On the first Monday of each month Emerging Markets ESG publishes a special interview with an academic, expert or practitioner about a specific topic with relevance to environmental, social and/or governance (ESG) issues.
This month’s interview, the 14th interview in the special interview series, is about ESG Sovereign Debt Rating and is with Pascale Sagnier, Head of ESG Thematic Research, AXA Investment Managers, Paris, France.
Since it was first established in 1994, AXA Investment Managers has expanded steadily, with the worldwide influence of its parent, the AXA Group, a significant contributor. The company’s dynamic business development is based on an ongoing dialogue and efficient collaboration between a handful of investment management centres in the world’s leading financial hubs (e.g., Paris, London, Hong Kong and New York) and local distribution offices on four continents. AXA IM is composed of seven single asset class-focused areas of expertise, each of which is amongst the leaders in its specific fields, and an investment solutions team composed of financial engineers, structured product developers, as well as fiduciary management and asset allocation specialists, who develop the most relevant, best-fit solutions. Its portfolios are either single or multi-asset-class solutions, and are built to always be fully in synch with its clients’ realities: their constraints and objectives, their risk appetite, their commitments to their own constituencies. Outlining the objectives of the AXA Group, Henri de Castries, Chairman and CEO, AXA Group Chairman and CEO, stated: “Our business is to protect people over the long term. In this business, trust and solid relationships are paramount. This means designing reliable solutions to meet the needs of our clients, managing risks in a professional way, treating our partners fairly, and developing a work environment built on strong values, inclusion, and trust.” In line with these objectives, AXA has committed significant resources to developing expertise in Responsible Investment (RI). It actively works to integrate Environmental, Social and Governance criteria into every portfolio managers’ decision-making processes, and has developed a range of specialised RI products. It aims to help ensure that RI is no longer viewed as a niche area of expertise, of interest only to a limited circle of investors. On the contrary, it believes it is a forward-looking investment strategy, which can deliver healthy, long-term, risk-adjusted returns across all asset classes and solutions. In the words of Henri de Castries: “This is part of creating a sustainable, long-term business, and becoming the preferred company for our customers, employees, and other stakeholders.” Pascale Sagnier joined AXA IM in 1986, where she was responsible for the research and management of French equities. From 1995 to 2002 she was senior portfolio manager for European equities funds; after 2002, she added the managing the Responsible Investment (RI) funds, European funds and French equities management. From 2005 to 2010, she was in charge of Responsible Investment Research and is today in charge of ESG Thematic Research. Before joining AXA IM, Pascale was analyst for the stockbroker Alphen/Eric de Lavandeyra and then fund manager for an insurance company. Pascale graduated in Economics from Université de Nanterre (Paris X) and also obtained a Masters from the Institut d’Administration des Entreprises (IAE) and a diploma from the Centre de Formation des Analystes Financiers (CFAF).
Emerging Markets ESG: Why is it important today to incorporate ESG criteria into sovereign debt rating?
Pascale Sagnier: Most investors had, until recently, considered sovereign bonds a defensive asset class that delivered consistent, low risk returns—especially for developed countries. Concerns about peripheral Eurozone countries’ ability to repay their debts and the ensuing crisis called into question the defensive nature of sovereign debt as an asset class – reflected by a divergence in borrowing rates for Euro sovereign debt issuers. Elsewhere, debt levels are projected to climb. The International Monetary Fund (IMF) estimates that by 2016 the debt-to-GDP ratios of the United States and Japan—major issuers of sovereign debt—will reach 115%, and 253%, respectively. The divergence in Eurozone yields and growing indebtedness among developed countries has led investors to re-evaluate their government bonds portfolios. Emerging markets – where levels of indebtedness are considerably lower and projected economic growth higher compared to developed markets – may offer a potential alternative source of sovereign debt securities.
We maintain that introducing ESG criteria into the investment decision-making process may help. Indeed, institutional investors, particularly pension funds and insurance companies, seek to limit reputational, or headline risk in order to avoid negative perceptions associated with a particular activity or regime – such as documented human rights abuses or labour rights violations – that could negatively impact investors’ own reputations or would not comply with their commitment to conventions such as the United Nations Global Compact.
The most straightforward way to address reputation risk uses a negative screening approach, drawing upon a pre-defined set of criteria to exclude or screen securities that are perceived as having higher risk, in comparison with their benchmark investment universe. We constructed a reputation risk score for sovereign debt comprised of governance and political commitment components, including: corruption, political stability and rule of law indicators, along with biodiversity, human rights, labour rights and weapons conventions. Clients can use the reputation risk score to exclude issuers with the highest reputation risk scores. This approach is particularly relevant for developing countries and emerging markets.
Emerging Markets ESG: What is the link between the value of a country’s sovereign debt and ESG criteria?
Pascale Sagnier: ESG criteria have increasingly been used for analysis of companies in the wake of the various financial market crises of the 2000s – marked by numerous malfunctions, in particular at the corporate governance level – and due to the lack of transparency about risk. While originally limited to SRI funds, ESG analysis has now become part of traditional analysis, as certain ESG indicators are acknowledged to have an impact on corporate valuations and on shareholder return on investment. In addition, investors and pension funds increasingly support responsible finance out of a belief that ESG problems must be incorporated into the decision-making process or through discussions with companies in order to reduce risks.
The current sovereign debt crisis makes the issue even more relevant, even if disclosure and analysis of ESG data on a country basis is still in its early stages. The questions that come to mind to explain the delay in ESG country analysis are the following:
- How can the ESG performance of a country be analyzed without being seen as “political?”
- Is there a link between sovereign debt, the economy and ESG performance? and, finally
- Is there value for investors and fund managers in adding ESG research to traditional analysis?
In this context, we defined an ESG methodology to assess countries with objective, reliable, measurable and relevant indicators for the three ESG criteria. We maintain that this could signal long-term risks and thus supplement economic analyses. The ESG indicators have to represent quantitative data and should go back at least ten years to take into account the economic cycle and its impact on ESG criteria.
Emerging Markets ESG: ESG criteria have been included in equity analysis for some time, whereas only more recently have they been included in corporate debt analysis and rating. Your work incorporating ESG factors in the rating of sovereign debt is innovative. Why has there been this time lag? Why has sovereign debt rating only recently embraced ESG criteria?
Pascale Sagnier: The drivers of sovereign creditworthiness depend on a multitude of factors, including: the domestic economy, institutional effectiveness, political stability, prospects for growth and the country’s position in the global marketplace, its fiscal health and monetary policy.
Adding ESG factors into the analysis may offer further insight(s) about a country’s situation, relevant drivers or the relationship between/among drivers. ESG factors enrich understanding of a country’s credit risks. We noticed that integration of these factors in the sovereign debt portfolio increases the credit quality of the portfolio.
In fact, our research revealed a meaningful correlation between a country’s ESG performance and its long-term credit rating.
Additionally, we found a positive and strong relationship between a country’s social performance and innovation effort (measured by R&D expenditure as a % of GDP). Also, good human development, with high levels of education, health and wealth, is a favourable condition for a country to innovate.
Moreover, we found a positive and strong link between a country’s governance and economic performance as measured by a country’s wealth (GDP/person) and real GDP growth. Especially, governance effectiveness and regulatory quality criteria exhibit the strongest correlation with economic performance. Better government effectiveness and policy implementation will promote economic development and growth. Indeed, rating agencies such as Fitch, Moody’s and S&P now use governance indicators in their assessment of debt. We identified a strong correlation between social performance and S&P ratings.
Emerging Markets ESG: Could you please explain the differences in analyzing ESG criteria as they relate to sovereign debt in emerging markets and in mature economies?
Pascale Sagnier: In terms of the criteria included in the model, we wanted to achieve a valid ESG assessment, whatever the level of the country’s development. This also explains the relative simple structure of the model.
To lessen the inevitable differences between rich and poor, industrialized and non-industrialized, and high and low economic growth countries, we incorporated into our model the “momentum” indicator for the E, S and G indicators, which measures the trend in the country’s ESG indicators over a long enough period (two five-year economic cycles) in order to smooth the impact of economic trends, in particular on greenhouse gas emissions, which are very closely tied to economic activity. This “momentum” indicator is relevant for emerging markets, which on average show a significant gap in their ESG score in comparison with advanced countries:
However, if we treat a developing country like an advanced country, the risk is that for a global portfolio, we will exclude or underweight developing countries and emerging markets. This is why emerging and developing countries are compared in their universe only, and we do the same for the advanced countries.
Emerging Markets ESG: Given the dynamic growth in emerging markets, particularly BRICS, how do you incorporate significant changes in ESG criteria in your sovereign debt rating methodology?
Pascale Sagnier: Despite a general improvement over the past ten years, developing countries and emerging markets often remain under particular scrutiny for their management of ESG issues. Our institutional clients are increasingly sensitive to these issues, since a failure to monitor them can directly impact their reputation in cases of an adverse development in a country where they are invested.
The impact of economic growth on ESG indicators is evident in areas such as carbon emissions or living wages. This is why, as explained above, we have integrated the notion of momentum of the three categories of ESG indicators. The momentum is calculated over 10 years to take into account the economic cycle – five years on five years.
We think that the focus on the momentum of the ESG score is specifically interesting for emerging markets. In emerging markets, the level of ESG standards is lower than those of advanced countries. So, the fast economic growth of the emerging markets should be accomplished together with improvement of ESG indicators, unless we need to worry about the sustainability of the economic growth over the long term. Without a focus on ESG issues, emerging economies may not reach their full potential in the long term.
 International Monetary Fund’s World Economic Outlook Database, September 2011.