In-depth insights from ING Investment Management. Emerging Market Debt: Integrating ESG into the Sovereign Perspective

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1 For professional use only In-depth insights from ING Investment Management August 2012 FocusPoint Views of the EMD team of ING Investment Management on the importance of gauging country creditworthiness through consistent analysis of ESG factors in emerging market debt investments. Emerging Market Debt: Integrating ESG into the Sovereign Perspective Environmental, Social and Governance (ESG) indicators gain in importance We have incorporated ESG into our sovereign scoring model The new scoring methodology gives better results in terms of predictive power

2 Integrating ESG into the Sovereign Perspective The last decade saw a great deal of intellectual energy spent on the so-called Environmental, Social and Governance (ESG) indicators and their relevance to investing in capital markets. While the bulk of the effort has focused on ESG in a corporate context through equity and corporate bond analysis, we have taken the subject to the level of sovereign creditworthiness. We have reinforced our sovereign scoring model by a robust and systematic framework incorporating the drivers of ESG across our universe of countries. Back-testing the results, we found a clear improvement of the new scoring methodology, as our sovereign risk model advanced in terms of its predictive powers for spreads paid by sovereigns. The following section will provide more detail on the specifics of this improved approach, starting with our viewpoint on the importance of gauging country creditworthiness through consistent analysis of ESG factors in emerging markets debt investments. We will elaborate on our new ESG methodology in Section 2, and discuss the main results of a back test we conducted on the model in Section 3. Section 4 provides a summary of our conclusions. 1. Country Risk and ESG Factors Increasing emphasis on soft factors Soft factors such as institutions, governance and social development all matter greatly for a country s creditworthiness. Having long viewed institutions as the decisive factor for development in colonial economies, modern academic literature has increasingly emphasized soft factors over more traditional considerations such as capital to labour ratios in explaining the differences in per capita incomes between countries. In essence, ESG factors determine how a country deals with the challenges of the future. The inherent uncertainty of the future will throw various tests at a country, be it a crisis with external shocks, such as global oil prices or changes in terms of trade resulting from a booming global economy, or internal factors such as demographic pressures. The extent to which a country addresses or recovers from such challenges has significant implications for its debt repayment capacity and willingness. The countries that are reasonably successful in producing a self-sustainable, quality way of living for their population over generations will be more creditworthy as they will have services and products of value to offer to other countries, ensuring the capacity to generate capital to repay debt. Countries with a poor quality of governance, on the other hand, are more prone to crises, which can easily turn into major systemic dislocations that threaten the ability and willingness to service debt. Macroeconomic data and national statistics will to some extent reflect the quality of governance in a country but cannot provide a direct measurement at all times. A well-governed country is more likely to have a higher GDP per capita than a mediocre-governed country. A high GDP per capita may also reflect temporary factors, however, such as an overvalued exchange rate, income from exhaustible resources or high cyclical prices for a country that is very dependent on one particular export product. An ESG perspective should also not be seen as all-inclusive. The state of the country s economy as captured in macroeconomic numbers should be seen as the starting point for its future and a key component for creditworthiness. It is unlikely that good governance will eliminate an unsustainable debt burden immediately. A measured combination of the two will provide the best results in understanding country risk and creditworthiness. Principles for Responsible Investment Initiative The revised incorporation of ESG factors in the sovereign risk scoring tool is in line with the broader commitment of ING Investment Management as a signatory to the United Nationsbacked Principles for Responsible Investment Initiative (PRI). The PRI provides a voluntary framework by which investors can integrate ESG issues into their decision-making and ownership practices to align their objectives with those of the society at large. 2

3 The growing interest in ESG factors by institutional investors, in particular, reflects the view that environmental, social and corporate governance issues can affect the performance of investment portfolios and should therefore be given appropriate consideration by investors. There are currently over 900 signatories from 48 countries to the PRI, representing a total of USD 30 trillion in AuM. Recent industry discussions entailed arguments that fund managers and financial analysts who can interpret and relate ESG factors to a company s future prospects may potentially develop a competitive advantage should others fail to recognise the same risks or opportunities related to those factors. The PRI framework places ESG issues as part of delivering superior risk-adjusted returns and therefore firmly within the bounds of investors fiduciary duties. 2. Integrating ESG into Sovereign Scoring Our Sovereign Risk Model Our recently revised methodology is meant to capture a broad series of soft or qualitative factors, such as the quality of the country s institutions, rule of law and ease of doing business; a stable, transparent and accountable political process; ability to cope with funding crises and cross-border stresses and economic foundations such as banking sector health, energy efficiency and trade diversification. The new indicators were incorporated into the Sovereign Risk Model (SRM). The SRM is an analytical framework that uses macroeconomic and debt indicators to produce scores on the relative creditworthiness of the countries in our investment universe. Having been introduced in 1997 to be updated on a quarterly basis, the SRM has been a key part of the portfolio construction process. The sovereign scoring model has in the past relied on analysts qualitative assessments on the soft factor phenomena. The revised approach provides a robust and systematic model that offers: Standardized scoring through time and across 65 emerging market countries (see Appendix 1) Consistent emphasis on a broad selection of ESG factors rather than giving too much weight on current themes, and A systematic measurement of quality of governance, through the use of a wide range of qualitative indicators produced by international organizations. Inputs for our risk assessment scoring The revised ESG methodology identifies five specific risk categories as inputs for our structural and qualitative risk assessment scoring, and came up with several indicators to measure each component. The risk scores are calculated per each category based on relative country rankings, and then aggregated to an ESG score for each country, using weightings based on back test results for the period from 2004 to macroeconomic inputs in the original model and the ESG score. The ESG data comes from a variety of sources, including the World Bank, Transparency International and the United Nations that use extensive surveys and expert assessments to capture and measure governance quality issues. The five specific risk categories are: Institutional Strength Institutional strength refers to the stability and effectiveness of a country s institutions, which we consider to be a prerequisite for a stable economy and business environment. The category focuses on the scale of public accountability, corruption perceptions, ease of doing business, human development and rule of law. Political Process Political process measures the government s ability to propose, pass and enforce its chosen legislation, the independence of public service from political pressures, the general quality of policy formulation and implementation. The category also captures the government s ability to foster private sector development as well as withstanding security issues. Financial and Economic Strength Financial and economic strength assesses the country s fundamental strength and weakness by focusing particularly on the health of the banking sector, reliance on fuel exports and the size of the agriculture sector. Weak financial conditions will retard growth and investments, while concentration and dependency on certain sectors will make the country more vulnerable to external shocks. Structural Changes Structural changes measure the trend of the country s governance quality as defined as the average of (relative) change for each of the aforementioned four sub-indicators. External Shock Resilience The model uses qualitative analyst surveys on two key areas: the first is the country s access to internal (fiscal reserves, resource and sovereign wealth funds) and external funds (bilateral swap arrangements, regional financial support initiatives, IMF lending facilities) in case of a debt sustainability concern and/or a capital market shock. The second indicator in the category focuses on the country s exposure to cross-border stresses, such as geopolitical, military and foreign relations crises in neighbouring countries, drug trafficking, arms smuggling, refugee crises, and environmental emergencies and disasters. The ESG scores can be seen in Appendix 1. A full SRM rating is then calculated for each country as a weighted average of the quantitative score based on the 3

4 3. Model performance tested Back test results show an improvement in predictive power of our model The EMD team conducted a back test for the original and revised models by using data from 2004 to 2011 against changes in associated emerging market bond yield spreads over the subsequent quarter. The back test results were used to determine weightings in the model (Exhibit 1). Exhibit 1. ING IM ESG Scoring 5% 15% 20% Institutional Strength Political Process Financial and Economic Strength Structural Changes External Shock Resilience 4. Conclusion: using the model in the investment process 25% 35% ESG factors will gain further in importance The debate around the broader study of ESG issues is important and very relevant to the current state of global financial markets, where sovereign investors have to develop a strong understanding of their markets that goes beyond the traditional economic indicators. This trend has arguably been brought further to the fore by the recent global credit and sovereign debt crises. A considerable number of ESG-focused models and indices have appeared in recent years. This demonstrates an increasing recognition that the integration of ESG information into investment decisions enhances asset managers and financial analysts ability to evaluate risks. However, the multiplicity and discrepancies between the various methods, and at times the lack of a clearly defined target audience dilute chances for such models to make a consistent contribution to financial investing. Our back test results are quite encouraging in this regard as they add to the increasing evidence that ESG issues can be material to performance of emerging markets debt, particularly over the longer term and during both down and up markets. The basing of category and indicator weightings on the back test results is meant to bolster the model s explanatory power. The model also benefits from the breadth of the coverage universe of 65 emerging market countries (see Appendix 1). The improved relationship between the revised model and the market trends and developments suggest that the revisions are likely to guide us towards better investment and portfolio construction decisions in the coming period. The integration of ESG factors in a more formal and systematic way into our investment process will also further serve our broader objectives as a signatory of PRI to contribute to a more long-term oriented, transparent, sustainable and well-governed investment market and business activity. Appendix 1. ESG Scoring, Q Total Score Hong Kong 92,38 South Africa 65,95 Jamaica 51,10 Taiwan 42,70 Chile 89,38 Romania 65,50 Tunisia 50,91 Kazakhstan 42,16 Singapore 88,23 Brazil 64,37 Albania 50,50 Gabon 40,18 Czech Republic 79,59 Panama 63,58 El Salvador 49,97 Algeria 39,90 Uruguay 79,35 Trinidad and Tobago 63,44 Mongolia 49,01 Senegal 39,05 Bermuda 78,38 Bulgaria 61,55 Dominican Republic 48,85 Ukraine 38,34 South Korea 78,05 Bahrain 60,36 Serbia 48,18 Ecuador 37,86 Poland 77,85 Turkey 60,25 Argentina 46,67 Belarus 36,03 Qatar 75,75 Ghana 58,93 Russia 46,54 Azerbaijan 35,65 Lithuania 73,65 Mexico 56,60 India 45,40 Egypt 34,46 Malaysia 72,18 China 56,40 Bosnia and Herzegovina 45,16 Venezuela 29,98 UAE 71,09 Colombia 55,53 Morocco 45,10 Nigeria 27,91 Costa Rica 70,66 Jordan 53,84 Sri Lanka 44,73 Pakistan 23,52 Latvia 70,15 Peru 53,83 Philippines 44,60 Iraq 22,31 Hungary 69,51 Georgia 53,80 Indonesia 44,59 Cote d'ivoire 21,90 Israel 67,12 Thailand 52,41 Vietnam 43,15 Croatia 66,51 Belize 51,79 Lebanon 42,76 4

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