision-makers four to five years, and the business cycle of environmentally impacting sectors around a decade.[4] Recalibrating the model to reflect these drivers, is critical in getting all the key actors to realize that ESG is not just about the progress due in a decade or more, but that short-term actions do matter.[5]

It is important to note that each of these proposed changes is like the piece of a puzzle, which could, once completed, give us a more robust, accurate, and grounded model: we will be tabling papers addressing those issues in the coming months.

For the investors who want to manage ESG risks in a more efficient way, producing more innovative solutions should be the best way forward.

[1] Ekaterina M. Gratcheva, Bryan Gurhy, and Dieter Wang. 2021. “1% Growth in Natural Capital: Why it Matters for Sovereign Bonds.”EFI Insight-Finance, World Bank, Washington, DC.

[2] Ekaterina M. Gratcheva, Teal Emery, and Dieter Wang. 2020. “Demystifying Sovereign ESG” EFI Insight-Finance. Washington, DC: World Bank.

[3] Carney, Mark. 2015. “Breaking the tragedy of the horizon – climate change and financial stability”.

[4] Ibid.

[5] Soledad Lopez, Navindu Katugampola, Barbara Calvi. 2020. “ESG in Sovereign Fixed Income Investing: Identifying Opportunities, Correcting Biases.”Morgan Stanley.

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