Governance factors such as institutional strength and political risks will have an impact on a sovereign’s ability and willingness to repay its debt on time. A country’s exposure and resilience to systemic environmental risks such as water scarcity will affect economic outputs, borrowing and its ability to attract foreign investment over the long term.

While the investment processes for corporate and sovereign bonds may be similar, analysis of company and sovereign creditworthiness is markedly different – most obviously in terms of the criteria assessed. In addition to corruption, investors have identified a number of other ESG indicators that provide greater insight into creditworthiness.

  • For more information on the links between ESG factors and sovereign creditworthiness, see Sovereign bonds: Spotlight on ESG risks.

In contrast to ESG analysis for listed equities, social factors tend to be given greater weight than environmental factors because of links between political stability, governance and a country’s ability to raise taxes or make reforms.

Key ESG criteria for sovereign bond analysis
Carbon intensity  Demographics  Institutional strength 
Water stress  Education and health capital  Corruption 
Energy resource and management  Health levels  Regime stability 
Natural disasters  Political and press freedoms  Rule of law 
Biocapacity and ecosystem quality  Human rights  Financial reporting 
Pollution  Labour standards  Regulatory effectiveness 
Biodiversity  Social exclusion  Adherence to conventions 
Agriculture  Income inequality  International relations 

Key considerations for analysing sovereign, municipal and supranational issuers

  • ESG factors can inform fundamental sovereign credit analysis, internal credit ratings and, ultimately, bond prices.
  • ESG scores or ratings can be used to differentiate issuers and inform diversification.
  • Single internal credit ratings that combine ESG and macro analysis will ensure portfolio management does not ignore key ESG risks.
  • ESG information on governments is available from UN bodies, the OECD, CIA World Factbook, Transparency International, the World Bank and similar organisations.
  • ESG factors play an important role in emerging market debt analysis where financial reporting may be unreliable.
  • Share ESG analysis between corporate and government bonds teams in relation to country risk, credit rating ceilings, ESG macro trends and areas of emerging regulation.
  • Consider different economic development stages of countries because developing countries tend to have lower ESG ratings but may improve faster than developed countries.
  • Local government ESG risk and government risks do not necessarily correlate and should be analysed separately.
  • ESG analysis can inform investors on the essentiality of municipal projects and identify risks to specific revenue sources.

Soveriegn issuers

Union Investment, a German investment manager, assesses corruption as a key indicator of sovereign credit strength because of the relationship between fraud, tax avoidance, financial mismanagement and an issuer’s ability to repay its debt obligations. There are strong correlations between corruption and the number of sovereign defaults.

Corruption levels of 87 countries (Corruption Perception Index) and sovereign defaults since 1970

Source: Union Investment, Transparency International

French investment manager Oddo Securities uses the environmental indicators listed below as part of its sovereign credit analysis. Together, these constitute one-third of aggregated ESG scores. Based on performance relative to average ESG score in the group, countries are divided into four categories from ‘strong’ to ‘limited’ opportunity. Scores are relative, so they allow investment teams to identify potential investment risks and opportunities. For example, in its 2012 study, Oddo identified Sweden, Denmark and New Zealand as demonstrating the best management of ESG-related risks of all OECD countries. By comparing the relative ESG risks of certain sovereigns, their opportunities to improve those scores and current credit ratings, investors can identify potentially mis-priced securities.

Oddo Securities’s environmental criteria for governments (2012)
Agriculture Food self-sufficiency FAO  1.0 
Arable land FAO  2.0 
Biodiversity  Endangered species  World Bank  2.5 
Climate change/
Per capita energy consumption  World Bank/IEA  4.0 
Per capita CO2 emissions  World Bank  2.0 
Carbon intensity of growth  World Resources Institute (WRI)  2.0 
Energy mix  International Energy Agency  2.0 
Water Pressure exerted on water resources  Aquastat (FAO)  4.0 
Renewable water resources per capita  Aquastat (FAO)  4.0 
Air pollution Sulphur dioxide emissions  World Resources Institute (WRI)  2.0 
Resources Ecological footprint  Global Footprint Network  2.5 
Forests  Aquastat (FAO)  2.0 
Maritime Exclusive Economic Zone Flanders Marine Institute (FAO data)  1.5 
Transport Sustainable mobility  Economic Commission for Europe (UN)  2.0 

Developing reliable and comparable environmental indicators for governments

For most sovereign bond investors, developing reliable environmental indicators is a significant challenge. Energy efficiency and natural resource use are commonly applied, but there is no strong consensus on how effective these are as indicators of credit strength.

  • The United Nations Environment Programme’s Finance Initiative (UNEP FI) is working with NGOs and financial institutions to develop robust environmental indicators based on a ratio of nations f ecological footprint and biocapacity (i.e., availability of natural resources and capacity to assimilate air and other types of pollution). It is assumed that surplus biocapacity is an indicator of long-term creditworthiness and therefore an effective forward-looking indicator for analysts. In 2014, UNEP FI will test this theory with investors to determine whether there is a strong causal relationship between the two.
  • French nonprofit RISKERGY aims to develop a sovereign credit rating methodology primarily based on energy resilience. Its mission is to create a more predictive rating methodology that will help investors to address risks related to less energy-resilient countries.

Emerging market debt investors

Of those interviewed by the PRI, emerging market debt (EMD) investors gave more weight to ESG factors because of the insights they provide in place of reliable financial indicators. For Rob Drijkoningen, managing director and cohead of emerging market debt at US investment manager Neuberger Berman, becoming a PRI signatory spurred on his team’s efforts to develop an internal analytical framework that incorporates material ESG factors alongside economic indicators. Forty percent of its overall sovereign debt score comprises ESG; the remaining 60 percent is based on traditional financial metrics.

It “was fuelled by a desire to have a more structured approach,” says Drijkoningen. “We lacked a comprehensive framework on ‘soft’ factors, which have a huge overlap with ESG criteria.” The team started with a list of 40 or 50 indicators and shortened that to 15. It back-tested all of them, looking at a pool of 65 issuers over a 10-year period to find out which were most effective.

Turkey is cited as a country with good economic fundamentals but a deteriorating ESG score. “Some of the macro fundamentals have recently improved, but slow growth makes the current account deficit less sustainable, and politics are having an increasingly nasty impact now….that is showing up in how we rate them,” says Mauricio Vargas, economist at Union Investment. Rene Lichtschlag, EMD fund manager with Union Investment, adds, “We saw corruption, rule of law, political stability going south, while movement in the macroeconomic indicators was either neutral or positive. We therefore adjusted our exposure.”

“Argentina has over recent years persistently understated inflation levels. In fact, this issue dates back to 2007, when just as a sharp increase in inflation due to medical insurance was widely anticipated, data was unexpectedly withheld and the Board of the National Statistics Office replaced overnight – in itself raising clear governance concerns. During visits to the country, it has become abundantly clear to us that inflation is being considerably understated. As a result, we have applied a higher risk premium to Argentinian debt securities.”

Colonial First State Global Asset Management, Responsible Investment and Stewardship Report (2013)

Municipal issuers

Municipal or local government bonds can be divided into two categories: general obligation bonds backed by tax inflows and revenue bonds backed by revenues from a specific project such as toll roads. The US municipal bond (muni) market is currently at US$3.7 trillion of debt outstanding.6 The market is considered fairly stable, although default rates have increased considerably since 2008. The bankruptcy of the city of Detroit in 2013 was the largest in US history and served as a wake-up-call for many city employee pension funds.

The analysis of munis shares characteristics with corporate credit analysis; this applies for ESG analysis as well. For both general obligation and revenue bonds, governance and social factors will affect the issuer’s ability to raise revenues from taxes or other types of income. Important environmental criteria include the carbon intensity of a state’s energy production and the quality of public infrastructure such as wastewater treatment plants.

US-based Breckinridge Capital Advisors manages investments in corporate and muni bonds. It says the risk of default in the municipal bond market is higher when public opinion on a project is ambivalent with regard to public infrastructure such as stadiums and housing. Peter Coffin, president at Breckinridge, says, “The more focused a project is on something that’s core to the government’s providing for the education, health care and well-being of its citizens, the safer the bond is”.8 Breckinridge integrates ESG analysis to help determine the ‘essentiality’ of a municipal project or issuer, the expected support of the community and the quality of the issuer’s governance practices. Local unemployment rate, median household incomes and constituent education levels are used as indicators of long-term creditworthiness in this model.

Supranational issuers

Supranational organisations, such as the World Bank and the European Bank for Reconstruction and Development, regularly issue bonds to finance sustainable development–related projects and businesses. These organisations are considered relatively low risk and typically issue investment-grade bonds. As a result, ESG analysis on supranationals tends to be more focused on their use of proceeds than on the creditworthiness of the issuer itself. Supranational issuers act very much like banks in the way that they finance their projects, typically with long-term loans, by issuing bonds.

ESG analysis will give investors additional insights into these projects and help to ensure that issuers interests are aligned with those of the investors in these bonds. Many of these investments are made in emerging market economies where regulatory frameworks and transparency may be poor and certain risks less obvious as a result. In these cases, investors should ensure that the issuer has the capacity to identify and manage ESG risks, for example, by following the IFC’s Performance Standards or the Equator Principles. The list below contains more details on themed bonds issued by supranationals .

KfW and Union Investment logos