Integrating ESG into sovereign risk analysis adds a holistic and long-term perspective, which can lead to better portfolio construction, says PIMCO's Lupic Rahman
Traditional sovereign credit analysis focuses on financial and macroeconomic variables that materially impact a country's probability of default and the expected loss if default occurs. We believe integrating environmental, social and governance (ESG) factors into this analysis can add a holistic and long-term perspective, which can lead to better portfolio construction.
Correlation between ESG factors and sovereign risk
A key goal in sovereign credit analysis is finding issuers that have lower long-term credit or default risk than what is reflected in market prices. In our view, including ESG factors improves this identification significantly. However, not all ESG components are equally important; some factors have a direct material impact while others have indirect and more diffuse effects.
• Variables related to governance ('G') have been found to be effective indicators of sovereign credit risk, particularly in countries at the lower end of the ratings scale where governance and the quality of institutions can be a binding constraint. This should come as no surprise: Moody's Investors Service reports that "about 30% of past sovereign defaults have been directly related to institutional and political weakness, ranging from political instability to weak budget management and governance problems or to political unwillingness to pay.
• Measures of social ('S') factors are less significant but tend to be highly correlated with GDP per capita and initial wealth conditions, which themselves are key drivers of sovereign risk. Intuitively, a country's social capital ‒ proxied by education, health, the poverty rate and inequality, among other factors ‒ is likely to be highly relevant in determining social cohesion, and productivity, which contribute to competitiveness and growth potential.
• Finally, environmental ('E') variables are least correlated with sovereign risk, aside from specific cases where the impact of climate change is more acute (due to hurricanes, earthquakes, etc.) or more immediate (e.g., sinking islands).
PIMCO's approach to ESG in sovereign analysis
Our sovereign analysis starts with in-depth, bottom-up country risk analysis. This includes taking stock of traditional financial and economic metrics, together with the ESG variables shown in Figure 1.
Figure 1: PIMCO ESG Scoring Framework
Next, PIMCO's proprietary sovereign ratings model assigns a credit rating to the sovereign. This uses five-year forecasts, current data and specific quantitative ESG variables from our country analysis as inputs. The final component is country-specific scenario analysis. We analyze long-term debt sustainability, resource depletion scenarios, natural disaster scenarios, and contingency risk. In each study we incorporate medium- and long-term risks to the sovereign from both macro and ESG factors.
Overall, we aim to identify and invest in sovereigns with robust underlying credit fundamentals, solid and improving medium-term prospects, lower downside risks and attractive pricing. We place paramount importance on avoiding countries where we believe creditworthiness is overpriced or deteriorating, or default appears likely. We believe these objectives are consistent with, and enhanced by, ESG considerations.
For more on ESG investing at PIMCO, visit PIMCO ESG.
Lupin Rahman, head of EM sovereign credit, PIMCO
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