FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS NOTES Abridged Version A New Dawn – Rethinking Sovereign ESG Abridged Version | A New Dawn – Rethinking Sovereign ESG © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. Chapter 2 was first published as a research report, “Hurdles for EM Sovereign ESG Strategies” by the research department of J.P. Morgan on February 25, 2021, and is reprinted here with the permission of J.P. Morgan. (c) JPMorgan Chase & Co., all rights reserved. Rights and Permissions This work is available under the Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO), http:// creativecommons.org/licenses/by/3.0/igo. Under the Creative Commons Attribution license, you are free to copy, distribute, transmit, and adapt this work, including for commercial purposes, under the following conditions: Attribution—Please cite the work as follows: Ekaterina M. Gratcheva, Bryan Gurhy, Teal Emery, Dieter Wang, Luis Oganes, Jarrad K. Linzie, Lydia Harvey, Katherine Marney, Jessica Murray, and Rupert Rink. 2021. “A New Dawn: rethinking Sovereign ESG” EFI Insight-Finance. Washington, DC: World Bank and New York, NY: J.P. Morgan. Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. Adaptations—If you create an adaptation of this work, please add the following disclaimer along with the attribution: This is an adaptation of an original work by The World Bank. Views and opinions expressed in the adaptation are the sole responsibility of the author or authors of the adaptation and are not endorsed by The World Bank. Third-party content—The World Bank does not necessarily own each component of the content contained within the work. 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Gratcheva egratcheva@wordbank.org Bryan Guhry bguhry@worldbank.org Dieter Wang dwang5@worldbank.org >>> Executive Summary Sovereign environmental, social, and governance considerations. Furthermore, when asked to assign a (ESG) investing is quickly becoming ordre du jour. weight to ESG versus traditional investment factors There remains, however, considerable “noise” around such as inflation, interest rates, and debt-to-gross the sovereign ESG framework, industry practices, and domestic product (GDP) ratios, more than 60 percent the definition of sustainability itself. This World Bank of participants assigned a weight of 20 percent or less publication consists of two independent reports. The to ESG. In a similar vein, more than 75 percent of first part is written by the World Bank and takes stock respondents say that dedicated ESG funds make up of the current sovereign ESG investing framework less than one-fifth of their overall EM sovereign and proposes improvements, while the second part strategy. On the other end of the spectrum, about one-fourth consider ESG factors for more than 80 presents a survey on ESG practices among Emerging percent of their AUM. Most respondents interested in Market (EM) sovereign debt investors conducted by sovereign ESG strategies are in Europe, 6 percent J.P. Morgan (JPM), who launched the first EM are in the United States, and 4 percent are in the Asia- sovereign ESG index in 2018. This publication is a Pacific region. Most of these are pursing ESG result of the World Bank’s proactive engagement with integration, 3 while a significant number are also stakeholders on pertinent sovereign ESG issues and pursuing exclusionary screening and engagement or is part of a publication series under the auspices of stewardship. 4 Half of respondents, though, reported the Global Program on Sustainability (GPS). 1 This that they don’t engage with sovereign issuers enough series focuses on ESG issues related to sovereign and want to improve. debt investing and disseminates practical, evidence- based recommendations for market participants that The investment objective—whether motivated by include institutional investors, sovereign issuers, achieving a certain risk adjusted return, having an credit rating agencies, and ESG data and service investment impact, or some combination of providers, among others. 2 both—is a key consideration when assessing how ESG factors are included in the investment The JPM survey emphasizes that ESG process. For decades, ESG factors, such as considerations are no longer a niche topic for governance and to a lesser extent social factors, have investors in EM sovereign debt, but the level of been a foundational tenet of sovereign credit analysis. penetration of ESG considerations into EM sovereign It has been only in recent years that ESG investing as debt investing remains mixed. About 65 percent of a consolidated “package” has become a more explicit respondents report that less than one-fifth of their part of the investment process, driven by the changing assets under management (AUM) have explicit ESG financial sector ecosphere, in response to demand 1 In response to market demand, the World Bank launched a sovereign 3 ESG integration is the practice of incorporating ESG- ESG data portal in 2019 with publicly available curated data comparable related information into investment decisions to help enhance risk- across 139 countries and 67 metrics. The World Bank’s analysis reveals adjusted returns, regardless of whether a strategy has a sustainable that up to 80 percent of data used for sovereign ESG scores by the mandate. major ESG providers rely on the sovereign ESG data available through 4 Exclusionary screening involves excluding from the investment the portal. process certain sovereigns involved in activities deemed unacceptable 2 The series is a knowledge product of GPS Pillar 3, which aims to or controversial from an ESG perspective. Engagement/stewardship promote high-quality data usage and sustainability analysis to better involves investor discussions with key country officials, organizations, inform decisions made by governments, the private sector, and and the like. By participating in engagements, investors learn about financial institutions. GPS Pillar 3 is led by the World Bank’s Finance, important initiatives and upcoming policy changes that may affect the Competitiveness, and Innovation (FCI) Global Practice (GP) in sovereign, and such engagements may also influence government collaboration with World Bank Treasury (TRE), the Development policies/information provision. Economics Vice Presidency (DEC), and other GPs. Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 1 > > > F I G U R E ES.1 - Overview of ESG investing approaches a. Investment goals are not necessarily exclusive of b. Investors face a trade-off, but it’s not an either-or each other decision from society at large. Although ESG investing initially along the three ESG dimensions. This view of ESG as focused on equity and corporate debt asset classes, an “output” of the investment process is closely given the size of the sovereign debt market it’s no related to impact investing paradigms. This is also surprise that ESG inve sting is becoming a stable part observable in the JPM survey, in which 30 percent of of the investment process for sovereign debt investors. respondents said that sustainability is integral to their However, the sovereign issuer is fundamentally sovereign ESG framework, while 60 percent have a different from a corporate entity, and this paper separate but complementary SDG framework and 10 documents the many issues at play that mean that the percent assess sustainability separate from the ESG framework adopted for corporates may not framework. The authors of this paper argue that it is necessarily fit the framework needed for a sovereign possible to have a “sweet spot” (figure ES.1a) that issuer. allows an investor to maximize return while also contributing to measurable sustainable outcomes. The rise in ESG investing has seen the advent of sovereign ESG scores, which are designed to ESG investing requires more clarity in its quantify a country’s resilience to material ESG terminology to better articulate its investment risks. Although sovereign ESG providers offer purposes. Figure ES.1b groups various terms that different ways of conceptualizing their ESG products are often used to describe the trade-off investors face and different aggregation methodologies, they tend to according to their relationship to financial, social, and focus on providing aggregated datapoints that have environmental materiality. Questions regarding some demonstrated financial materiality in addition to materiality or impact are central to this confusion and standard sovereign credit risk analysis. Moreover, there is need for further efforts at a global level to market practice incentivizes portfolios with higher streamline both investment terminology and aggregated ESG scores. This purpose-neutral methodologies. approach only considers ESG as an input in the For example, investors who consider only financially investment process but does not necessarily consider material ESG risks in the investment process may not how an investment contributes to ESG outcomes. in fact contribute to sustainable outcomes. Indeed, Investors are beginning to focus on ESG factors sustainability has different shades, ranging from weak as an output metric from investment decisions. 5 sustainability, which assumes complete This purposeful approach considers an investment’s substitutability between the different capital stocks, to impact on wider nonfinancial systems, measured strong sustainability, which assumes no 2 <<< Abridged Version | A New Dawn – Rethinking Sovereign ESG substitutability so that all-natural capital must be greenwashing (24 percent). [[AQ: Will the readers conserved. This backdrop complicates ESG investing know what greenwashing is?]] further. There is also a clear regional distinction Sovereign ESG performance sets a benchmark for between interpretation of the role of fiduciary duty and subnational investment decisions and is ESG investing, as well as regulatory approaches to increasingly a driver of capital allocations. 6 ESG across regions. Similar to how market performance or country factors The transmission channels of investing in are used to evaluate performance and shape portfolio sovereign debt to sustainable outcomes are construction, sovereign ESG scores do not only serve complicated and are defined by the nature of the to profile sovereign-level instruments, such as asset class. The nature and scope of sovereign government bonds. Sovereign ESG scores also bonds, the primary vehicle for sovereign ESG trickle down to subnational entities, such as investing, obscures how an investment achieves ESG municipalities and corporations. Especially in output. The rise in sovereigns issuing thematic bonds countries where data coverage and quality are lacking, may help in part alleviate some investor concerns. In country-level indicators are often used to fill in missing the JPM survey, most asset managers do not values for smaller entities. Furthermore, a reliable and currently see the link between sovereign debt and transparent sovereign ESG framework is in high sustainable outcomes as a major problem (only 16 demand, as it would also enable a fairer comparison percent do). The survey found that the current primary of corporates across borders. concern for investors is the lack of ESG standardization (42 percent) and the prevalence of The paper identifies two structural challenges with the current sovereign ESG framework. First, > > > F I G U R E ES.2 - Sovereign ESG environmental pillar has many facets that are difficult to measure 6 See, for example, ISS 2019. Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 3 > > > F I G U R E ES.3 - Strong income bias in sovereign ESG scores sovereign ESG providers, who have laid the level of income in developed countries could disguise foundation for the operationalization of ESG investing ESG risks that could lead to misallocated capital and in sovereign fixed income markets, converge on the potentially perverse incentive of driving capital measuring good sovereign performance on away from low-income countries toward rich ones. governance (G) and social (S) issues but not on This relationship also has important implications for measuring the environment (E) pillar at the sovereign sovereign ESG indices and other investment flows, level. One of the main reasons for disagreement on which are influenced to a varying extent by sovereign the E pillar is the complex question of what a “good” ESG scores. The JPM survey emphasizes that this environmental performance is. The five major issue is also a focus for the asset manager community: environmental themes from the World Bank’s 24 percent of respondents listed it as the most sovereign ESG data portal, for example, are directly dominant concern about sovereign ESG investing. linked with at least seven of the United Nations As seen in figure ES.3, average ESG scores Sustainable Development Goals (figure ES.2). This across seven ESG providers correlate closely close relationship highlights the importance of with gross national income per capita across 133 accurately measuring environmental indicators but countries. The regression line exhibits a significantly also the challenge. This is also manifested in the JPM positive slope. survey: 70 percent of the respondents underrepresent the E pillar because of data challenges, whereas 26 percent underrepresent the S pillar and only 4 percent underrepresent the G pillar. The second challenge is that while sovereign ESG providers converge on what good sovereign ESG performance is, that ideal is driven by an ingrained income bias. About 90 percent of sovereign ESG scores are explained by a country’s national income, thus richer countries have better ESG scores. Whether this truly reflects sustainability can be debated. However, current sovereign ESG scores set questionable incentives. For example, the 4 <<< Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> Path Forward As a result of these structural challenges, the articulate (a) their financial and sustainability current sovereign ESG framework needs to objectives, (b) the mechanisms by which they will be correct course and become more transparent. We achieving these objectives, (c) the metrics by which list guiding principles for a Sovereign ESG 2.0. they will measure success or failure, and (d) the framework that should provide a solid foundation for approach for balancing these objectives when they future developments and avoid the structural are not aligned. Transparent methods are also critical challenges of the current framework (figure ES.4). to allow stakeholders understand what is being Five key areas that both the World Bank and other measured. More transparency in rating approaches stakeholders can focus on are identified. These are (a) and data sources employed facilitates a constructive clarity on investment objective (b) transparent dialogue between data providers, rating agencies, methods, (c) improved data, (d) incorporation of and investors. forward-looking scenarios, and (e) unbiased from a Availability of data is a critical issue to advance country’s level of income. the sovereign ESG framework. For example, to Foremost, investors need to be able to clearly analyze the recent performance of sovereigns on define their preferred investment approach, ESG issues requires more frequent and recent data whether that be purpose-neutral or purposeful coverage. A reliable data environment also makes the ESG investing or some combination of both. construction of rules-based investment indices Investors and asset managers need to clearly feasible. Despite good progress (World Bank Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 5 > > > F I G U R E ES.4 - Key areas to focus on for Sovereign ESG 2.0 sovereign ESG data portal, World Resources Institute Forward-looking assessments are also critical data platform, advances in geospatial data), because the risks from climate change are significant shortcomings remain, particularly on the expected to be more frequent and larger in the environmental side. Large data gaps and lags mean future than in the past. Traditionally, financial that it is often necessary to impute missing data or materiality has been determined by looking at extrapolate data forward. Advances in geospatial data statistical relationships in past data. With the collection as well as machine learning methods offer consequences of environmental degradation and a promising way forward, but they also require climate change looming on the horizon, E indicators significant technical expertise and support to be more need to not only represent the value of the broadly and publicly available. environment today but also capture the value of its protection and the costs of its loss for future World bank wealth data are a promising source generations. Looking at nature from this perspective for additional data insight. The purpose of wealth also sheds light on the risks and opportunities that data largely overlaps with the goals of sovereign ESG stem from natural assets. scores, but the latter have adopted wealth data only to a limited degree. The economic materiality, The ingrained income bias is a fundamental forward-looking perspective, and long history of challenge for sovereign ESG investing. consistently curated data suggest that wealth data Recognizing and adjusting for this bias is a key could be a potential input for better-quality data. requirement for Sovereign ESG 2.0. Ideally, ESG Wealth data address two major shortcomings of scores should give an accurate representation of a current sovereign ESG data. First, wealth data assign country’s sustainability that is not primarily a result of an economic value to environmental resources and, its level of income. However, removing this bias is not second, the comparatively long history of wealth data a simple exercise, as any adjustment method rests allows focus on recent developments in upon assumptions about what ESG scores should environmental performance. represent and what “good” ESG performance is. 6 <<< Abridged Version | A New Dawn – Rethinking Sovereign ESG While some practitioners have advocated income between MDBs and private institutions will need to adjusting by using a regression adjusted for GDP per grow to help EM issuers access capital markets. capita, the authors of this paper argue that this may Further public-private cooperation (including IFC and lead to overcorrection and would fail to capture the Amundi, JPMorgan Chase Institute, and others) is nonlinear nature of income’s impact. We therefore essential to continue to also transform the financial propose two alternative approaches (momentum and industry collectively toward greater sustainability peer group scoring) that may serve the goals of through, among other things, design of new financing income adjustment better. We also discuss the instruments and development of market-ready drawbacks of these methods, such as additional data practices and frameworks. requirements and the sensitivity of peer group The World Bank will continue to work with key selection. stakeholders on the issues identified in this paper. The level of capital market development is a The guiding principles identified provide a solid binding constraint for operationalizing a more foundation for future work, and the World Bank will equitable sovereign ESG framework. The very continue to play a proactive leading role. The paper nature of the financial system as well as the highlights that sustainability is a complex topic and prevalence of benchmark investing in the sovereign that the current sovereign ESG framework may in fact emerging market (EM) universe means that only a few disadvantage poorer countries. It is also important EM sovereigns can attract meaningful flows to their that policy makers and key stakeholders are local currency sovereign debt market. Multilateral cognizant of these dynamics and that MDBs and development banks (MDBs), such as the World Bank, governments of advanced economies support middle- continue to play an important role with respect to and low-income countries in their efforts to make their financial sector deepening, contributing to efforts to economies more sustainable. This work may or may support developing countries’ sustainable not be through the sovereign debt market. Although growth. The World Bank’s Finance, Competitiveness, sovereign ESG investing is certainly one lever to and Innovation (FCI) and Treasury global practices attract ESG-orientated capital, other methods such as also provide technical assistance and advisory taxation and regulatory changes could also help and services on bond market development as well as on be relatively more effective in lower-income countries. thematic sovereign bond issuance. Cooperation Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 7 >>> J.P. Morgan ESG Investor Survey J.P. Morgan’s Emerging Markets (EM) Research Key Takeaways Team and Global Index Research Group conducted a survey of dedicated EM investors with sovereign debt strategies. The survey aimed to gauge investor opinions on a range of topics related 1. Investors that manage ESG-aligned funds to environmental, social, and governance (ESG) are primarily motivated by their own respective strategies, focusing specifically on EM sovereigns mission statement rather than the evolution of the rather than corporates, including but not limited to regulatory landscape. Most investors consider ESG their ESG investment and sustainable finance integration to be within their fiduciary duty. Results investment philosophy, the materiality of ESG factors, show that 90 percent of client interest and inflows the trade-offs between fiduciary duty and currently originate from Europe, followed by North sustainability goals, and issues around ESG scores America (6 percent) and the Asia-Pacific region (4 for EM sovereigns. percent). The survey was small by design, our intent being to start with a small sample size with the potential 2. Emphasis on the E and S in ESG strategies is growing, but G remains the most important to grow in the future. The survey was designed to when conducting sovereign assessments. One- take the temperature of a relevant group in order to quarter of investors selected the E pillar as the most better understand investor attitudes toward sovereign underrepresented pillar in sovereign ESG data. Data ESG approaches and to begin the conversation challenges could contribute to the difficulty in regarding both challenges and opportunities. The integrating social factors into sovereign assessments. survey received a response rate of 70 percent, representing investors with almost US$650 billion in assets under management (AUM), indicating the high 3. Investors generally agreed that better ESG level of interest by managers looking to grow their fundamentals should lower sovereign credit risk, ESG-aligned funds. More details on their but there remains uncertainty if implementing characteristics are in Table ES.1. ESG investing would sacrifice returns. Investors believe that sovereign ESG should support the > > > development journeys of EM countries rather than T A B L E 1 - Survey participants rewarding only high performers, highlighting a key tension within current frameworks. Dedicated Emerging Markets AUM $645 bn Real Money 96% 4. Investors overwhelmingly rely on external Hedge Fund 2% data vendors to assess ESG factors, MSCI and Asset Owners 2% Sustainalytics being the most commonly used # Responses from Europe 51% providers. The third top provider was Verisk # Responses from US 35% Maplecroft. A minority of vendors have an entirely in- # Responses from Asia 14% house EM sovereign ESG approach. Source: J.P. Morgan 5. Most investors believe that they are not engaging enough with debt management offices (DMOs), which are seen as having a critical role in providing sovereign ESG data to investors. 8 <<< Abridged Version | A New Dawn – Rethinking Sovereign ESG Selected Figures from the Survey Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 1 Other insights into sustainable finance you may be interested in Riding the Wave: Navigating the ESG Landscape for Sovereign Debt Managers. by S. Boitreaud, E. Gratcheva, B. Gurhy, C. Paladines and A. Skarnulis Demystifying Sovereign ESG. by E. Gratcheva, T. Emery and D. Wang A New Dawn - Rethinking Sovereign ESG. by E. Gratcheva, B. Gurhy, T. Emery and D. Wang Credit Worthy: ESG Considerations in Sovereign Credit Ratings. by E. Gratcheva, B. Gurhy, F. Stewart, A. Skarnulis and D. Wang 1% Growth in Natural Capital: Why it Matters for Sovereign Bonds. by E. Gratcheva, B. Gurhy and D. Wang Natural Allies: Wealth and Sovereign ESG, in: The Changing Wealth of Nations 2021: Managing Assets for the Future. by E. Gratcheva and D. Wang Natural Capital and Sovereign Bonds. by D. Wang Spatial Finance: Challenges and Opportunities in a Changing World by WWF and World Bank. The Global Program on Sustainability (GPS) promotes the use of high-quality data and analysis on natural capital, ecosystem services, and sustainability to better inform decisions made by governments, the private sector, and financial institutions. Find out more on http://worldbank.org/gps 2 <<< Abridged Version | A New Dawn – Rethinking Sovereign ESG Abridged Version | A New Dawn – Rethinking Sovereign ESG >>> 3