The small ‘s’ in ESG is about to get a lot bigger

It’s hard being an EM portfolio manager, at least when it comes to acting with integrity on social risk. While your employers have most likely signed you up to align your investment practices with ESG principles, most of the debt in your universe is issued by governments that aren’t just lukewarm on gender rights and worker protection, but routinely use arbitrary detention, torture, and extrajudicial execution.

As shown in Figure 1, we categorise over three-quarters of EM issuers as at least ‘high’ risk on these metrics, while 60% of issuers face an ‘extreme’ risk for labour rights and human security.

By way of example, the death of a bystander in protests in South Africa in March underscored the problem of police brutality that drives the country’s ‘extreme’ risk score for human security. Equally, worker fatalities in the run-up to the Qatar World Cup underscore why the country still registers as ‘extreme’ risk across our Labour Rights indices.

Yet both countries are popular destinations for EM investment.

In recent years, some asset managers have agreed how to square the circle: exclude from your portfolio the pariahs like North Korea that are largely un-investable anyway; pay attention to human rights concerns when they threaten returns; and ignore them when they don’t. In short, tweak around the edges, but don’t do anything to constrain your performance.

But regulators and asset owner clients have called time on this approach. Consequently, fund managers are going to have to work the ‘S’ in ESG a lot harder.

SFDR – driving social disclosure for investors

Firstly, Brussels is driving a paradigm shift on the ‘S’. Under the Sustainable Finance Disclosure Regulation (SFDR), from 1 July 2022 asset managers will need to report on human rights abuses in their sovereign portfolios, as well as explain how they address these abuses in any funds that they label sustainable, before submitting reports by June 2023. The SFDR has extra-territorial reach beyond the EU, making it a de-facto global disclosure standard.

Sovereign debt will be a key battleground because governments are the ultimate guarantors of human and labour rights. But Brussels has set its sights on all dimensions of social risk in all asset classes. In July 2021, the EU Commission’s Platform for Sustainable Finance issued a draft report on a proposed ‘Social Taxonomy’, heralding additional reporting requirements.

Secondly, the current generation of asset owners – and more progressive portfolio managers – want not merely to avoid negative impacts, but to direct and invest capital where it can have the most positive impact. And all while still achieving decent returns.

In one sense, this isn’t news. Ever since the launch in 2015 of the UN’s Sustainable Development Goals for 2030 (SDGs), alongside other impact investing frameworks since then, impact considerations have driven much of the sustainability buzz, with social and development issues playing a central role.

But outside smaller-scale targeted efforts in private markets and development finance, impact evangelists haven’t yet had any systemic effect on capital allocation.

As Figure 2 shows, portfolio and foreign direct investment remains heavily concentrated in the best SDG-ranked sovereigns – which invariably tend to be developed markets.

And the needle has barely moved over the last decade. Poorer-scoring countries have enjoyed a modest increase in inflows since 2010, almost all likely driven by macro factors rather than investors’ commitment to impact.

Now, however, asset owners want to see action; 2030 is looming ever closer, and the socio-economic devastation wrought by the pandemic in many emerging markets has underscored the urgency.

A fresh approach to ESG analysis is needed

The disconnect between rhetoric and reality on social impact is, of course, partly because the asset management industry is bound by fiduciary duty. Poorer countries with greater impact needs often imply higher risks relative to the returns they offer, and in some cases are technically un-investable for mainstream debt or equity managers.

But it is also about inadequate data. Traditional SDG scoring methodologies use a handful of structural KPIs to incentivise portfolio managers to reward those already doing well, while the weaker performers that need investment the most miss out.

Any impact investor in emerging or frontier markets, and especially in sovereign debt, has to answer two questions: which countries most need capital, and which governments are best positioned to use it to close the impact gap? Lending to countries with less need for support on an SDG will frustrate impact-focused clients. But so too will funding governments that need more help but aren’t willing to reform or commit to improve on key areas of governance.

We can draw on our indices to help investors navigate the resulting trade-off.

Figure 3, for example, maps sovereigns on SDG 1 (poverty eradication) and SDG 8 (decent work and economic growth) across both the impact opportunity (how much of a gap there is to close in the first place) and governance performance (namely, the laws, institutions, policies and processes put in place to close that gap). Countries that score highest on both axes are best positioned to benefit from investment. While the negative correlations show just how fine a line managers have to walk, governments quickly become attractive targets for investment by taking the right steps.

Deploying this approach, Senegal, Rwanda and Ghana might be top of mind for investors looking to shift the dial on poverty eradication (SDG 1), both in terms of maximising their investment impact and SDG progress. In August, Rwanda saw a heavily oversubscribed issuance of only its second Eurobond since 2013, in a sign of already strong demand from investors.

Meanwhile, to invest appropriately in relation to decent work and economic growth (SDG 8), managers could consider channelling capital to the West African state of Senegal, which under President Macky Sall is something of an outlier in an otherwise volatile region in terms of making tangible governance progress (including against corruption) in recent years.

Ahead of a presidential election in 2024, the Sall government will need to uphold prudent fiscal management. But with cash-strapped state bodies remaining vulnerable, the sovereign could be a good opportunity for institutional investors wanting to have an impact on decent work and employment, potentially via the existing national development plan (PSE).

How to reach an optimal solution?

Nothing is risk free. Investments that are truly impact-aligned will not always achieve the best returns. But investors can use our two-dimensional approach as an input into their portfolio analytics to seek an optimal mix of both.

Figure 4 sets the ratio of impact opportunity over governance risk against conventional financial risk for EM/FM hard currency issuers. It shows, at a simple level, that an impact-seeking investor could use conventional portfolio analytics to optimise impact against risk. Country-level impact opportunities and risk data can also be applied in other asset classes with some adjustments, for example modifying country risks with firm-level performance data in equities.

Share the burden

To spread the risk burden, private investors can also collaborate with other stakeholders such as regional development finance institutions to partially de-risk investments in frontier economies with very shallow capital markets.

Alongside broader investor engagement with governments, sustainability-linked sovereign bonds are another option – and well suited for data that systematically offset impact opportunities against policy performance and governance.

Abandoning the easy win-win rhetoric of the past decade may prove too bitter a pill for some to swallow. But encouragingly, asset owners and leading asset managers are already beginning to move on these fronts. We also expect regulatory definitions of fiduciary duty to evolve to acknowledge the changing investment environment.

Ultimately, whatever approach an investor opts for, our advice is clear: SDG, impact need, and country ESG performance all have to be critical inputs if asset managers want to have systemic impacts on social risk.