Nina Röhrbein finds out how the sovereign debt crisis is affecting countries’ ESG rating

While the implementation of environment, social and governance (ESG) factors in equities and corporate bonds seems fairly straightforward, the same cannot be said for sovereign bonds.

“This is the year to think about the evolution of ESG, and sovereign debt is one of the subjects to be tackled by some of the players,” says Matt Christensen, head of responsible investment at AXA Investment Managers (AXA IM). “Every crisis tends to end up touching ESG. The sovereign debt crisis is no different. Italy’s debt problem, for example, has a connection to the bond investing community, which touches on the governance system of the EU and on ESG as a factor.”

Traditional rating agencies are still in the early stages of implementing some ESG criteria into their sovereign bond ratings, as they struggle to incorporate qualitative criteria into their systems, according to market players.

MSCI ESG Research started its sovereign bond ratings with a client-customised coverage universe five years ago. In late January, it launched a scaled-up version, designed to provide ratings on 99% of sovereign bonds issued, which aims to identify a country’s exposure to and management of ESG risk factors and explain what impact these factors might have on the long-term sustainability of its economy.

German Oekom research has rated countries according to environmental and social criteria, including governance, since 2001. It covers 52 countries across the EU, BRIC, OECD and other major economies in Asia and Eastern Europe, and uses around 150 criteria, two thirds of which are qualitative and one third is quantitative.

AXA IM is undertaking an internal project on sovereign bond ESG ratings, which is due to be launched in the summer. It is based on the four areas of environment, social, governance and political commitment.

“The weightings and rankings currently use an equally-weighted approach, whatever the country category as described by the IMF,” says Christensen. “But this might not be the same between advanced and emerging economies, which is one of the areas we are still working on.”

ESG sovereign rankings are based on information from governments, the World Bank, the Global Footprint Network, the International Energy Agency, UN statistics, government agencies, NGOs, international conventions and other sources.

“We do not just see whether a country has signed treaties; we will find out what the situation is like on the ground,” says Oliver Rüter, research director at Oekom research. Oekom uses quantitative data to assess infrastructure, education, health, education and military expenditures, while qualitative assessments are undertaken particularly in the areas of political system and human rights, where Oekom looks at indicators such as free elections, democracy, discriminations, torture and the death penalty.

However, some countries do not provide enough or good enough data.

“Data is sketchier than on the corporate side,” says Rüter. “Qualitative data in the social area is relatively good. Quantitative data, however, is more difficult to obtain, especially when you go beyond EU and OECD countries. And some of the data we have used in the past, such as the use of pesticides and land consumption in agriculture, has been discontinued.”

In Oekom’s sustainability ranking this year, Greece, Italy, Portugal, Spain and the US all failed to attain prime status.

“Italy and Greece have shown a high share of corruption, which was coupled, particularly in Greece, with high expenditures for the military and declining budgets for education, health and a mix of energy,” says Rüter. “But there is no correlation between high national debt and bad ratings, and low national debt and good ratings - it simply depends what the money was spent on.”

Nevertheless, with the rating models of Oekom, AXA IM and MSCI ESG Research all pointing to the problems Greece and Italy have had, could investors have foreseen the problems with sovereign bonds issued by these countries?

Hewson Baltzell, head of product development at MSCI, is cautious. “We cannot strongly say that the ESG research is predictive at this time, as these issues need to be considered over the medium and long term, although over the last five years we have had lower ESG ratings for those countries than credit agencies did,” he says.

Rüter adds: “Greece was already receiving poor ratings in our sustainability rating at a time when conventional rating agencies were still giving it scores in the A range.”
However, while ESG research may have highlighted the problems in Greece and Italy, other highly indebted countries performed rather well.

As Ireland’s debt crisis was a result of a pure banking crisis, the ESG rating of the country did not signal any problems. In fact, Ireland’s social system and education looked strong before its financial meltdown. “Ireland is a country that fundamentally is in good medium-term shape, although it needs to clean up its house financially,” says Baltzell.
Within the EU, Ireland and Portugal did not rank badly in terms of their overall ESG scores, according to AXA IM’s model either because both countries have a less negative impact in terms of climate change and other social issues.

But ESG ratings have been anything but favourable for the world’s biggest bond issuers - the US and Japan. The US was ranked forty-fourth by Oekom, as many of the hopes pinned on the inauguration of Barack Obama as president have not been fulfilled.
While investors cannot easily stop investing in big bond issuers such as the US and Japan, it is possible for them to significantly underweight poorly-rated countries, especially since bond investors care more about maturity and yield than about being balanced relative to an index in terms of country exposure.

“The point of ESG ratings is to provide additional insight into the fundamental characteristics of countries over the medium and long term,” says Baltzell. “Having a good ESG ranking gives a country a more promising outlook over time than one that does not, and this fact might partly mitigate a poor credit rating. Conversely, countries that currently have good credit ratings but appear to be unsustainable over the long term could see those good ratings fall, unless they address their long-term ESG issues.”