Conceptualising ESG in sovereigns

In the first part of this Insurance Asset Risk/ Schroders roundtable, insurers discuss how they consider ESG in their sovereign debt investments

Vincent Huck: How are you integrating, or approaching sustainability, in your investments in sovereign debt?

Catherine Chen: Our business model is slightly different from our peers because our assets are 100% managed asset managers. We normally delegate our asset managers to engage directly with the issuers however they want to.

We do monitor asset managers' engagement activities through our proprietary RI/CC manager monitoring framework which was piloted in 2020 and implemented in 2021. And our monitoring framework last year focus on engagement across equities and corporate bonds, but not so much in sovereign bonds.

Jean-Francois Coppenolle: Within the Net-Zero Asset Owners Alliance we did some work on sovereigns last year jointly with PCAF. It was a two-step process.

The first step was measuring the emissions of these sovereigns, which led to many discussions such as what is the best metric to choose for the numerator? How do we consider imported emissions, which are especially material for developed markets?

In relation to the denominator, there was a lot of discussion as how the GDP should be adjusted so as not to penalise emerging market sovereigns, they have high emissions and lower GDP in comparison with developed market sovereigns.

There is a question of what's the best measure, but also the degree of fairness that needs to be introduced, because really the key objective is to decrease real-world emissions not only in developed markets but especially in emerging markets, and we all know that most efforts need to be made into financing the emerging markets, you can't create a framework that disincentives investments in emerging markets.

So, at this stage, only the metric to measure carbon intensity was agreed, and there's now a question of which target to set. This is the second step of the process which is currently under development.

For us, European investors, the SFDR mandates reporting on carbon intensities of sovereign portfolios. This metric has been adopted by the European commission and we have to report on that. We have to take this indicator into consideration when we manage and optimise our portfolios, so that we can improve the carbon score of the sovereign portfolio in order to have an impact on real world emissions

As an insurance company, our sovereign allocation is mostly invested in euro-denominated sovereign. These sovereigns are better positioned for reaching our net-zero goals. Obviously, we have emerging markets allocation as well, which is residual compared to the Euro sovereigns or US treasuries.

We are also looking at whether the countries we are investing in allow freedom to be exercised, such as freedom of speech, freedom of press or equal rights to all citizens.

Finally, in France there is a new law called Article 29 on the Energy and Climate law which requires French investors to think beyond climate and take biodiversity objectives into consideration, even for sovereigns

Thor Abrahamsen: A primary focus for us is ESG at the company level. Most of our money is managed by external managers, so we rely quite heavily on them in terms of ESG processes and we have certain criteria for what ESG processes they have in place and what they have signed up to before we can consider an investment. But the focus so far has been much more on individual companies rather than sovereign.

The concept of ESG within sovereigns is very murky, more so than for individual companies. Particularly given that most of us are in some way constrained to what we can invest in, in terms of our core fixed income positions.

One thing that we've looked into is the ESG scoring of sovereigns but again it's still quite murky.

Take for example, Germany. If you're a European-based investor you're more or less forced to hold German bonds. But right now, is Germany's ESG good? I'd argue no. They're firing up coal mines left, right, and centre in order to save themselves from a bad energy policy.

Yet I suspect that Germany would probably have a high ESG score. And that shows that there is a difference between what the politicians might say the goal is versus what they're actually doing, and as an investor should you focus more on their intention rather than actually what they're doing to decide whether they fit in with your ESG framework?

Anand Rajagopal: Net-zero milestones have so far focused a lot on equities, corporate bonds and real estate exposures. The next area(s) of focus are expected to cover Sovereigns, and potentially even Sub-sovereigns, Supranationals and agencies (SSAs).

We look at ESG integration here thru a dual approach. Aviva investors manages our public assets, including those in Sovereigns and SSAs.

On one layer of our approach is the Aviva Investors' ESG framework itself, which is a proprietary framework that combines qualitative and quantitative dimensions.

There are various data points that come from a variety ofdata sources to inform a quantitative score on a country level across 11 composite indicators, and that helps situate on a relative basis how a certain sovereign is vis-a-vis others, and that's across Developed Markets (DM) and Emerging Markets (EM). The qualitative process provides a subjective forward-looking framework to assess sovereign ESG factors, culminating in an ESG momentum assessment that complements the above quantitative country model. ESG analysts/experts within AI follow such processes and integrate relevant insights into the overall credit outlook being built on each issuer by the sovereign/credit analysts and portfolio managers.

The second layer of our approach is the UK Life ESG and Franchise risk framework that we have developed given our recent foray into EM Debt and increasing involvement in non-U.K. Sovereigns and SSAs. It has required us to think about DM and EM sovereigns together in a comprehensive manner, which has necessitated a group-level approach on ESG and Franchise risk considerations.

We have drawn upon the jurisdiction index, which helps define country-level risk ratings and is built across many different dimensions. Here, we created a bespoke country-level score focused on certain dimensions that are far more crucial from a political and a social perspective. Such dimensions include human rights, civil liberties and political rights, freedom of the press, rule of law, terrorism, corruption, arms export controls and a lot of other similar dimensions that don't necessarily get captured explicitly in a typical ESG framework.

We focused on these franchise risk dimensions on a country- level and calibrated the entire DM and the EM space to allow us to specify appetite thresholds at which we would be comfortable investing in. We then joined up this franchise risk framework with ESG assessments on sovereigns' efforts towards Paris Agreement / climate change goals, in addition to considerations for broader governance and the sovereigns' vulnerabilities and resilience against physical effects of climate change.

For the latter, we have relied on Notre Dame Global Adaptation Initiative's index, and married that information with where the sovereigns are on GHG emissions per capita and also in their journey towards addressing in part or in full the Paris Agreement goals.

In summary, we have an overlay on top of the asset manager's framework so that we are able to look at emerging market and developed market sovereign investing in as prudent a manner as possible.

There is no perfect solution to this, it is all still evolving, and we need to keep refreshing and refining our frameworks.

Separately, the integration process can vary considerably from an asset owner's or asset manager's perspective depending on the extent of discretion in the investment mandates – be it non-discretionary, limited discretionary or fully discretionary ones.

Hetal Patel: Phoenix Group does not have an in house asset manager, we have a wide range of managers. In the past, we would have taken a much more passive approach, let the managers lead, and noted the manager's approach to ESG investing, but we had a big change in mindset in the past couple of years.

We've built out a sustainable investments team to bring that decision-making in-house in terms of having our own policy which we then sit down with managers to understand where they are, to explain where we want to be, and to make sure the two integrate with each other.

As to where we are in terms of sovereigns, we've almost taken a piecemeal approach. We're quite well integrated on the credit and equity side. On the sovereign side, we see this as a little bit more of a higher-hanging fruit in that whether you look at it, in terms of climate measurement, or whether you think about it in terms of stewardship, it's a much more challenging beast. So for our principal source in terms of thinking about ESG risk in connection with sovereign is to look at the data vendors and how they price this.

We're at a stage where we're aware of the risk, but this is the next area for us to move on to, to develop a more proactive framework to say these are the sorts of name we'd want to be invested in or not, based on these sorts of criteria.

Most of our exposure tends to be UK and US-based, and so exposure to EM and other sovereigns is fairly limited on our side.

Paul Grainger: Firstly, it's really important not to penalise the emerging markets just because developed markets have had their industrial revolution and been the biggest contributors to the stock of carbon. But the reality is, we shouldn't be penalising those countries who are yet to have their industrial revolution and bring people up the income scale, and also use that money to promote education, which has a lot of positive 'S' metrics.

As fiduciaries, we have a framework that we think is robust and transparent looking at these things, but it has to be flexible to every client's individual needs and their solutions. We recognise that all our clients have slightly different needs, and we have bespoke mandates for many clients and a framework that we can flex to meet those needs.

The key thing that we try to do, is create a framework that's robust and transparent. And when we talk about it being transparent, it's transparent not just for what's included now, but for how other countries could be included in the future or maybe excluded if something adverse happens.

We spend a lot of time thinking about what the controversies are out there, and what are the opportunities for countries. Because ideally, if we go forward several decades, we would like every country to be sustainable and investable, but at the moment not every country is.

We're also not purely focused on net-zero. We have to be very cognisant of the 'S' social sides are important and have a lot of materiality. The 'G' side has always been particularly important from an investment standpoint in any sovereign investment, whether that's developed market or emerging market, because that tends to be where the biggest risk has come from to the downside from an investment standpoint.

Our approach is a three-legged stool.

The first leg is focusing on the country in the round, looking at the UN SDGs. For various reasons, such as transparency. Looking at all 17 metrics.

The second is around net-zero and making sure that countries have a clear policy that we can then follow and monitor and make sure they are doing what they say they do.

And the third leg to the stool is freedom and the ability of the population to express their views, their issues, freedom of press, freedom of elections, etcetera.

We think that all those three things are really important to have a country that is sustainable over the long-term from both a social standpoint but also from an investment standpoint.

One of the key challenges that we have is that the data for this, the quant side, is really, really light. So, like any investment analysis, we have to take the hard backward-looking data, the lag data, have a framework and then think about how the forward-looking subjective analysis should be done, and then how we measure that going forward to make sure that we're sort of marking what we expect to happen to market as it were.