Astrid Sofia Flores Moya
With an almost 60 trillion-dollar sovereign debt market, the case for ESG integration remains unclear. According to the World Bank’s 2021 paper A New Dawn – Rethinking Sovereign ESG, Sovereign ESG investing suffers from a lack of clarity over investment objectives. Limited to its use as a risk-adjustment tool, Sovereign ESG data has not been explored for its impact-investing potential. Can ESG data thus drive better investing and contribute to improved sustainability outcomes?
Today’s sovereign ESG scores are primarily used as a supplementary tool to evaluate a country’s creditworthiness or for reporting on the sustainability characteristics of fixed income portfolios. In other words, Sovereign ESG has been dominated by a risk-management focus where ESG factors are used as an input in the investment process to reduce risks and enhance financial performance. But this ignores potential non-financial benefits in terms of contributing to sustainability outcomes (i.e., as an output).
ESG investing can inform financial decision-making in three main paradigms: (1) using ESG as an input; (2) or as an output; (3) or as a combination of both. The latter impact-driven paradigms are less common, and would, in addition to financial objectives pursue wider non-financial performance factors. This could include for example investing in a manner that contributes to greater energy efficiency, higher school attainment or lower corruption, with targets often being linked to the United Nations Sustainable Development Goals (SDGs). Using ESG as both an input and output could offer a sweet spot, with Sovereign ESG scores serving as a tool to identify risks more efficiently but also to assess the impacts of regional, corporate and project-level financing.
However, getting sustainability right in the sovereign ESG investing space isn’t straightforward.
Figure 1: Sustainable investing quoted assets by strategy & region 2020 (in billions of US dollars)
The scalability versus effectiveness trade-off for Sovereign ESG products
Where investors pursue sustainability objectives through their investment strategies, they often encounter a trade-off between scalability and effectiveness for the asset at hand. The Sovereign Debt market has great potential for scalability; it is large and liquid with an outstanding debt of US$58.9 trillion, yet it proves challenging when trying to pursue or measure specific sustainable outcomes.
Market practices that target the reduction of aggregate ESG risk may have the perverse impact of increasing funding gaps and thus decreasing the effectiveness and impact of sovereign ESG investment. For example, ESG-adjusted benchmark indices can be tilted to boost the aggregate ESG score relative to its traditional benchmark, resulting in portfolios of only strong ESG-performing developed market issuers. Emerging markets - with larger room for ESG improvement and where fruitful sustainable outcomes are often greatest - are thus disadvantaged and make up a very small part of the financing pie. This is a consequence of the Income-Bias inherent to sovereign ESG scores.
Additionally, the prevalence of benchmark investing in sovereign emerging markets (EM) universe and the relatively lower level of capital market development mean a few emerging issuers can attract meaningful flows to their local currency sovereign debt market. According to the World Bank, only 11% of local currency sovereign bonds outstanding are included in the main EM sovereign bond indices on average, compared to 84% for equivalent hard currency debt.
However, better data and the steady growth of Sovereign ESG investing can generate indirect positive effects. For example, more granular ESG scores at the sub-national level create greater impact investment opportunities. Also, as the sovereign debt market is often the entry point for foreign investors, large, targeted investments can trigger or amplify development responses from emerging economies’ financial markets. Therefore, an ESG-conscious investor’s decision could help foster a more effective and sustainable allocation of capital at the global level.
Government bonds, such as Green, Social or Sustainability-Linked bonds, are another effective and more direct alternative: they have been created to be impactful. They incorporate clear ESG targets and are designed to finance climate, social or environmental-related projects and activities. However, being relatively recent, they have not reached scale yet: for OECD countries, sovereign green bonds currently only account for around 0.2% of all government debt securities (OECD, 2021), while the issuance of Social and Sustainability-linked bonds has only started recently (cf. our recent analysis).
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