Central and east European countries are among the best in the world for environmental, social and governance performance, according to a new way of looking at the issue that aims to remedy some of the flaws in conventional ESG rankings.
Lithuania’s government bonds are the best globally to invest in for ESG impact, according to Impact Cubed, an investment analytics firm in London. In the top 10 are Czechia, Poland, Estonia, Hungary and Slovenia. Romania, Croatia and Slovakia are close behind.
On typical scorings from providers such as MSCI or Sustainalytics, only a couple of these would get in the top 20.
Government bond investors increasingly want to take ESG factors into account, as their colleagues in other asset classes do. But this presents difficulties. Most ESG analytics and methodologies are designed for equity investors.
“This is an incredibly important area,” said Nannette Hechler-Fayd’herbe, chief investment officer of Credit Suisse’s international wealth management division. “The data and analysis for bonds are far younger and less available than for equities, so we don’t have all the answers yet. Especially for sovereigns it’s proving even more delicate and difficult.”
While analytics designed for equities can be some help for corporate bond investors, they are no use for government bonds.
Marisa Drew, chief sustainability officer at Credit Suisse, said a country might be committed to reducing carbon emissions to net zero, but have poor social infrastructure, putting an investor’s ‘E’ and ‘S’ views in conflict.
The major ESG agencies do offer sovereign ratings. But whereas investors habitually complain that corporate ESG ratings from different providers are uncorrelated, leaving them bewildered, with sovereigns, it is the opposite. The different rankings are too similar, and seem to tell investors little they didn’t know.
“In a lot of methodologies the same very wealthy countries are ranked at the top and the low income ones at the bottom,” said Arleta Majoch, partner at Impact Cubed. “It is always the usual suspects — of course Finland has the best gender equality.”
This is not just uninformative — it encourages investors to put money in the safest countries, not those which need help.
"As the World Bank has referred to, the current ESG approaches are basically a wealth ranking," said Majoch. "What does it do from the perspective of directing capital to where it could have impact? We thought: nobody else is measuring this, so we should do it ourselves.”
Mainstream ratings track countries’ levels of social and environmental development, to inform investors about possible ESG risks. Impact Cubed aims to measure ESG impact, by determining which countries are improving fastest.
"There is not the same difficulty with data for sovereigns as there is for corporates," said Majoch. "The data are very well available from multiple sources."
From 247 indicators of progress towards the 17 Sustainable Development Goals, Impact Cubed has chosen 29 metrics with good data going back several years.
For some SDGs it has up to three indicators — for example, for SDG 4 Quailty Education, children who can read, gender equality in education and years in education. For others, there is just one, such as, for SDG 14 Life Below Water, plastic waste.
Traditional ESG raters use the same data. But by studying the data from the past 20 years, Impact Cubed has worked out how fast countries typically improve.
For example, it might take an average of 2.5 years for a country with life expectancy of 60 to raise this to 61. If life expectancy is 85, it is likely to improve more slowly. Impact Cubed rates each country annually on whether it is advancing on each metric faster or more slowly than normal at its level of development.
Countries can thus be sorted for each metric into leaders — those with high levels and still progressing faster than average; stalled, with high levels but sub-par progress; laggards, with low levels and slow progress; and those catching up, which have low levels but are advancing fast.
When Impact Cubed applied this analysis to 20 countries with high conventional ESG scores, it found a wide dispersion. Germany and Czechia are leaders on 62% of the factors, but the US only on 32% and Australia on 26%.
Looking at the full universe of debt issuers, Lithuania does even better than Germany, with leadership on 65% of factors. "One possible reason is that environmental and economic sustainability issues are a core focus of its National Commission on Sustainable Development, which is chaired by the prime minister, and works across the government and private sector to implement its sustainable development strategy," Impact Cubed surmised in a research paper.
Picking the best improvers by counting the total of leader and catching up statuses produces a top 20 in which 19 are European, but 10 are emerging markets. Besides the nine named above, the United Arab Emirates comes in at number nine. Among major EU states, France, Italy and Spain fail to make the top 20.
Impact Cubed weights the 29 metrics equally. "We don't apply a weighting scheme," said Majoch. "We see weightings of the underlying pillars to produce an overall score as one of the main culprits in the subjectivity of ESG research."
But users of the system could choose different weightings themselves, or use a subset of the indicators.
The data Impact Cubed uses is all public and it has been transparent about the nature of its methodology. But the data cleaning and crunching, such as removing political bias, and the ESG ratings themselves are a commercial product.
So far, it has been testing the system and gaining feedback from a number of existing clients and new institutions, covering a mixture of emerging market and developed market investors. William Blair International and Neuberger Berman have both been willing to go public that they have participated in the consultation.
ESG factors might seem more material to EM investors — and in equities, ESG quality produces stronger outperformance in EM than DM, according to Credit Suisse. But Majoch said: "If normal ESG ratings are a wealth ranking than developed market investors don't have a way to differentiate between developed markets. It's a hot topic. They all want a fresh perspective — something to engage with clients on on ESG."
Users can input their government bond portfolio into the system and be shown its biases, with regard to all 29 factors — rather like equity investors use factor analysis to determine whether they are underweight quality stocks or overweight momentum. Knowing this information, investors can then tweak their exposures to improve their ESG impact characteristics.
Impact Cubed is not doing performance attribution to these factors yet, but it does do risk attribution.
Impact Cubed works only with investors, not issuers. However, at some point, it is possible to imagine issuers wanting to publicise that their sustainable development performance is improving, as tracked by the Impact Cubed rankings.
When Credit Suisse advises emerging market governments, Drew said, “we say that when you are able to demonstrate an ESG story, you see excitement from the investment community. It may happen over the longer term, but countries that can demonstrate leadership will attract capital. Is your ministry diverse? Are your energy services driving towards green? If you can tell a really good, cohesive story, there will be a long term benefit [in capital markets access and pricing]. But it's hard to prove today.”
Identifying improvers makes sense for investors that want to optimise their portfolio performance by integrating ESG analysis. But, depending on how impact is defined, investing in improvers does not necessarily mean the investor is having impact.
"Our way of looking at sovereign investor impact," said Majoch, "is that these countries will keep issuing debt. Some countries in emerging markets only started issuing last year. With traditional ESG approaches, some would not be investable, because they're at the bottom of the pile. But if you ask a different question, you come up with a different answer. If you're more focused on the countries that are pulling their weight, that debt becomes investable. That's why we feel this is aligned with our mission."