Where values and politics meet investing

In the third and final part of this Insurance Asset Risk/ Schroders roundtable, insurers highlight the subjective nature of ESG investing in govvies

Vincent Huck: But the fact that it is value driven is really the issue. My personal values say that a country like Botswana would have a higher ESG score than the US, yet from a financial investment perspective you'd probably pick US sovereign bonds over Botswana sovereign bonds... So how do you put this sort of value system approach into an investment decision process?

Jean-Francois Coppenolle: That is down to each investor to determine, because the other way is to optimise the return of the portfolio based on ESG constraints, and ESG constraints are driven by regulation but also by each investor's values and ESG frameworks.

Some investors might want to invest into Botswana or Mauritania, and not invest into US debt because it's super carbon intensive – so it's up to investors. But what I'm saying is that the 'G' and the 'S' are easier to measure than the 'E'.

Anand Rajagopal: I agree that there are several organizations, for e.g., the World Bank and other multilaterals, that provide data on the 'S' and the 'G'. This has helped us conceptualise franchise risk thinking across many relevant dimensions.

An important piece in the ESG puzzle is that of engagement with issuers.

It's not always that easy to engage with a sovereign because sometimes even the issuer contacts points vary across multiple governmental departments/institutions/DMOs/treasury etc. There's also the issue of perhaps relatively less explicit covenants or limited recourse to the issuer itself (when compared to corp issuers). So, there are structural and economic or political challenges when attempting to conduct such sovereign engagements.

Even then, there are benefits to sovereign engagement and there's also the growing trend for ESG-optimised portfolios as such. Such engagement can be accomplished through various approaches including direct engagement with issuers, unveiling of fiscal plans, looking at investor roadshows, IMF events and ad hoc events, in addition to country research trips by the research analysts/portfolio managers.

Those are crucial points through which we are able to glean valuable information not just on the 'E', but also on the 'S' and 'G' i.e., will the sovereigns deliver on what some of their ESG policies are actually claiming and not just for the short-term, but also medium-term and long-term, while keeping in mind that political cycles can always change and are usually, short-term, in nature.

Hetal Patel: It's very curious because I talk to our stewardship team to understand where our priorities are with respect to engaging with corporates and sovereigns. We see sovereign engagement as higher hanging fruit, because it is much more difficult to get traction exactly for that reason of varying contact point, and the difficulty to know who are you dealing with? There's the issuing entity, the debt office, the central banks, and of course the actual people who can drive change - the policymakers.

And the area that we need to be more vocal on, as a UK insurer, is on our own government where we have deeper connections and influence them so that they then put pressure on other countries.

But, I mean, that in itself is a challenge. The way we see us moving forward is really to try and work collaboratively on engagement with sovereigns. But even the traditional collaborative networks, like the PRI, they're focused on the corporate side. There isn't a natural collective voice yet to look sovereigns.

Catherine Chen: We have most exposures in developed markets. Our UK exposure is more manageable, in terms of engagement, as a UK headquartered company. But looking at the US, though our exposure is limited, I'm slightly concerned because the Biden administration seems to have some hiccups at the moment in terms of climate related regulation and how they're going to roll-out that. We are currently looking at, jointly with our asset managers, how we can quantitatively measure regulation and policy risk from an ESG perspective in our sovereign holdings. We don't have an answer on that yet.

Also, I believe that although four or five years ago, governance was the main factor influencing govvies' pricing, followed by social consideration, today environmental factors have picked up dramatically, and that may give opportunities to capture some alpha.

Marcus Jennings: There's definitely evidence to suggest that more people are looking at environmental and social factors compared to a few years ago. That is partly a function of ESG growing as an industry within asset management but also maybe to a certain extent that we are just seeing more physical implications of climate change come to fruition.

What that means in terms of sovereign pricing is a little bit murky, I would say. This is what complicates matters even further. If you had a drastic weather event in emerging markets there would probably be an element of credit risk priced into yields as a result, should it be particularly bad. But if you had the same event in developed markets, would bonds rally or would they sell-off? Now that's a big open debate.

On engagement, we also want to do more work with institutions and governments going forward, but we have to be realistic in the sense of how much we can actually influence their behaviour.

We don't want to say to clients that we can materially change outcomes and then under-deliver. For example, we're cognisant of that fact that we are as a proportion of US debt quite small in the scheme of things, so to what extent are they going to listen to our opinion?

Finally, what does good look like? Who am to impose myview of what good 'E', 'S' and 'G' looks like? That's why we've use the SDGs as a framework to say what looks good and what looks bad.

Because you have 193 states that signed up for those goals in 2015, so it's very hard for sovereigns to pushback against that. By using the SDGs, you can reduce that subjectivity and biases of individuals as to what looks good and what doesn't.

Paul Grainger: The only certainty we have here is what we do today will not be exactly what we will be doing in the future.

All this has to continue to evolve. Specifically with engagement a real challenge is to have meaningful engagement, not have a box-ticking exercise.

We could quite easily go and engage with every single treasury, every single debt management office, every single conference that went on around the world. The challenge with that is how many of them are actually meaningful? How much impact you're going to do?

Our approach currently on the sovereign side is to really focus on the treasury and the debt management offices where hopefully if they hear enough times from similar investors saying similar things that are well articulated and very clear that will have an impact.

And things do change, today when we tell a treasury that we are not including them in our sustainable investment universe, we have incoming calls asking 'why', and they want to understand more how we took that decision. Five years ago, this didn't happen.

Where we as an industry need to get to is collectively engaging with some of these sovereigns whether it's through things like the investment associations, or other entities, but really coming together with the same focus.

Even in the UK our ability to individually influence government thinking is quite low. Collectively we're stronger, and that's one thing that should hopefully improve going forward.

Thor Abrahamsen: If it was just 'S' and 'G' we were talking about it would be a much more straightforward discussion. You can get around the concept and see the alpha potential of that. You can invest according to an alignment between your own views of the world and countries' culture and values.

This is both for EMs and DMs, although with EMs you are faced with a challenge that traditionally the allocation is always a small proportions of the overall portfolio, because we have very few liabilities in EMs, so that pushes EMs in the alpha bucket..

So 'S' and 'G' are taken for granted, but if you take a step back and look at developed markets, and really take a hard look at things, you can absolutely look at some developed markets and say the 'G' is all over the place and the 'S' is reverting to the Middle Ages in some cases.

So, then the focus for developed markets becomes mostly on the 'E'.

'E' is incredibly difficult, we all know that data is difficult.

The problem is that DMs have been spending 25-30 years exporting our carbon intensity offshore. Does that make it good? Does that make us less carbon intensive because were exporting our manufacturing abroad? Which we might have to import or rebuild possibly back home in the next 20 years, which is more carbon intensive, but is that good for 'E' or bad for 'E'?

My favourite example is Germany. Is it a good sustainable investment because Germany has a net-zero target? Or is it bad because they're firing coal plants because they have messed up their energy policies for decades?

So it's not just about data. In the end it comes back to the individual investors what you think is right, what you think is wrong and then make a choice that way. And maybe that choice has an impact on your individual returns on the portfolio, maybe not.

Anand Rajagopal: On the just transition debate, this was recently highlighted as one of the key principles/goals to achieve by the NZAOA members. Conceptually, this translates to draw carbon pricing revenues from the more favoured and developed market side of the equation to then cross-subsidise the emerging world - where the transition pathway still needs to be chalked out and where help is actually genuinely required.

Also, going back to the question on to what extent you can influence through engagement.

We have found through our engagement (for e.g., through AI's sovereign engagement letters sent out to almost 40countries) that the likelihood (and extent) of information that we are able to glean through engagement increases when there are new issues coming to market.

Paul Grainger: We spend a lot of time talking about sovereigns, but the role of supranationals and agencies is really important for the returns that you're looking to get as the investor in the portfolio from entities that are trying to do the right thing.

And my very simple observation for this is that these are entities that have been doing the right 'sustainable things', whether it's 'E', 'S' or 'G', for many, many decades. They've got experience and most of them have good governance.

But they also provide both the means to engage, because they do issue regularly and these entities are happy to engage with people who buy their bonds, but they also help meet that return objective for clients.

You know, when we talked about risk versus alpha, sometimes those entities are almost forgotten as falling between sovereign and credit. They're not the most exciting part of the market but they're hugely relevant for both sustainability and returns going forward.

Anand Rajagopal: Sovereigns, in addition to Sub-sovereigns, Supranationals and Agencies (or SSAs) are areas we have paid attention to, especially in 2021 when credit spreads were tight and SSAs looked particularly attractive from a return on capital standpoint. Some of those opportunities still exist in the backdrop of a volatile 2022.

Now, the one thing we have always tried to ascertain information on is the level of sovereign linkage - explicit or implicit - in the case of SSAs. Supranationals are further complicated as there could be multiple sovereigns involved in the ownership structure. Such situations become increasingly complex when trying to ascertain a forward path of travel on ESG and even more so on the bondholders' ability to exert any influence on the issuers' ESG and sustainability behaviours.