ESG in Sovereign Bonds
We recently spoke to Prakriti Sofat, emerging market (EM) portfolio manager and economist about how Goldman Sachs Asset Management applies environmental, social and governance (ESG) factors to its investment process for sovereign bonds.
Q1: Why are ESG factors important for sovereign bond investing?
We believe that an ESG lens is important when investing in sovereign bonds for two key reasons. First, ESG considerations, ranging from rule of law to youth unemployment and climate change, impact macro outcomes and in turn the willingness and ability of a sovereign issuer to service debt. In other words, ESG factors are consistent with—and enhance—our sovereign investment process. Second, governments that issue sovereign bonds set the policies that can influence progress on environmental and social themes such as the climate transition and inclusive growth.
The sovereign bond market is the largest segment of the global fixed income universe, yet ESG integration has been less systematic in sovereign bond investing relative to other asset classes. We have long incorporated ESG considerations in our assessment of sovereign bonds, with a focus on governance and social factors, particularly when investing in emerging markets. Recently, we have formalized our sovereign ESG framework and enhanced our assessment of environmental risks.
In short, we believe sovereign bonds have an important role in driving sustainable outcomes given their large scale in global capital markets and given sovereigns drive and finance a country’s social and environmental policies.
Q2: Can you tell us more about the ESG framework for sovereign bonds at Goldman Sachs Asset Management?
We have a formalized ESG rating process that evaluates each sovereign based on quantitative ESG metrics and qualitative analysis that captures a country’s ESG momentum, whereby we determine if a country is making progress on ESG issues. The process is transparent, data-driven and forward-looking, with ESG ratings owned by sovereign economists, which we believe ensures full integration into our credit risk evaluation.
Digging deeper into the detail, we identify data that enable us to quantify material ESG risks. We source this data from well-conceived academic datasets and policy studies to ensure consistency for cross-country comparisons. Various datasets are aggregated to compile E-, S- and G- scores for each sovereign. I think it is important to highlight that the integration of quantifiable and objective ESG metrics ensures we focus on credit risks rather than forming subjective value judgements on a particular country.
That said, we recognize that ESG risks can lack visibility or be latent for a long time before posing significant downside investment risk. In addition, ESG data may not fully reflect the financial materiality of ESG issues for countries at different stages of development. This is why our framework combines quantifiable metrics with our economists’ qualitative analysis which can be enhanced through engagement with sovereign bond issuers. There are fewer direct channels for engagement with sovereign bond issuers relative to corporates but where possible we meet with policymakers responsible for monetary and fiscal decisions, including those in treasury departments, government agencies and debt management offices. We also engage with supranational entities such as the IMF, World Bank and OECD.
A qualitative overlay allows us to take into consideration a sovereign’s forward trajectory and policy efforts that may enhance resiliency to ESG risks. For example, we may identify a sovereign that has a weak ESG profile but improving ESG potential that we believe will eventually be reflected in sovereign bond valuations. It also allows us to incorporate new ESG developments—that may be gathered through engagement with policymakers or via policy announcements—into our analysis in a timely manner given various ESG data are updated with a lag. We can further apply our judgement on the materiality of ESG developments by country. Deforestation, for example, is more applicable to countries with rainforests than to a country that is mostly desert.
Our sovereign ESG ratings currently reflect a 60% weighting for governance factors and 20% for both social and environmental considerations. Importantly, we also correct for an ingrained income bias that is common among sovereign ESG ratings.
Q3: Can you tell us more about the ingrained income bias and how you address it?
Sovereign ESG ratings in the investment industry exhibit a strong positive correlation with a country’s income, meaning ratings are structurally biased towards richer countries. In fact, World Bank research shows that 90% of sovereign ESG ratings across various rating providers can be explained by a country’s gross national income.
This so-called ingrained income bias can conceal ESG risks in rich developed countries, while overstating risks in poorer developing countries. As a result, capital may flow towards high-income countries and away from developing countries where funding is most needed. To address this income bias, we adjust our social and environmental scores for a country’s GDP per capita.
Q4: Interesting. So you do not adjust governance scores for a country’s income and you assign a higher weight to the governance pillar than the other two pillars combined. Can you explain the significance of the ‘G’ in ESG in your framework?
We believe that governance indicators, such as the quality of institutions and policymakers, send the most important signal on sovereign credit risk, particularly for countries at the lower end of our ESG rating scale. This is because the forward trajectory of a country is crucially dependent on governance even if its starting economic fundamentals are solid. Robust governance contributes to the quality, stability and predictability of the policy environment and is often associated with stronger potential growth. It can also bolster resilience in event of a domestic or external shock and is therefore an important consideration in determining the risk of financial and economic crises. In addition, countries with improving governance are more likely to focus on social and environmental issues.
To evaluate the quality of institutions, we use several third party data, including World Bank governance indicators that assess factors such as political stability, rule of law, regulatory quality and control of corruption, among others. We also look at the World Bank’s Ease of Doing Business rankings which can influence a countries ability to attract capital needed for investment and economic growth.
Given the lack of global ranking for policymakers—at the central bank, ministry of finance and in government—we have created our own scoring based on a simple principle: a policymaker’s progress in delivering stable growth with low and stable inflation.
Q5: The recent spike in energy prices has sharpened focus on the climate transition and environmental risks, given extreme weather events have intensified energy shortages. How do you incorporate environmental issues into your sovereign ESG ratings?
Interestingly, analysis of historical returns suggest sovereign risk is least correlated with the environmental pillar. However, the materiality of environmental factors, particularly in relation to climate change, is rising and more so for regions with greater climate-risk exposures such as those along or close to the earth’s equatorial zone. There is already evidence of extreme weather events becoming more widespread. A recent World Meteorological Organization report noted that climate-related disasters surged fivefold over the past 50 years, with economic losses increasing sevenfold.
Put another way, financial materiality cannot be fully imputed from statistical relationships in past data given the rising frequency and severity of extreme weather episodes. From a credit risk perspective, environmental risks matter because these risks can have non-linear economic and investment implications.
Our environmental framework is oriented around four themes: water scarcity, air quality, climate change and energy, and biodiversity and habitat. With respect to climate change, we seek to understand both physical risks and transition risks. Physical effects of climate change can be event-driven such as extreme weather events like hurricanes or flooding, or longer-term shifts in weather variability like a rise in sea level. Our sovereign ESG framework was the first to incorporate the only known dataset matching physical climate risk exposure to the distribution of population, agricultural production and overall GDP creation within countries.
Transition risks are related to the changes in policy and the market in response to the climate transition. We recently enhanced our methodology to evaluate the transition risk of a country by taking into consideration nationally determined contribution (NDC) plans that outline medium-term climate policies. Our transition risk analysis also looks at a country’s carbon emissions gap, namely the gap between current greenhouse gas emissions and an emissions reduction target.
It’s worth noting that environmental issues are closely intertwined with governance and social issues. For example, inadequate environmental protection can be a signal of weak governance, while air pollution or water scarcity can lead to social discontent.
Q6: Let’s talk about social issues—how can they affect countries’ credit worthiness and growth potential?
Social factors shed light on the level of social cohesion in a country which has implications for policy-making, political stability and economic outcomes, all of which can impact the ability and willingness of a sovereign to repay debt.
Our framework looks at quantifiable social metrics, such as the level of urbanization and penetration of information and communication technology, because these metrics are signposts for structural trends that influence economic growth and development, including the rise of a middle class. Many social factors, such as gender equality, can affect long-term growth potential but can also generate short-term impacts. For example, rising income inequality can lead to political instability as observed in recent years across both developed and emerging economies. To evaluate the vulnerability of a country to social instability, we have created a heat map that looks at factors such as youth unemployment, gender inequality, and the quality of public service delivery and healthcare.
It is important to highlight that a “paint-by-numbers” approach on social issues, and indeed ESG metrics in general, can be systematically biased against developing countries where the potential for progress is arguably greater. This is why our correction for an ingrained income bias and qualitative overlay discussed earlier is so important.
Q7: Finally, how do you see ESG integration in sovereign bond analysis evolving?
We will continue to evolve our sovereign ESG framework, incorporating innovations in ESG data as we did at the start of this year when we added physical climate risk data to our analysis. The availability, timeliness and consistency of ESG data is critical and we are encouraged by advances in geospatial technologies and momentum around standardised national reporting on environmental issues, both of which we believe will enrich sovereign ESG analysis.
More broadly, the pandemic has amplified policymakers focus on ESG issues, with governments globally embracing a “build back better” mindset. We see this as an opportunity for us to expand our engagements with sovereign bond issuers, particularly in relation to their climate policies.
We also expect the sovereign bond ecosphere to continue to evolve with rising green, social and sustainability (GSS) sovereign bond issuance. Proceeds from GSS bonds are linked to environmental or sustainable outcomes, and therefore provide investors with an opportunity to not only view ESG as an input in investment decisions, but also view ESG an output that drives better environmental and social outcomes.
In the United Kingdom, this material is a financial promotion and has been approved by Goldman Sachs Asset Management International, which is authorized and regulated in the United Kingdom by the Financial Conduct Authority. 256627-OTU-1496533
 See World Bank Demystifying Sovereign ESG, Gratcheva, Emery and Wang (2021).  See “Environmental, Social and Governance (ESG) Performance and Sovereign Bond Spreads: An Empirical Analysis of OECD Countries,” 22 November 2016.  Sovereign Climate Risk Scores are powered by Moody's Corporation affiliate Four Twenty Seven.