Investors urged to track ESG risks

With Moody’s  putting Austria, France and the UK on negative credit watch last week,  environmental, social and governance issues may seem irrelevant to the  government bond market at present.

Yet MSCI, the index and information provider, recently launched a new tool  allowing investors to assess the exposure of their sovereign bond holdings to  ESG issues.

There is increasing demand for information on how ESG factors affect  sovereign borrowing, according to Hewson Baltzell, head of product development  at MSCI.

While the financial crisis is not directly responsible for this increased  interest, it has focused attention on the need for investors to understand the  risks their portfolios contain. “Investors are now looking more carefully at  countries and after recent events they may be sceptical about bond ratings  anyway,” Mr Baltzell says.

It is important for investors to be aware of the risks countries face and how  that might lead to volatility, says Mark Robertson, head of communications at  Eiris, the ESG research group, which also rates sovereign bonds according to ESG  criteria. “Our ratings show that the extent to which countries differ in their  approach to tackling key ESG challenges … is striking,” he adds.

Another factor is the growing number of investors that have signed up to the  United Nations’ Principles for Responsible Investment: as of October 2011, 915  institutions representing $30tn of assets under management were signatories. “If  investors are applying ESG analysis to more asset classes, we need to have good  coverage in fixed income and sovereign bonds are a big part of that – they make  up more than half of the bond market,” Mr Baltzell adds.

The PRI has seen strong interest from its signatories regarding how ESG  issues can affect fixed income investments, and several signatories have  launched products in the field, says James Gifford, executive director of the  PRI.

“In the case of sovereign bonds, it is clear ESG issues such as political and  social risk can have a sizeable impact,” he says. “For example, the current  situations within the eurozone, in Hungary,  and implications from the Arab spring all demonstrate the importance of  investigating the relationship between ESG issues and a country’s credit  worthiness.

“However, a greater understanding is required to fully appreciate how these  issues impact sovereign credit ratings and capital markets.”

The MSCI ratings cover 90 countries responsible for 99 per cent of sovereign  bond issuance and provide information going back five years. The ESG ratings on  Greece, Italy, Spain, Portugal and Ireland in 2007 were much lower than their  conventional bond ratings, Mr Gifford points out.

This is a point backed up by Raj Thamotheram, president of the Network for  Sustainable Financial Markets. “There’s little doubt that the traditional rating  process for sovereigns is deeply flawed. What’s happening in Greece and the US,  for example, is far from being a ‘new’ development,” he says.

“Similarly, the way the credit rating agencies ignored corruption, social  inequality, and other lead indicators of risk in Egypt is yet another example of  the very limited – and misleading – approach of the mainstream rating models,” he adds.

A report released last year by Bank Sarasin* points to the positive impact  that sustainability can have on the performance of sovereign bonds. “Sustainable  economic development is a basic prerequisite for being able to service sovereign  debt,” it says.

“Although ‘traditional’ credit ratings are designed to assess a country’s  future ability to perform and meet its payment liabilities, most recently they  have, in many cases, tended to be more of a barometer of current performance  than an indicator of future performance. Sustainability criteria provide a  useful supplementary analytical tool here, by serving as leading  indicators.”

The performance of the sovereign bonds of sustainable countries has been  better than average for both mature and emerging economies, it adds, with the  most important drivers of performance being ecology, education, health and  public governance.

An ESG approach can highlight future problems in some economies that are not  reflected in traditional ratings and might give investors pause. “Both China and  India have a number of environmental, social and governance problems they are  wrestling with that are not reflected in the market,” Mr Baltzell says.

China scores lower than its peers on key governance indicators such as civil  liberties and political rights, adds Mr Robertson. It has also shown  deterioration in environmental and social areas, especially in carbon dioxide  emissions and public education.

But concerns are not restricted to emerging markets: the US, which has the  world’s largest and most liquid sovereign debt market, is ranked only 34th in  Eiris’s ratings while recently, a coalition of investors, NGOs and universities  urged the Bank of England to investigate how the UK’s exposure to polluting and  environmentally damaging investments might pose a systemic risk to the UK  financial system and long term growth.

Ben Caldecott, head of policy at Climate Change Capital, one of the  signatories to the letter, says MSCI’s move is important, “but ultimately this  ESG information needs to be embedded in existing ratings, not separated  out”.

* Sustainable fulfilment of sovereign obligations: Sustainability and  performance of sovereign bonds, July 2011