New Sovereign ESG Ratings show E and S factors now highly material for bond pricing
by David Wille and James Lockhart Smith,
Despite growing pressure from asset owners and regulators, sovereign debt investors are still struggling to incorporate environmental and social factors into the investment process. On the one hand, they find it hard to justify including social issues in their models because they can’t identify a material relationship with market risk premia. On the other, they are increasingly taking note of environmental risks, but still find it difficult to quantify and track them in a timely way and gauge their likely impact on governments’ creditworthiness.
However, an analysis of our new Sovereign ESG Ratings, which feature six years of quarterly historical data, covering 37 separate issues across 9 ESG dimensions, breaks the assumptions for social risks, showing that they are highly material to debt pricing, while also revealing that transition risk has now started to affect spreads for the first time.
The Ratings offer investors an entirely new method for assessing and tracking environmental, social and governance (ESG) risks for sovereign debt issuers. They are built on a subset of our existing factor-level risk data, where we use an array of data science-driven approaches to extract signals from unstructured, geospatial, proprietary and structured datasets, and draw on nearly 350 indicators. The Ratings employ a novel statistical approach that does a better job of identifying material changes in an issuer’s sustainability profile than conventional scoring. The new dataset features a headline ESG rating as well as E, S and G pillar ratings for all debt issuers.
All in all, analysis of the ESG and E, S and G signals at the headline and pillar levels shows that social risks, not just governance risks, play a significant role in shaping market pricing. Even controlling for other important factors such as issuers’ credit ratings and levels of indebtedness, a one-notch improvement in an issuer’s Social rating is associated with bond spread tightening of over four percent, as shown in Figure 1. This is equivalent in magnitude to a similar Governance rating upgrade. While Environment rating upgrades are not statistically significant at the level of the E pillar, our analysis – as detailed below – shows that environmental factors are increasingly on investors’ radar. In particular, the key issue of energy transition is now being priced in by markets for the first time.
Better data on human and labour rights = better signals of sovereign debt pricing
Many investors have doubted the materiality of the S in ESG because traditional assessments of social risks did not show an independent statistical relationship with bond pricing – perhaps unsurprisingly given that many of these datasets are proxies or even direct measures of a country’s wealth.
But our Social pillar rating and scores, built on a unique dataset that combines machine learning and geospatial analytics to assess all aspects of social risk – including, critically, countries’ individual human rights guarantees, enforcement capabilities and violations – overcomes these limitations. Accordingly, our analysis makes the case that sovereign investors can and should explicitly take social factors into account when assessing an issuer’s sustainability profile. We find that the best performers on human and labour rights enjoy spreads around half as narrow as those of the worst performers, even when controlling for important factors such as that country’s level of income (see Figure 2).
Climate risks finally come into focus for sovereign investors
Of the four dimensions that compose the Environment pillar of our Sovereign ESG Ratings, the Transition Risk dimension (the black line in Figure 3 below) now shows a clear relationship with bond pricing, alongside physical risk. We found that the best-performing government issuers on the Transition Risk dimension – those moving fastest towards a low-carbon economy – enjoy bond pricing that is 13 percent lower than the worst performers.
This is a change from what we observed in our previous joint research in 2019 on market behaviour during the 2013-2018 time period, where we found that markets were at best ignoring and at worst actively penalising government issuers that were making the most progress in the economic transition away from fossil fuels.
Changes in our Environment and Governance Pillar scores are leading indicators of market sentiment
While our Environment pillar had no significant relationship with market risk premia, we did find that changes in the E and G pillars appear to be leading indicators of changes in bond pricing.
Specifically, during the 2017-2021 period, a one-notch improvement to an issuer’s Environment rating in a given quarter implied a spread tightening of more than 134 basis points 12 months later. This result held even after controlling for all relevant macroeconomic factors and for credit ratings. We also see a similar, though smaller, relationship between Governance improvements and spread narrowing the following year.
The presence of this 12-month lag between changes in E and G performance and changes in the perceived riskiness of those issuers underscores the extent to which sovereign bond markets are still remarkably inefficient when it comes to pricing ESG risk factors. We know from our analysis that investors are taking note of the importance of environmental risks, but they still find it hard to quantify these risks in a consistent and timely way. However, in some ways it is more surprising to find that changes in G factors are only gradually priced in. The inference is that while obvious shocks like civil unrest and coups get noticed immediately, more subtle structural shifts – for example the watering down of anti-corruption legislation, or an apparently benign reform of electoral institutions – still do not because investors miss key signals.
Our new Sovereign ESG Ratings dataset aims to help drive the widespread incorporation of environmental, social and governance factors in government debt markets. With the climate crisis deepening and the pandemic’s socioeconomic shockwaves extending into 2022, these issues will only grow in salience not just from an ethical perspective but also due to their tangible impact on sovereign credit sustainability. The Sovereign ESG Ratings dataset can help investors to minimise these downside risks, capitalise on emerging investment opportunities and create portfolios that tightly align with their values.