Our monitoring process is a crucial aspect of how we integrate ESG

Fundamental research has always been at the heart of our investment approach, The Capital System^TM. We believe that analyzing material environmental, social and governance (ESG) issues can help us better understand long-term risks and opportunities.

Monitoring is a key aspect of our ESG integration approach for equity, corporate debt and sovereign issuers.** For these asset classes, we complement in-house research and analysis with monitoring of third-party ESG data, where available. Our goal for monitoring is to surface external views of potentially material ESG risks.

Importantly, investment decisions are made based on a long-term view, engagement and analysis — never solely on monitoring results. The data is often a catalyst for deeper research, debate and collaboration among investment professionals.

Why integrate ESG considerations when investing in government bonds?

The ability of a government to repay bond investors can be affected by “E,” “S” and “G” risks that may not be fully reflected in traditional financial analysis. For example, low levels of corruption, social cohesion, the rule of law and effective government can set the stage for economic resilience and potentially reduce the risk of financial, political and social upheaval. Conversely, from a bond investor’s perspective, less favorable ESG indicators could suggest greater risk that a government borrower struggles to meet its obligations regarding coupon payments and return of principal.  

There are challenges in assessing “E,” “S” and “G” risks for sovereigns, compared to other asset classes. Difficulty in obtaining and analyzing ESG data and lack of consistency in defining material issues have been cited as barriers for more widespread adoption.* In addition, some sovereign ESG risks can evolve slowly. Depletion of natural resources, rising inequality and shifting political trends are examples of changes which occur and have impacts that can unfold over many years or decades.

Despite these challenges, there seems to be broader recognition among bond investors that ESG risks have the potential to affect default risk and investment outcomes. Recent academic and industry studies support this claim and demonstrate that ESG scores and sovereign credit ratings are highly correlated. In particular, governance and social scores show positive correlations with credit ratings — above 0.81, according to a recent World Bank calculation.^†

Our sovereign ESG monitoring methodology: Focused on material risks, recognizing nuance

Capital Group’s monitoring methodology for sovereigns was developed through a partnership between our ESG team and our investment professionals who have experience analyzing sovereigns. In addition to in-house collaboration, we reviewed academic research and assessed competitor methodologies to help find the right approach for us.

Sovereign monitoring methodology

Our monitoring process for sovereigns leverages raw scores from three data sources as detailed below.

Capital Group’s proprietary methodology blends these third-party scores and adjusts for gross national income (GNI). Issuers with the lowest scores — either on a GNI-adjusted basis or in absolute terms — are flagged for additional research and review.

The GNI adjustment allows us to assess an issuer’s performance relative to peers with similar wealth. We find this distinction to be increasingly important in addressing the income bias ingrained in ESG scores for sovereigns. According to research from the World Bank,^‡ average sovereign ESG scores across data providers are highly correlated with GNI per capita, which overly penalizes poorer countries based on their level of development and resources. Improvements in ESG-related metrics are often a natural part of a country’s economic development process; and as such, we believe it is important to evaluate the strength of an issuer’s ESG metrics given their level of economic development.

Sovereign bonds: Screening methodology (illustrative example of issuer scores)

Our monitoring process is built into Ethos, Capital Group’s proprietary ESG data platform, where investment analysts can view and resolve monitoring flags. For flagged issuers in Ethos, investment analysts share information and perspectives on material ESG risks and how those affect their investment thesis.

We also integrate ESG into our sovereign investment process through our proprietary data analytics platform, EM Live, which is used for exploring relative value and other traditional financial metrics for sovereign issuers. In EM Live, our investment professionals are able to track and analyze the underlying ESG indicators used in our sovereign monitoring process. In addition, in periodic portfolio reviews, our investment analysts review and analyze updates to ESG metrics for issuers in their coverage.

Our investment professionals can track a country's governance indicators across several dimensions (illustrative example)

We believe it is important to acknowledge the limitations of these datasets, which are backward looking in many cases and may not cover all sovereign issuers in our coverage universe. Our investment professionals therefore aim to identify forward-looking risks in their proprietary research and to discuss risks and concerns with issuers where possible. Data is not considered in isolation — it’s used to help inform our long-term view and dialogue with issuers.

Why we view the ‘G’ as typically more material for sovereigns

Our proprietary ESG scoring is currently most heavily weighted towards governance metrics for sovereigns. Countries that pursue best practices in “G” standards often have easier access to new financing and lower cost of capital, as governance indicators can directly relate to a sovereign’s ability to repay its financial obligations.^§

A multi-country analysis on the impact governance indicators can have on development and growth suggests good governance, such as government effectiveness and control of corruption, as measured by the World Bank’s governance indicators, is associated with a higher level of per capita GDP and higher overall rates of GDP over time.^||

Among sovereign issuers, the relative importance of “E” and related “S” risks may increase in the future.  For example, increased water stress and broader scarcity among natural resources could result in significant disruptions to business operations and reliance on alternative inputs or new technologies. Macroeconomic impacts, such as population displacement driven by resource scarcity, also have the potential to unfold over the longer term.

Monitoring is just one piece of the puzzle

“Monitoring is just one step in our overall ESG integration process, and flags are merely guideposts,“ says fixed income investment analyst Holger Siebrecht. “Improvements or declines are not necessarily linear.” For example, a country’s improving governance data may coincide with deteriorating environmental data. Countries may not progress equally across all areas at once.

Alongside fundamental research and analysis, our investment professionals' local experience is, in our view, critical for developing well-rounded and differentiated investment perspectives. Our commitment to meeting with government officials (in person or virtually) is a distinctive aspect of our research and engagement process. Rather than solely relying on roadshows, our experienced sovereign bond investment analysts and portfolio managers will often visit the countries in their coverage.  

“When our investment professionals engage with governments via meetings and roadshows, they will often emphasize the importance of transparency, good governance and adopting international standards,” explains fixed income portfolio manager Kirstie Spence. “Governments that pursue best practices can improve their access to financing and lower their cost of capital.”

For emerging markets, ESG can sometimes be a thorny issue, according to Kirstie: “Because they are often in the earlier stages of industrialization, these countries may, in some cases, struggle with the economic and societal changes that are a necessary part of improving their ESG profile.”

That’s why, in certain instances, our analysts engage directly with sovereigns to gain a better understanding of these ESG indicators. After a flag is raised, our starting point is further research, debate and, in some cases, engagement with the issuer. “Bringing ESG issues to the forefront of discussions enhances our dialogue with issuers and helps us fine-tune our valuations,” says Kirstie.

ESG monitoring in action: three country case studies

As noted, a flag in our monitoring process generally prompts deeper research and analysis by our investment professionals.

Here are three instances where our monitoring process helped inform our sovereign research and analysis:

Final thoughts

Monitoring of relevant third-party data is a key aspect of how we integrate ESG into our investment approach. However, investment decisions are always made based on a long-term view, engagement and analysis — never solely on monitoring results.

We are continuing to enhance the ways in which we embed ESG in our overall sovereign investment approach. The ESG data we consider as a part of our sovereign monitoring process may evolve as sources improve.

What won’t change is the reason that we’re making this effort: It is our belief that, by incorporating information on material ESG risks and opportunities into investment research and analysis, we can help to improve long-term outcomes for investors.