21 June 2024
Summary
• Despite sovereign bonds accounting for trillions in assets globally, there is less ESG data available in this segment compared to corporate bonds and equities.
• The effects of climate change could have huge implications for a country’s debt levels, sovereign bond valuations and credit ratings.
• Calculating the carbon footprint of investments can be particularly challenging, and metrics for measuring corporate debt such as revenue or enterprise value are not as applicable for sovereigns.
• Beutel Goodman uses its own proprietary sovereign ESG framework to assess sovereigns, local authorities, government agencies and other sovereign-related debt issuers.
By Beutel Goodman Fixed Income Team
Sovereign bonds are one of the largest asset classes globally. Total sovereign debt, according to the Organisation for Economic Co-operation and Development (OECD), reached US$66 trillion at the end of 2023,[1] while bonds issued by sovereign governments, government agencies, local authorities and supranationals make up approximately 66% of the Bloomberg Global Aggregate Index. Despite its importance to the global bond market, there are distinct challenges when it comes to conducting ESG analysis on these investments, including availability, comparability and usefulness of data; a lack of access to decision makers at these issuers can also limit engagement on sovereign ESG policies. This has meant that ESG analysis for sovereigns generally lags that of corporate bond and equity issuers.
ESG Matters for Sovereigns
Sovereigns face a unique set of material risks in ESG that could impact the long-term financial sustainability of an investment. Factors such as climate resiliency spending (preventive) and relief spending (reactive to a climate event) are likely to increase a country’s debt levels, which may impact its debt burdens, valuations and credit ratings; the ultimate negative impact for a sovereign bondholder is a sovereign default. A study of 23 OECD countries from 2007 to 2012 found that countries with higher ESG ratings traded at lower bond spreads relative to their lower-rated peers.[2] While sovereigns can default on debt payments for different reasons, specific ESG risks such as political instability can have a major impact. For example, a scenario where civil unrest prevents a government from implementing austerity measures, thereby leaving the state incapable of paying its debts.
Physical and transition risk are also important ESG factors for sovereigns. By 2050, if global warming does not stay well below 2°C, it is estimated that up to 4.4% of the world’s GDP could be lost annually. The data also shows geographic disparities, with emerging markets facing a larger share of potential damage related to physical risk.[3] Approximately 3.3 billion to 3.6 billion people live in areas that are highly vulnerable to climate change.[4] The rising number of extreme weather and climate events have also exposed millions of people to acute food insecurity and reduced water security.
Case Study: Russia
A study by Bloomberg released just after Russia invaded Ukraine in February 2022 found that ESG-focused funds held US$40 billion in Russian sovereign debt.[5] This is notable as prior to the invasion, Russia would have been flagged for material ESG risks for its rule of law and political stability; in fact, it ranked near the bottom of the Institute for Economics and Peace’s Global Peace Index.[6] All three major global credit rating agencies subsequently withdrew their credit ratings on Russian debt after sanctions were imposed against the country. The Russian government also threatened to repay its foreign currency debt not in the currency in which it was issued, but in rubles. This example highlights the importance of robust ESG analysis on sovereign debt as ESG risks are not limited to corporate issuers.
Metrics
One of the more significant challenges in sovereign ESG analysis is calculating the carbon footprint of investments. Corporate emissions are generally calculated using revenue or enterprise value. We find that neither of those two factors adequately captures the carbon footprint of a sovereign, since government revenue is not as straightforward and cross-comparable as corporate revenue and governments do not have equity with which to calculate an enterprise value. Therefore, in our view, sovereign emissions should be reported separately to corporate emissions in a portfolio since they cannot be expressed as a per revenue or per enterprise value including cash (EVIC) basis.
There are many methods to base sovereign GHG emissions, such as per capita, per unit GDP and per unit of debt. Additionally, adjustments are needed to the definitions of Scope 1, 2 and 3 emissions to fit a sovereign’s emission profile. Therefore, it is not possible to have one carbon footprint metric for a fixed income portfolio, it must be broken out as two measures — one for sovereigns and one for corporates.
It is important to note that if corporate methodology was applied to a sovereign, then a government would only be responsible for public sector emissions; arguably, it should be responsible for the emissions of the whole country. The Partnership for Carbon Accounting Financials (PCAF) recommends sovereign emissions to be classified as:
- Scope 1 Emissions: domestic GHG emissions from sources located within the country’s territory, including emissions from exported goods and services;
- Scope 2 Emissions: GHG emissions occurring as a consequence of the domestic use of grid-supplied electricity, heat, steam and/or cooling that is imported from another territory; and
- Scope 3 Emissions: GHG emissions attributable to non-energy imports as a result of activities taking place within the country’s territory.
Timeliness also seems to be an issue in conducting ESG analysis; for example, the latest emissions data available for Canada is for 2021. The Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) project is attempting to remedy this issue, similar to what the Task Force for Climate-Related Disclosure has done on the corporate side. ASCOR is an investor-led project to develop a free, publicly available, independent tool that assesses countries on their progress in managing the low-carbon transition and the impacts of climate change. The framework has been developed in part by the Transition Pathway Initiative. ASCOR released its first version of its assessment tool in December 2023 and the initiative initially assessed 25 countries that represent approximately 70% of the world’s GHG emissions. Based on the results, ASCOR noted three gaps:
- A large emission gap due to a lack of ambition in countries’ targets and trends;
- An implementation gap with insufficient sectoral policies to meet their targets; and
- An international climate finance gap, which high-income countries need to work towards closing.[7]
The results provide a basis for sovereign bond investors to engage with national issuers on climate risk.
Sustainable Finance
There is currently $1.89 trillion of sustainable finance bonds outstanding in the sovereign space globally; the majority of issuance is by government-related entities. Countries have issued $586 billion of labelled bonds, the majority of which are green bonds at 50%, followed by social at 30%, sustainable at 19% and sustainability-linked bonds (SLBs) at 1%. For more details on sustainable finance, please read our article: What Colour is my Bond. Of note, Uruguay and Chile have issued SLBs where the key performance indicators are linked to the countries’ commitments to the Paris Agreement.
Beutel Goodman Engagement
Beutel Goodman favours an approach that incorporates diligent stewardship and influences positive change in the long-term value of our holdings by having a “seat at the table”. Engagement on the sovereign side has traditionally been focused on meetings with federal and provincial departments of finance on fiscal policies. Engaging with sovereigns and local authorities on environmental and social policies and laws can be challenging, and investors need to be mindful of engaging without partaking in political lobbying or exerting political influence. Sovereign engagement can also be conducted through letters of support. For example, in September 2022, Beutel Goodman joined with other asset managers in submitting a joint response on “Canada’s Options to Cap and Cut Oil and Gas Sector Greenhouse Gas Emissions to Achieve 2030 Goals and Net-Zero by 2050”. We encouraged the Government of Canada to adopt practical and effective regulatory changes to incentivize emission-reduction innovation and implementation to further limit climate change, which would also reduce systemic risk in our portfolios. We also seek to engage with sovereigns and local authorities on their sustainable bond frameworks, where applicable.
Beutel Goodman Framework
Beutel Goodman has a proprietary sovereign ESG framework that it uses to assess sovereigns, local authorities, government agencies and other sovereign-related debt issuers using environmental, social and governance factors to help identify material risks. This framework is in addition to our process we use to analyse the credit metrics or creditworthiness of an issuer, and as such should be used and viewed concurrent to the bottom-up credit process of sovereign and related issuers. The framework is used not only for direct sovereign analysis but also for identifying material sovereign ESG risks in different countries where companies we analyze operate.
Exhibit 1: Material Sovereign ESG Themes.
Source: Beutel, Goodman & Company Ltd.
ESG performance among countries tends to reflect significant income disparities with developed market (DM) countries outperforming their emerging market (EM) peers, who in turn outperform frontier market (FM) countries. Therefore, meaningful analysis should be done within a country’s relevant income cohort or income bias may incentivize capital flows toward only high-income countries. High-income, developed countries tend to have stronger institutions, greater equality and more prosperity, which are typically tied to better ESG scores. To overcome this, we believe that analysing a country’s score relative to its peer group is ideal and allows for non-quantitative analysis and considerations to be incorporated. In deciding the peer group, we use the World Bank’s income and geographic classifications.
We believe that rather than focusing on a particular point in time, using trends helps to better understand whether a country is working towards ESG improvements. Forward-looking assessments are also critical because the risks from climate change are expected to be more frequent and larger in the future than in the past. Within the constraints of the data that is available, we have made our framework as forward-looking as possible. We expect that as data becomes more uniform and accessible, we will adapt the framework accordingly.
As part of looking forward, we use indicators such as the Notre Dame Global Adaptation Initiative, Coastal Protection, and Sovereign Warming Potential, which look at how a country’s actions align with the temperature scenarios from MSCI. Additionally, we compare sovereigns not just within their peer group, but also examine their historical progress by looking at current versus 1-year, 5-year and 10-year levels to assess progress of the metrics or the lack thereof.
Our objective in fixed income investing is to maximize portfolio returns while preserving capital. We believe our ability to reach this objective is hampered by investing in countries that are:
- Democratically challenged;
- Involved in armed conflict;
- Militarized within its borders; and
- Controlled by authoritarian regimes.
To assess these material risks, we look at several comprehensive and publicly available indices that are routinely updated. The following tables (Exhibits 2, 3 and 4) illustrate data that we use in our comprehensive sovereign database to track performance and trends.
Exhibit 2. Beutel Goodman’s ESG Factors for Assessing Sovereigns.
| Factor |
Source |
| Energy Security | |
| Energy Consumption (per capita) | World Development Indicators – World Bank Database |
| Energy Imports | World Development Indicators – World Bank Database |
| Energy Productivity | World Development Indicators – World Bank Database |
| Energy Resource Depletion | World Development Indicators – World Bank Database |
| Fossil Fuel Energy Consumption | World Development Indicators – World Bank Database |
| Renewable Electricity Output | World Development Indicators – World Bank Database |
| Renewable Electricity Consumption | World Development Indicators – World Bank Database |
| Energy Resource Management Score | MSCI ESG Research |
| Energy Security Score | MSCI ESG Research |
| Transition Risk | |
| Paris Agreement Ratification Status | UNFCCC |
| Party to Basel Convention | MSCI ESG Research |
| Sovereign Warming Potential | MSCI ESG Research |
| Climate Protection Score | Germanwatch Climate Performance Index |
| Climate Protection Index Score | Germanwatch Climate Performance Index |
| Country GHG Intensity | MSCI ESG Research |
| Germanwatch Climate Performance Index | Germanwatch Climate Performance Rank |
| CO2 Emissions Final Domestic Demand | IEA, OECD |
| GHG Emissions (% of World Total) | World Development Indicators – World Bank Database, UNFCCC |
| GHG Emissions (Per Capita) | EU Emissions Database for Global Atmospheric Research |
| Physical Risk | |
| Environmental Externalities and Vulnerability Risk Management Score | MSCI ESG Research |
| Environmental Externalities Score | MSCI ESG Research |
| Environmental Externalities and Vulnerability Risk Factor Score | MSCI ESG Research |
| Vulnerability to External Events Score | MSCI ESG Research |
| Environmental Performance Score | MSCI ESG Research |
| Management of Environmental Externalities Score | MSCI ESG Research |
| Heating Degree Days | World Development Indicators – World Bank Database |
| Heat Index 35oC | World Development Indicators – World Bank Database |
| Water Stress | World Development Indicators – World Bank Database |
| World Risk Index | UNFCCC |
| Notre Dame Global Adaptation Index | University of Notre Dame |
| Coastal Protection | World Development Indicators – World Bank Database, Ocean Health Index |
| Natural Resource Risk | |
| Agriculture and Forest Land | World Development Indicators – World Bank Database |
| Tree Cover Loss | World Development Indicators – World Bank Database |
| Forest Cover Change | World Development Indicators – World Bank Database |
| Natural Resource Risk Exposure Score | MSCI ESG Research |
| Natural Resource Risk Management Score | MSCI ESG Research |
| Mineral Resource Depletion Score | MSCI ESG Research |
| Resource Conversation Score | MSCI ESG Research |
| Water Resource Management Score | MSCI ESG Research |
Source: Beutel, Goodman & Company Ltd.
Exhibit 3. Social Factors.
|
Factor |
Source |
| Human Rights | Civil Liberties by Freedom House, The World Press Freedom Index |
| Access to Electricity | The World Bank Database |
| Access to Water | The World Bank Database |
| Access to Sanitation | The World Bank Database |
| Fertility Rate | The World Bank Database |
| Population Aged 65 and Above | The World Bank Database |
| Hospital Beds | The World Bank Database |
| Literacy Rate | World Development Indicators – World Bank Database |
| Female Labour Income Share | World Inequality Database |
| Unemployment Rate | The World Bank Database |
| Net Migration | The World Bank Database |
| Seats Held by Women in National Parliament | The World Bank Database |
| Gini Index | The World Bank Database |
Source: Beutel, Goodman & Company Ltd.
Exhibit 4. Governance Factors.
| Factor | Source |
| Democracy | Democracy Index (World Intelligence Unit) |
| Peace | Global Peace Index (Institute for Economics and Peace) |
| Money Laundering and Bribery | The Basel AML Index (Basel Institute on Governance) |
| Money Laundering and Bribery | United Nations Sanctions List |
| Freedom | Freedom House Index (Freedom House) |
| Political Rights | Freedom House |
| Political Stability | The World Bank |
| Voice and Accountability | The World Bank |
| Fiscal Policy | Open Budget Survey (International Budget Partnership) |
| Corruption Perceptions Index | Transparency International |
| Control of Corruption | The World Bank |
| Rule of Law | The World Bank |
| Regulatory Quality | The World Bank |
| Government Effectiveness | The World Bank |
Source: Beutel, Goodman & Company Ltd.
Conclusion
Even though the sovereign sector lags corporates, incorporating sovereign ESG risks and opportunities into investment analysis is important as those holdings that typically make up a significant portion of fixed income portfolios. We will continue to monitor industry best practices to improve our framework and engagements with sovereigns and local authorities.
[1] OECD (2024), Global Debt Report 2024: Bond Markets in a High-Debt Environment, OECD Publishing, Paris, https://doi.org/10.1787/91844ea2-en.
[2] Crifo P, Diaye MA, Oueghlissi R. “Measuring the effect of government ESG performance on sovereign borrowing cost.” 2015.
[3] “Lost GDP: Potential Impacts of Physical Climate Risks” S&P Global, November 27, 2023.
[4] IPCC, 2023: Summary for Policymakers. In: Climate Change 2023: Synthesis Report. Contribution of Working Groups I, II and III to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, H. Lee and J. Romero (eds.)]. IPCC, Geneva, Switzerland, pp. 1-34, doi: 10.59327/IPCC/AR6-9789291691647.
[5] Schwartzkopf, Frances “ESG Funds Get Brutal Wake-up Call on Russian Bond Holdings” Bloomberg, March 2022.
[6] https://www.visionofhumanity.org/wp-content/uploads/2023/06/GPI-2023-Web.pdf
[7] “Countries’ progress on managing climate change: The first ASCOR assessment results” July 2023, Transition Pathway Initiative
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Related Topics and Links of Interest:
- An Efficient Frontier for Canadian Equities
- Finding Value Beyond the Index
- A Top-Down, Bottom-Up Dichotomy in Global Equity Investing
©2024 Beutel, Goodman & Company Ltd. Do not sell or modify this document without the prior written consent of Beutel, Goodman & Company Ltd. This commentary represents the views of Beutel, Goodman & Company Ltd. as at the date indicated.
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Please note Beutel Goodman’s ESG and responsible investing approach may evolve over time. We do not use ESG factors to pursue non-financial ESG performance. Also note that the integration of ESG and responsible investing considerations into our investment process does not guarantee positive returns. Past performance does not guarantee future results.
For more information on our approach to ESG and Responsible Investing, please visit https://www.beutelgoodman.com/about-us/responsible-investing/.
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