FINANCE FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT 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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The series is a Development Economics Vice Presidency (DEC), and other knowledge product of GPS Pillar 3 with the objective to promote GPs. Focusing on ESG issues in sovereign investing, the series the use of high-quality data and analysis of sustainability to disseminates practical, evidence-based recommendations for better inform decisions made by governments, the private market participants, including institutional investors, sovereign sector, and financial institutions. GPS Pillar 3 is led by the World issuers, credit rating agencies, and ESG data and service Bank’s Finance, Competitiveness and Innovation (FCI) Global providers, among others. >>> “A New Dawn – Rethinking Sovereign “Demystifying Sovereign ESG” focuses ESG” proposes improvements to the on comparing the sovereign ESG sovereign ESG framework and builds on methodologies of leading sovereign findings and recommendations discussed ESG providers and describes structural in other papers in the series. challenges posed by the current sovereign ESG framework. “Riding the Wave: Navigating the ESG “Paving the Path: Lessons from Chile’s Landscape for Sovereign Debt Managers” Experiences as a Sovereign Issuer for provides a thorough discussion of Sustainable Finance Action” provides sovereign ESG from a debt management a concentrated study of Chile’s ESG- office perspective. focused issuances to date and relevant lessons. “Spatial Finance: Challenges and “Credit Worthy: ESG Considerations in Opportunities in a Changing World” Sovereign Credit Ratings” demystifies (produced in partnership with the World the role of ESG factors in country Wildlife Fund) discusses challenges with credit ratings and highlights potential the E data, including at the sovereign ESG impact on the creditworthiness of level, and explores the use of satellite data countries with the application of the World to address the quality and availability of E Bank’s wealth and stranded asset data. data. “1% Growth in Natural Capital: Why It The chapter “Natural Allies: Wealth Matters for Sovereign Bonds” quantifies and Sovereign ESG” from the book the materiality of natural capital and its The Changing Wealth of Nations 2021: impact on sovereign bonds by adjusting Managing Assets for the Future focuses for ingrained income bias. on challenges in ESG data and discusses solutions with the application of the World Bank wealth data. “Natural Capital and Sovereign Bonds” introduces the concept of ingrained income bias and presents evidence that sovereign bond yields reflect a country’s various types of natural capital. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 3 >>> Contents Abbreviations 6 Acknowledgments 7 Headline Messages 9 Executive Summary 13 Chapter 1: A New Dawn 21 Introduction 21 Sovereign ESG and Sustainability 26 Structural Challenges in Sovereign ESG 1.0 31 Sovereign ESG 2.0 37 Conclusions 49 Chapter 2: J.P. Morgan ESG Investor Survey 51 Overview 52 Top Takeaways of the Survey 52 Survey Results 55 Looking Ahead: A Green Light at the End of the Tunnel 64 References 67 Appendix A Glossary of Terms 70 A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 5 >>> Abbreviations E Environmental EM Emerging Market EPI Environmental Performance Index (Yale) ESG Environmental, Social, and Governance G Governance GDP Gross Domestic Product GNI Gross National Income GPS Global Program on Sustainability IIB Ingrained Income Bias JESG J.P. Morgan ESG ND-GAIN Notre Dame Global Adaptation Initiative (Country Index) NGFS Network for Greening the Financial System MDBs Multilateral development banks OECD Organisation for Economic Co-operation and Development PCA Principal Component Analysis RRI RepRisk Country ESG Risk Index S Social SDG Sustainable Development Goals UN United Nations WBG World Bank Group WGBI World Government Bond Index WGI Worldwide Governance Indicators 6 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> Acknowledgements Chapter 1 of this publication was produced by a team consisting of Ekaterina M. Gratcheva, Bryan Gurhy, Teal Emery, and Dieter Wang under the supervision of Anderson Silva, all from the Finance, Competitiveness, and Innovation (FCI) Global Practice of the World Bank. 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. The team of research analysts who authored the report consists of Luis Oganes, Jarrad K. Linzie, Lydia Harvey, Katherine Marney, Jessica Murray, and Rupert Rink. The authors would like to express appreciation for the comments received during the formal peer review process, including those from Girum Dagnachew Abate (economist, CROCR), Kassia Antoine (economist, CROCR), Michael Brown (economist, CROCR), Marc Schrijver (senior financial sector specialist, EAEF2), Heike Reichelt (head financial officer and head of investor relations and new product development TRECI), Fiona Stewart (lead financial sector specialist, EFNLT, FCI), Aart C. Kraay (deputy chief economist and director of development policy, DECVP), James Cust (economist, AFECE), Raffaello Cervigni (lead environmental economist, SENGL; task team leader for the Global Program on Sustainability), Eric Bouyé (manager, TREPK), Rodrigo Cabral (senior financial officer, EMFMD), James Seward (senior financial officer, TRECI), Nepomuk Dunz (junior professional officer, EFNLT), and Samantha Power (consultant, EFNLT). External comments and feedback were also received from FTSE Russell/Beyond Ratings, ISS, MSCI, RepRisk, Robeco (formerly RobecoSAM), Sustainalytics, V.E, and from individuals that include Robert Patalano (OECD), Harun Đogo (Morgan Stanley), Jarrad Linzie (J.P. Morgan), Liliana Jerónimo (Central Bank of Portugal), David Lubin (Citibank), Diane Menville (Scope Credit Rating Agency), Rodolphe Bocquet (ex-founder of Beyond Ratings), Jonathan Amacker (Imperial College), and Yvette Babb (William Blair). A special thank you to Jean Pesme (global director of the Finance, Competitiveness, and Innovation Global Practice of the World Bank). This publication has been funded by the Global Program on Sustainability. The views expressed herein are solely those of the authors and should not be attributed to the World Bank. The report was edited by Marcy Gessel and Kevin Morrow (Publications Professionals, LLC). Florencia Micheltorena led the creative design and formatting of the publication. We thank them all. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 7 8 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> Headline Messages I. Environmental, Social and Governance (ESG) investing has become part of mainstream finance. With more than $40 trillion of funds under sustainable management, ESG investing is no longer niche investing, including in emerging market (EM) sovereign debt markets. A recent J.P. Morgan survey of EM sovereign debt investors indicates that ESG factors are increasingly being used as an input into investment decisions. This is not only true for investments in sovereign debt markets but also other investments on the national and subnational level. II. ESG scoring frameworks need improvement. The motivation for sovereign ESG investment decisions has evolved from “ESG as input”— primarily a way to manage ESG-related risks—to also encompass “ESG as output,” with investors seeking to affect ESG conditions positively. In the “ESG as input” view, ESG scores are used as additional inputs into financial decision-making, such as assessing the risk-return profile of an investment. In contrast, the “ESG as output” view considers an investment’s impact on broader, nonfinancial issues, such as environmental and social systems. This report argues that both views are not mutually exclusive and that investors can balance both to achieve a “sweet spot.” Sovereign ESG assessments should make it easier for investors to pursue traditional investment goals, while also contributing to measurable sustainable outcomes. The current ESG framework is not always conducive to this perspective. III. The sovereign ESG framework must overcome three challenges: lack of clarity, the ingrained income bias, and poor environmental data quality. Unclear terminologies, overlapping concepts, and opaque scoring methodologies raise fundamental questions about the outcomes of ESG investing compared with the stated goals. This lack of clarity hampers the ability of investors to balance the use of ESG for investment and risk management decisions with goals for investment impact. Investment goals and the purpose of ESG scores must be conceptually aligned. Distinguishing between weak and strong sustainability further complicates ESG investing. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 9 10 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT IV. The ingrained income bias may VI. Sovereign ESG needs to adjust incentivize capital flows toward high- course toward a more transparent income countries and away from framework: Sovereign ESG 2.0. countries where funding is needed most. Greater overall clarity in sovereign ESG is needed to better align Leading sovereign ESG providers score countries consistently the use of tools with intended purpose. The Sovereign ESG 2.0 on Social and Governance issues but differ on the Environmental framework should improve on the existing framework along five pillar. Unlike the documented “aggregate confusion,” which guiding principles: describes the large differences among corporate ESG scores by various ESG providers for the same firm, sovereign ESG scores are generally consistent with each other. This consensus 1. Clarity on investment objectives may appear desirable, but a deeper look reveals that this is 2. Transparent scoring methodology not necessarily true. More-developed countries tend to have 3. Improved data sources stronger institutions, more equality, and more prosperity. 4. Incorporation of forward-looking scenarios Therefore, higher income tends to be tied to better ESG scores, 5. Accounting for the ingrained income bias especially regarding Social and Governance issues. Because of this ingrained income bias, about 90 percent of ESG scores can be explained by a country’s gross national income. As a VII. Capital market development result, richer countries have better ESG scores. Whether efforts should continue and this truly reflects sustainability in every country is debatable. Furthermore, the sovereign E pillar includes a host of information cooperation between the public and on a sovereign’s environmental condition and has the smallest private sector remains important. weight in overall sovereign ESG scores. The very nature of the financial system, as well as the More concerning, the predominant role of income sets prevalence of benchmark investing in the sovereign emerging questionable investment incentives. The income bias could market universe, means that only a few EM sovereigns can disguise the ESG risks of prosperous developed countries, attract meaningful flows to their local currency sovereign debt while greatly exaggerating the risks in developing nations. This market. Multilateral development banks (MDBs), such as the discrepancy sets potentially perverse investment incentives that World Bank, continue to play an important role in deepening drive capital away from lower-income toward higher-income financial sectors and support developing countries’ sustainable countries. This relationship also has profound implications for growth. Cooperation between MDBs and private institutions other investment flows, such as infrastructure investment, as will need to grow to help EM issuers access capital markets. well as sovereign ESG indices, which are strongly dependent Further public-private cooperation (for example, IFC and on sovereign ESG scores. Amundi, JPMorgan Chase Institute, among others) is essential for continuing the transformation of the financial industry toward greater sustainability. V. Poor environmental data quality stands in the way of better assessment VIII. The World Bank will continue to of a country’s sustainability. lead and support sustainable finance. Improving the underlying environmental data sources is Sustainability is a complex topic. More good can be achieved if essential. The current data landscape makes it difficult to market practices that become embedded in the financial system accurately assess recent performance, consistently compare are equitable and transparent for all. Both private and public country performances or construct reliable investment indices. sectors have key roles to play. ESG investors should explicitly Compared to their scoring on Governance and Social issues, articulate their investment goals, and ESG score providers ESG providers score countries on Environmental issues much should facilitate this through clarity on how they score. It is less consistently. This is due to disagreements on what “good” important that policy makers in MDBs and governments of performance is on a conceptual level, but also due to data gaps, advanced economies support middle- and low-income countries out-of-date statistics, and heterogeneous reporting standards, in their efforts to make their economies more sustainable. which often force providers to fill in and estimate missing values. Finally, although sovereign debt markets are important, they Fortunately, recent advances in geospatial technologies, as well may not always be the best way to achieve desired sustainability as pressure for more standardized national reporting and the results. Taxation and regulatory changes may be a better way to newest version of the Changing Wealth of Nations data show encourage ESG-oriented capital. promise for mending these gaps. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 11 12 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> Executive Summary Environmental, social, and governance (ESG) investing is quickly becoming ordre du jour in sovereign debt investing. There remains, however, lack of clarity around frameworks for scoring sovereign ESG performance, industry practices, and the definition of sustainability itself. This World Bank publication consists of two independent reports. The first part is written by the World Bank and takes stock of the current sovereign ESG investing framework and proposes improvements. The second part presents a survey on ESG practices among emerging market (EM) sovereign debt investors conducted by J.P. Morgan (JPM), which launched the first EM sovereign ESG index in 2018. This publication is a result of the World Bank’s proactive engagement with stakeholders on pertinent sovereign ESG issues and is part of a publication series under the auspices of the Global Program on Sustainability (GPS). The JPM survey emphasizes that ESG considerations are no longer a niche topic for investors in EM sovereign debt. However, the level of penetration of ESG considerations into EM sovereign debt investing remains mixed. About 65 percent of respondents report that less than one-fifth of their assets under management (AUM) have explicit ESG considerations. Furthermore, when asked to assign a weight to ESG versus traditional investment factors such as inflation, interest rates, and debt-to-GDP ratios, more than 60 percent of participants assigned a weight of 20 percent or less to ESG. In a similar vein, more than 75 percent of respondents say that dedicated ESG funds make up less than one-fifth of their overall EM sovereign strategy. On the other end of the spectrum, about one-fourth consider ESG factors for more than 80 percent of their assets under management (AUM). Most respondents interested in sovereign ESG strategies were in Europe, 6 percent were in the United States, and 4 percent were in the Asia-Pacific region. Most of these said they were pursing ESG integration, in other words incorporating ESG-related information into investment decisions to enhance risk-adjusted returns, regardless of a sustainable mandate. A significant number were also pursuing exclusionary investment screening, a practice of excluding certain countries involved in ESG practices deemed unacceptable. Many also are increasing engagement or stewardship with sovereigns although half of respondents reported that they do not engage with sovereign issuers enough and want to improve. The investment objective—whether motivated by achieving a certain risk-adjusted return, having an investment impact, or some combination of both—is a key consideration when assessing how ESG factors are included in the investment process. For decades, ESG factors, such as governance and to a lesser extent social factors, have been a foundational tenet of sovereign credit analysis. Yet, the explicit integration of ESG factors into the investment process is a recent phenomenon. Even though ESG investing has A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 13 its roots in equity and corporate debt, the increased focus of off investors face, according to their relationship to financial, sovereign debt investors comes as no surprise, given the social, and environmental materiality. Questions regarding size of the government bond market. The sovereign issuer materiality or impact are central to this confusion, and there is, however, fundamentally different from a corporate entity. is need for further efforts at a global level to streamline both This report documents various reasons for why the corporate investment terminology and methodologies. For example, ESG framework may not necessarily be fit for purpose for investors who consider only financially material ESG risks sovereign debt investing. in the investment process may not, in fact, contribute to sustainable outcomes. Indeed, sustainability has different Investors are beginning to regard ESG factors as output shades, ranging from weak sustainability, which assumes metrics of investment decisions, rather than another complete substitutability between the different capital stocks, set of “input” parameters. In this “output” approach, to strong sustainability, which assumes no substitutability ESG factors influence not only the financial value of an such that all natural capital must be conserved. This nuanced investment, but also reflect its impact on wider, nonfinancial distinction complicates ESG investing further. There is also systems. This is observable in the JPM survey, in which 30 a clear regional distinction between interpretation of the role percent of respondents said that sustainability is integral of fiduciary duty and ESG investing, as well as regulatory to their sovereign ESG framework, while 60 percent have approaches to ESG across regions. a separate but complementary Sustainable Development Goal (SDG) framework and 10 percent assess sustainability Attributing ESG investing in sovereign debt to separate from the ESG framework. This paper argues that it sustainable outcomes is complicated by the nature is possible to have a “sweet spot” (Figure ES.1) which allows of the asset class. The nature and scope of sovereign an investor to maximize return, while also contributing to bonds, the primary vehicle for sovereign ESG investing, measurable sustainable outcomes. obscures how an investment achieves ESG output. The rise in sovereigns issuing thematic bonds may help ESG investing requires more clarity in its terminology partially alleviate some investor concerns. In the JPM to better articulate its investment purposes. Figure ES.2 survey, most asset managers do not currently see the link groups various terms that are often used to describe the trade- between sovereign debt and sustainable outcomes as a > > > F I G U R E E S . 1 Ov rvi w of ESG inv stin ppro ch s ESG inv stin cont ins multitud of t rminolo i s. Fi ur 1.1 loc t s th id l “sw t spot” s th int rs ction of common inv stm nt p r di ms. Fi ur 1.1b roups v rious t rms th t r oft n us d to d scrib th tr d -off inv stors f c , ccordin to th ir r l tionship to fin nci l nd soci l/ nvironm nt l m t ri lit . . Inv stm nt o ls do not b. Inv stors f c tr d -off, n c ss ril xclud ch oth r but it’s not n ith r-or d cision Fin nci l Environm nt l m t ri lit m t ri lit R sponsibl inv stin “Sw t spot” ESG s input ESG s output Purpos Imp ct Risk-r turn -n utr l Purpos ful inv stin inv stin “V lu ” “V lu s” Source: World Bank staff illustration. Note: ESG = environmental, social, and governance. 14 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > FIGURE ES.2 Sov r i n ESG nvironm nt l pill r h s m n f c ts th t r difficult to m sur Th fiv m jor nvironm nt l th m s from th Sov r i n ESG d t port l r dir ctl link d with t l st s v n of th Sust in bl D v lopm nt Go ls. This clos r l tionship hi hli hts th import nc of ccur t l m surin nvironm nt l indic tors. Emissions and pollution CO2 emissions GHG net emissions/removals Methane emissions Sust in bl Nitrous oxide emissions PM2.5 air pollution D v lopm nt Energy use and security Go ls Electricity production from coal sources Energy imports Primary Energy intensity Fossil fuel energy consumption Renewable electricity output & consumption Environment/climate risk and resilience Cooling Degree Days Droughts, floods, extreme temperatures Maximum 5-day Rainfall Heat Index, Mean Drought Index Food Security Agricultural land Agriculture, forestry, and fishing Food production index Natural capital endowment and management Forest area Adjusted savings: natural resources depletion Adjusted savings: net forest depletion Annual freshwater withdrawals Mammal species, threatened Environm nt l Terrestrial protected areas Marine protected areas Pill r Source: World Bank staff Illustration. Note: CO2 = carbon dioxide; ESG = environmental, social, and governance; GHG = greenhouse gas; PM2.5 = particles of less than 2.5 micrometers diameter. major problem (only 16 percent do). The survey found that the current primary concern for investors is the lack of Three Structural Challenges ESG standardization (42 percent) and the prevalence of greenwashing (24 percent). The paper identifies three structural challenges with the Sovereign ESG performance sets a benchmark and current sovereign ESG framework: Lack of clarity, the drives capital allocations for subnational investment ingrained income bias, and poor environmental data decisions. Sovereign ESG scores serve not only to quality. First, unclear terminologies, overlapping concepts characterize sovereign-level instruments, such as and opaque scoring methodologies raise fundamental government bonds. Similar to how the performance of an questions about the de facto outcome of ESG investing investment portfolio is evaluated against market indices compared to its stated goal. This lack of clarity hampers the or industry factors, in many cases sovereign ESG scores balancing between the “ESG as input” and “ESG as output” also serve as a benchmark for performances of subnational views. Investors who truly aim for the sweet spot may in fact entities. Moreover, sovereign ESG scores also trickle do harm to sustainable outcomes, when investment goals down to subnational entities, such as municipalities and and the purpose of ESG scores are conceptually not aligned. corporations. Especially in countries where data coverage The JPM survey on EM sovereign investors supports this and quality are lacking, country-level indicators are often concern with lack of ESG standardization being the greatest used to fill in missing values for smaller entities. This concern of ESG going forward, and with transparency among emphasizes the high demand for a reliable and transparent the main concerns on existing ESG data. sovereign ESG framework, which would also enable a fairer comparison of corporates across borders. Second, while sovereign ESG providers may converge on what good sovereign ESG performance is, that ideal is driven by an ingrained income bias (Figure ES.3). About 90 percent of sovereign ESG scores are explained A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 15 16 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT by a country’s national income, thus richer countries tend objective, more transparent methods, improved data to have better ESG scores. Prosperous countries tend to quality, incorporation of forward-looking scenarios, and have better institutions and less inequality, which are linked 5accounting for the ingrained income bias. to better social conditions and governance. But ESG is multifaceted and whether this truly reflect sustainability Foremost, investors need to be able to clearly define can be debated. More concerning, the predominant role their preferred investment approach, whether that be of income sets questionable investment incentives. The “ESG as input”, “ESG as output” or some combination income bias could disguise ESG risks of prosperous of both. Investors and asset managers need to clearly developed countries, while greatly exaggerating the risks articulate (a) their financial and sustainability objectives, in developing nations. This sets potentially perverse (b) the mechanisms by which they will be achieving these investment incentives that drive capital away from lower objectives, (c) the metrics by which they will measure income toward higher income countries. This relationship success or failure, and (d) the approach for balancing these also has profound implications for sovereign ESG indices objectives when they are not aligned. Transparent methods and other investment flows, which are strongly dependent are also critical to allow stakeholders to understand what is on sovereign ESG scores. The JPM survey emphasizes being measured. More transparency in rating approaches that the ingrained income bias is also a focus for the asset and data sources facilitates a constructive dialogue manager community: 24 percent of respondents listed it as between data providers, rating agencies, and investors. the most dominant concern about sovereign ESG investing. Availability of data is critical to advancing the Third, poor environmental data quality stands in the sovereign ESG framework. More frequent and timely data way of better assessing a country’s sustainability. coverage would improve analysis of recent performance of Sovereign ESG providers, who have laid the foundation for sovereigns on ESG issues. A reliable data environment also the operationalization of ESG investing in sovereign fixed- makes the construction of rules-based investment indices income markets, converge on measuring good sovereign feasible. Despite good progress—for example the World performance on Governance and Social issues but not on Bank sovereign ESG data portal, World Resources Institute measuring the Environment pillar at the sovereign level. data platform, and advances in geospatial data—significant The sovereign E pillar includes a host of information on a shortcomings remain, particularly on the environmental side. sovereign’s environmental condition and has the smallest As the majority of JPM survey participants indicate, the E weight in overall sovereign ESG scores. One of the main pillar is currently underrepresented due to data challenges. reasons for disagreement on the E pillar is the complex Large data gaps and lags mean that it is often necessary to question of what a “good” environmental performance is. impute missing data or extrapolate data forward. Advances The five major environmental themes from the World Bank’s in geospatial data collection, as well as machine learning sovereign ESG data portal, for example, are directly linked methods, also offer a promising way forward, but they also with at least seven of the United Nations SDGs (Figure require significant technical expertise and support to be ES.2). This close relationship highlights the importance more broadly and publicly available. of accurately measuring environmental indicators but also the challenge. This is also manifested in the JPM World Bank wealth accounting data are a promising survey: 70 percent of the respondents underrepresent source for additional data insight. The purpose of wealth the E pillar because of data challenges, whereas 26 data largely overlaps with the goals of sovereign ESG percent underrepresent the S pillar and only 4 percent scores, but the latter have adopted wealth data only to a underrepresent the G pillar. limited degree. The economic materiality, forward-looking perspective, and long history of consistently curated data suggest that wealth data could be a potential input for better- The Path Forward quality data. Wealth data address two major shortcomings of current sovereign ESG data. First, wealth data measures the economic value to environmental resources and, As a result of these structural challenges, the current second, its comparatively long history and high frequency sovereign ESG framework needs to adjust course and allows focus on recent developments in environmental become more transparent. We list guiding principles for a performance. Sovereign ESG 2.0. framework that should provide a solid foundation for future developments and avoid the structural Forward-looking assessments are also critical because challenges of the current framework (Figure ES.4). Five the risks from climate change are expected to be more key areas that both the World Bank and other stakeholders frequent and larger in the future than in the past. can focus on are identified. These are clarity on investment Traditionally, financial materiality has been determined by A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 17 looking at statistical relationships in past data. With the The level of capital market development is a binding consequences of environmental degradation and climate constraint for operationalizing a more equitable change looming on the horizon, E indicators need to not sovereign ESG framework. The very nature of the financial only represent the value of the environment today but also system, as well as the prevalence of benchmark investing capture the value of its protection and the costs of its loss for in the sovereign EM universe, means that only a few EM future generations. Looking at nature from this perspective sovereigns can attract meaningful flows to their local also sheds light on the risks and opportunities that stem currency sovereign debt market. Multilateral development from natural assets. banks (MDBs), such as the World Bank, continue to play an important role with respect to financial sector The ingrained income bias is a fundamental challenge deepening, contributing to efforts to support developing for sovereign ESG investing. Recognizing and adjusting countries’ sustainable growth. The World Bank’s Finance, for this bias is a key requirement for Sovereign ESG 2.0. Competitiveness, and Innovation (FCI) and Treasury global Ideally, ESG scores should give an accurate representation practices also provide technical assistance and advisory of a country’s sustainability that is not primarily a result services on bond market development as well as on of its level of income. However, removing this bias is not thematic sovereign bond issuance. Cooperation between a simple exercise, as any adjustment method rests upon MDBs and private institutions will need to grow to help assumptions about what ESG scores should represent and EM issuers access capital markets. Further public-private what “good” ESG performance is. While some practitioners cooperation (for example, IFC and Amundi, JPMorgan have advocated income adjusting by using a regression Chase Institute, among others) is essential to continue to adjusted for GDP per capita, the authors of this paper also transform the financial industry collectively toward argue that this may lead to overcorrection and would fail greater sustainability through, among other things, design to capture the nonlinear nature of income’s impact. We of new financing instruments and development of market- therefore propose two alternative approaches (momentum ready practices and frameworks. and peer-group scoring) that may serve the goals of income adjustment better. We also discuss the drawbacks of these The World Bank will continue to work with key methods, such as additional data requirements and the stakeholders on the issues identified in this paper. sensitivity of peer group selection. The guiding principles identified provide a solid foundation > > > F I G U R E E S . 3 Sov r i n ESG scor s h v stron incom bi s Av r ESG scor s cross s v n ESG provid rs r hi hl corr l t d with GNI p r c pit cross 133 countri s. Th r r ssion lin xhibits si nific ntl positiv slop . ESG scor Av r GNI p r c pit corr l tion = 87.9% Low incom Low r middl incom Upp r middl incom Hi h incom Source: World Bank staff illustration. Note: GNI = Gross National Income. 18 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT for future work, and the World Bank will continue to middle- and low-income countries in their efforts to make play a proactive leading role. The paper highlights that their economies more sustainable. This work may or sustainability is a complex topic and that the current may not be through the sovereign debt market. Although sovereign ESG framework may in fact disadvantage poorer sovereign ESG investing is certainly one lever to attract countries. It is also important that policy makers and key ESG-orientated capital, other methods such as taxation stakeholders are cognizant of these dynamics and that and regulatory changes could also help and be relatively MDBs and governments of advanced economies support more effective in lower-income countries. > > > FIGURE ES.4 K r quir m nts of Sov r i n ESG 2.0 2. Tr nsp r nt M thods 1. Tr nsp r nt 3. Improv inv stm nt d t obj ctiv Sov r i n ESG 2.0 5. Unbi s d 4. Forw rd- from incom lookin Source: World Bank staff illustration. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 19 1. 20 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> A New Dawn – Rethinking Sovereign ESG Introduction >>> Key Takeaways 1. “ESG as input” and “ESG as output” are two mutually nonexclusive approaches to environmental, social, and governance (ESG) investing: (a) ESG integration or a purpose-neutral approach using ESG factors as an input in the investment process to manage ESG-related risks that affect the financial risk of the investment portfolio and (b) a purposeful approach using ESG factors as an output of the investment process to achieve measurable, sustainable impacts. 2. The sovereign ESG framework has predominately been focused on (a), not on (b). This is not an either-or decision: investors can pursue a mix of both approaches. It is possible to have a sweet spot whereby an investor can improve risk management of a portfolio while also contributing to measurable sustainable outcomes. This approach of balancing financial materiality and environmental materiality is called dual materiality. 3. The World Bank team has identified structural challenges in the current sovereign ESG framework. First, we highlight the terminology confusion. Secondly, our research shows that there is a strong relationship between the output of the current sovereign ESG methodologies—sovereign ESG scores—and countries’ level of income. Thirdly, we find that there is little agreement on what constitutes or how to measure good sovereign environmental performance among ESG data providers, compared with the performance of governance and social factors.. 4. The sovereign ESG investing framework is also becoming important for country capital allocations. Sovereign ESG performance is becoming a key part of overall country risk assessments and could affect decisions of many ESG-conscious investors to invest in a country, therefore influencing capital flows. 5. A sovereign ESG framework with greater transparency is needed so that investors can make informed investment decisions to ensure alignment of ESG tools with investment objectives. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 21 This paper consists of two independent reports on objectives? What reforms to the current sovereign ESG the topic of sovereign environmental, social, and framework are required to help move the financial system governance (ESG) investing. The first chapter presents a toward greater sustainability? World Bank report that takes stock of the current sovereign ESG investing framework and proposes improvements. The Sovereign debt is a unique asset class because the second chapter presents a survey conducted by J.P. Morgan sovereign issuer is fundamentally different from a (JPM) on ESG practices among emerging market (EM) corporate issuer. As a result, the external validity of sovereign debt investors.1 The survey broadly emphasizes empirical findings and mechanisms related to ESG, which that ESG considerations are no longer a niche topic for primarily have emanated from the corporate world, should investors in emerging market (EM) sovereign debt although not be assumed. For example, a sovereign is involved in a the level of penetration of ESG into EM sovereign debt diverse array of activities that involve many societal tradeoffs. investing remains mixed.2 There are two mutually nonexclusive approaches to The World Bank promotes sustainable development and sovereign ESG investing. Up to now, ESG investing has shared prosperity globally, and developing sustainable focused on ESG integration, which uses ESG factors as financial markets is a key conduit for attracting capital an input in the investment process to help minimize ESG- for this purpose. Cooperation between multilateral related risks (that is, a purpose-neutral view).3 In the EM development banks (MDBs), such as the World Bank, and context, this approach emphasizes governance issues due private institutions will need to grow to help mobilize capital to their strong place in existing sovereign credit analysis and and finance a more sustainable future in emerging markets. exclusion-based investment mandates. As part of this effort, the World Bank proactively engages with many asset owners and asset managers, institutional As ESG investing becomes an integral part of the investors, banks, and other private sector participants on financial sector, investors are also beginning to focus pertinent ESG-related issues. These discussions have been on ESG from an impact or output viewpoint rather the primary motivation for this paper. than as another investment input parameter.4 This more purposeful approach considers ESG factors that affect not This publication is targeted at both policy makers and just the financial value of the asset but also its impact on key stakeholders in the industry. Specifically, the paper the wider nonfinancial aspects such as environmental, and answers the following questions: social systems. This ESG-as-output view is closely related to the impact-investing paradigm. However, having impact • Sovereign ESG and sustainability: To what extent does the through project financing is more tractable than having impact current sovereign ESG framework that we call “Sovereign on a sovereign level. While dealing with impact-washing ESG 1.0” contribute toward sustainability? and measuring impact is difficult on any level, attributing • Promises and realities of sovereign ESG: What are the environmental improvements to specific investments is issues that need to be addressed for the sovereign ESG particularly challenging on a countrywide scale. As we will framework to be better aligned with the sustainable argue later in this report, the relevance of ESG as an output development goals (SDGs)? How does the ability of ESG is instrument specific. Sovereign ESG discussions have investing to enable sustainable development outcomes fare been primarily focused on sovereign bonds. In this report, we in the face of market realities? therefore also focus on sovereign debt markets, but many • Toward Sovereign ESG 2.0: What does Sovereign ESG of the key considerations are also applicable to broader 2.0 need to look like to be better aligned with sustainability sovereign capital allocation decisions. 1 The survey was conducted in January 2021 and received 51 responses from EM investors across three regions that represented almost US$650 billion in assets under management (AUM). 2 We emphasize that results should not be considered representative of the full universe of institutional bond investors since respondents were selected and agreed to participate in this survey. These takeaways should instead be seen as upper boundaries for the wider market in terms of ESG adoption. About 65 percent of respondents reported less than one-fifth of their AUM as having explicit ESG considerations. On the other end of the spectrum, about one-fourth consider ESG factors for more than 80 percent of their AUM. Furthermore, when asked to assign a weight to ESG versus traditional investment factors (inflation, interest rates, debt-to-GDP ratios), more than 60 percent of participants assigned a weight of 20 percent or less to ESG. Similarly, more than 75 percent of respondents said that dedicated ESG funds make up less than one-fifth of their overall EM sovereign strategy. 3 In a 2020 report, J.P. Morgan recognized that ESG investing has started to shift from purpose-neutral to purposeful, bringing this investment approach closer to the concept of sustainable development. As a result, EM investors are increasingly seeking out frameworks and methodologies to qualify and quantify impact to avoid accusations of green-washing or impact washing. This ongoing evolution of the financial industry toward a greater focus on development outcomes, while also retaining the broader market appeal of traditional ESG investing, will help attract new sources of capital for EMs to meet their development objectives and Sustainable Development Goals in the years ahead. 4 As these two approaches to ESG investing are often presented in different ways, box 1.1 provides an overview of different framings, while appendix A provides a repertoire of commonly used terminology pertaining to both approaches. Figure 1.1 illustrates the two main ESG investment approaches and shows that there may be overlap between these concepts. 22 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Sustainability has different shades, ranging from weak materiality and environmental materiality (called dual sustainability, which assumes complete substitutability materiality) arguably stands at the heart of the debate on between the different capital stocks such as produced whether sustainable investing and traditional investment goals capital and natural capital, to strong sustainability, are mutually exclusive. The JPM EM ESG investor survey which assumes no substitutability, so that natural capital gives a clear answer: less than 13 percent of respondents must be conserved (Pelenc, Ballet, and Dedeurwaerdere believe that following an ESG strategy implies sacrificing 2015). Lack of consensus and clarity on the nature of investment returns compared to a market benchmark. sustainability pursued through investing in various asset While 36 percent are ambivalent, the remaining 51 percent classes complicates ESG investing further. On top of this, believe that the sweet spot is achievable in some form. ESG investing contains a multitude of terminology interpreted The sweet spot, however, does not mean that financial and and applied differently by different market players. Figure environmental materiality are equivalent. Some 64 percent of 1.1a locates the ideal “sweet spot” as the intersection of respondents consider the primary purpose of ESG as being common investment paradigms. Figure 1.1b groups various the better quantification of a sovereign’s credit risk situation. terms that are often used to describe the trade-off investors The remaining 34 percent believe that the main purpose face, according to their relationship to financial, social, and is to measure a country’s sustainability profile and effort. environmental materiality. Box 1.1 also provides an overview of the varying terminology used to distinguish between ESG The World Bank team identified structural challenges investing objectives. in the current sovereign ESG framework. Our research shows that there is a strong relationship between the It is possible to have a “sweet spot” whereby an investor output of the current sovereign ESG methodologies used can pursue traditional investment objectives while also by sovereign ESG providers—sovereign ESG scores—and contributing to measurable, sustainable outcomes, as countries’ level of income (Boitreaud et al. 2020; Gratcheva, figure 1.1 illustrates. This approach of balancing financial Gurhy, and Wang 2021; Wang 2021). This implies that > > > F I G U R E 1 . 1 Ov rvi w of ESG inv stin ppro ch s ESG inv stin cont ins multitud of t rminolo i s. Fi ur 1.1 loc t s th id l “sw t spot” s th int rs ction of common inv stm nt p r di ms. Fi ur 1.1b roups v rious t rms th t r oft n us d to d scrib th tr d -off inv stors f c , ccordin to th ir r l tionship to fin nci l nd soci l/ nvironm nt l m t ri lit . . Inv stm nt o ls do not b. Inv stors f c tr d -off, n c ss ril xclud ch oth r but it’s not n ith r-or d cision Fin nci l Environm nt l m t ri lit m t ri lit R sponsibl inv stin “Sw t spot” ESG s input ESG s output Purpos Imp ct Risk-r turn -n utr l Purpos ful inv stin inv stin “V lu ” “V lu s” Source: World Bank staff illustration. Note: ESG = environmental, social, and governance. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 23 the level of income in developed countries could disguise contrast to the relatively high level of correlation for aggregate ESG risks while undervaluing sustainability performance ESG, S, and G scores, there is a markedly lower level of in developing countries, a situation which could lead to correlation between environmental pillar scores. Reasons misallocated capital and the potentially perverse incentive of for this include data lags, nonalignment of financial and driving capital away from low-income countries toward rich environmental materiality, and the longer time horizon and countries.5 If this result is indeed the intended purpose of nonlinear nature of environmental risks. ESG scores, it is then worth asking what value ESG scores add, de facto, compared to existing sovereign credit ratings. The rest of the paper is organized as follows. Section While richer countries receiving better credit ratings is in 1.2 outlines the current sovereign ESG investing framework line with their stated goal of measuring creditworthiness, it and how it contributes toward sustainability objectives while is questionable whether this is also in alignment with the section 1.3 highlights structural challenges of the current purpose of ESG scores. sovereign ESG practices and approaches. Section 1.4 proposes a new sovereign ESG 2.0 investment approach, We find that environmental factors can often be which in addition to the underpinnings of the current sovereign misconstrued by investors with wide disparity among ESG 1.0 framework, we argue, would more transparently sovereign ESG data providers. The results show that there align with sustainability objectives. Potential reforms are is little agreement on what constitutes “good” sovereign highlighted followed by the conclusion. The JPM survey is environmental performance among ESG providers. In then presented. 5 In its report, J.P. Morgan has also acknowledged that the current sovereign ESG investing framework, which assigns low-income EM countries the lowest ESG scores, perpetuates their development challenges. Indeed, J.P. Morgan has been seeking solutions to address this issue for sovereign investors within their sovereign index methodology as well as establishing a development finance institution to spur additional capital toward financing the UN SDGs in EMs. 24 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> BOX 1.1 Terms for differentiating the purposes of ESG investing There is a lack of clarity about the purpose of ESG investing and the terminology used to describe it. Questions regarding materiality are central to this confusion, so we present terminology and distinctions that help more clearly articulate the multiple potential goals of ESG investing. Regulators are beginning to clarify terminology. There is clear distinction in using different terms under the European Commission’s (EC) Guidelines for Reporting Climate-Related Information and American trust fiduciary law. In its 2019 guidelines, the EC defined financial and nonfinancial materiality with regard to assessing and reporting climate change impact on companies. While it defined financial materiality in the broad sense of affecting the value of the company rather than in the narrow sense of affecting its financial statements, it clarified the directionality of this impact: by climate change on companies, which is the focus of the task force on climate-related financial disclosures (TCFD). It defined nonfinancial materiality to assess the company’s impact on the environment. Consideration of both factors is defined as dual materiality. Figure B1.1.1 illustrates these concepts adapted for the sovereign context. There has been a clear regional distinction between interpretation of the role of fiduciary duty on ESG. In 2020, Schanzenbach and Sitkoff (2020) proposed an ESG investing taxonomy of collateral benefits ESG versus risk-return ESG to reflect American trust fiduciary law’s emphasis on investment motive.a US fiduciary law constrains investments based on considerations of the potential effects of US institutional investors using collateral-benefits ESG. While risk-return ESG investing could provide superior risk-adjusted returns, they argue that achieving collateral benefits as an objective may not necessarily achieve this (Schanzenbach and Sitkoff 2020). The Network for Greening the Financial System (NGFS) has also defined two high-level socially responsible investing (SRI) objectives for central bank portfolios: (a) a financial SRI objective that aims to address the impact of climate-related risks and ESG-related risks on the portfolio and (b) an extra‑financial SRI objective that aims to address the impact of the portfolio on the environment and society, alongside financial returns (figure B1.1.1). These objectives are increasingly likely to overlap as adaptation and mitigation policies evolve in response to climate change. For a climate-specific scope, the two high-level goals can be translated into a carbon risk objective and a climate friendliness objective (Dupré et al. 2015). > > > F I G U R E B 1 . 1 . 1 Du l m t ri lit in Sov r i n ESG Inv stin Fin nci l m t ri lit Environm nt l m t ri lit Wh t is it bout? Wh t is it bout? ESG-r l t d issu s th t ff ct fin nci l Inv stm nt o ls th t ff ct ESG-r l t d d cision-m kin , such s risk-r turn topics, such s Sust in bl D v lopm nt profil s or fin nci l st bilit Go ls or P ris Clim t Go ls Who is th udi nc ? Who is th udi nc ? C pit l m rk ts, inv stors, r ul tors, Civil soci t , consum rs, ov rnm nts, insur nc comp ni s, p nsion funds comp ni s, mplo s Source: World Bank staff illustration; European Commission 2019. Note: ESG = environmental, social, and governance. a. Collateral-benefits ESG is defined as an investment approach that considers sustainability outcomes as part of its investment process, while risk-return ESG is an investment process that considers material E, S, and G inputs to the investment process with the exclusive motivation of improving risk-adjusted returns. For a broader international perspective, refer to PRI and UNEP FI 2019. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 25 Sovereign ESG and Sustainability >>> Key Takeaways 1. Sovereign bonds are limited in their ability to serve as a direct vehicle to achieve sustainable development goals mainly because of the complicated transmission channels from investments in the asset class to the real economy. 2. Nevertheless, sovereign debt has an important role to play in the sustainability discussion, given its large scale within the global capital market. Moreover, sovereigns drive and fund the country’s economic, social, and environmental policies because that is the role of government. The ESG investing framework was originally designed increasingly important for subnational capital allocation. for equities (and corporate bond) investing and was Specifically, sovereign ESG metrics may also implicitly later adapted to sovereign debt investing. Since 2017, affect allocations to corporates, infrastructure, or private ESG investing in sovereign fixed income has become investments within a country. Especially in countries increasingly mainstream (see box 1.2). The timeline where data coverage and quality are lacking, country in figure 1.2 demarcates major events in the evolution level indicators are often used to fill in missing values for of ESG investing in the sovereign fixed income asset smaller entities. Furthermore, a reliable and transparent class. The sovereign ESG framework is used primarily sovereign ESG framework also enables comparison of by sovereign fixed-income investors but is also becoming corporates across borders that is fairer. > > > FIGURE 1.2 Sov r i n ESG: Th ro d to m instr m This tim lin d m rc t s m jor v nts in th world of sust in bl fin nc . Sinc th form tion of th Unit d N tions Principl s of R sponsibl Inv stm nt, th topic h s in incr s d tt ntion n mom ntum in r c nt rs. • First sov r i n soci l bonds • World B nk • COVID-19 crisis GPIF p p r World B nk r n ws focus on • JPM l unch s l unches sust in bilit World B nk’s P ris A reement NGFS JESG indic s soverei n ESG • 22 soverei ns GPS nd SDGs founded • Ass t d t port l h ve issued public tions Fr nce issu s m n rs reen bonds first r n issu whit • Germ n issu s OAT p p rs first r n bond 2006 2013 2015 2016 2017 2018 2019 2020 2021 Form tion Neuber er Berm n Pol nd issu s Ni eri issu s Chile issu s • FTSE Russ ll of UN PRI Sov r i n ESG first sov r i n first Afric n first sov r i n l unch s Public tion r n bond sov r i n r n bond clim t risk- r n bond djust d • WWF sov r i n N tC p ind x • SwissRe biodiv rsit ind x UN PRI l unches 2 World B nk pr ctic l uide to public tions ESG inte r tion in on Soverei n ESG soverei n debt & DMOs Source: World Bank staff illustration. Notes: DMO = debt management operation; ESG = environmental, social, and governance; GPIF = government pension investment fund; GPS = Global Program on Sustainability; JESG = J.P. Morgan ESG; JPM = J.P. Morgan; NatCap = Natural Capital; NGFS = Network for Greening the Financial System; OAT = French government bond, SDG = sustainable development goal; UN PRI = United Nations Principles for Responsi- ble Investment; WGBI = World Government Bond Index; WWF = World Wildlife Fund. 26 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> B O X 1 . 2 ESG Investing and Sovereign Debt The rise of environmental, social, and governance (ESG) investing in sovereign debt is notable both because of the unique role of governments and because of the scale of the asset class. The focus on sovereign debt is not surprising given the acceleration of global climate policy initiatives and political commitments that have moved both the issuer and investor communities to become increasingly proactive in repositioning themselves. The COVID-19 pandemic has also resulted in a stark increase in global sovereign debt levels as the full mechanisms of the state have been called upon to meet the social and health emergency brought about by the crisis.a Because sovereign fixed income is the biggest investment asset class, the integration of ESG investing as a more systematic part of it can be viewed as a natural and expected progression. Sovereign issuances of green and labeled bonds, the continued growth of ESG-tilted investment benchmarks, and growing sovereign-level offerings from ESG data providers reflect a quickly evolving financial sector ecosphere. Issuance of labeled bonds in emerging markets (figure B1.2.1) and emerging market ESG fixed-income assets under management (AUM) (figure B1.2.2) continue to grow. Although sovereign labeled bond issuances attract much of the market attention, the overall amount outstanding represents only about 0.2 percent of sovereign debt outstanding—so there is room for this market segment to continue to grow, given investment demand. In the meantime, investment mandates with ESG factors integrated will likely drive sovereign ESG asset allocations. > > > F I G U R E B 1 . 2 . 1 Clim t bond initi tiv Sov r i n Gr n, Soci l, nd Sust in bilit Bond Surv : 22 sov r i ns h v issu d l b l d bonds sinc 2016. Luxembourg Denmark Netherlands Belgium Sweden Canada United Kingdom Germany Lithuania Ireland Poland France Hungary Uzbekistan Spain Greece South Korea Italy Arab Rep. of Egypt Mexico Hong Kong SAR, China Guatemala Thailand Vietnam Colombia Côte d'Ivoire Ecuador Ghana Seychelles Nigeria Kenya Peru Brazil Indonesia Fiji DM Chile DM int nt to issu EM EM int nt to issu EM not p rt of surv Source: Climate bond initiative survey 2020. The survey covered 97% of issuance with 19 out of 22 sovereign issuers sharing their experience on issuing a labeled instrument. As of November 2020, 22 national governments had issued sovereign labeled bonds totaling USD96bn. In addition, at least 14 other sovereign governments across the world have indicated their intention to issue such bonds. Note: DM=Developed Market; EM = emerging market. a. Public debt increased by US$8.5 trillion through September 2020, which included US$1.4 trillion in emerging markets. >>> A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 27 >>> B O X 1 . 2 Continued > > > FIGURE B1.2.2 Em r in -m rk t JESG ss ts und r m n m nt, US$, billion 30 25 20 JESG ind x Suit 15 10 5 0 1H 2018 2H 2018 1H 2019 2H 2019 1H 2020 2H 2020 M rch-21 AUM ($ billion) Source: JPM. Note: JESG = J.P. Morgan ESG. 28 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT The transmission channels of investing in sovereign worth noting that the outcomes of sovereign ESG investing fixed income to achieve sustainable outcomes are can be circumvented using other levers such as taxation complex. While integrating ESG investing into sovereign and regulatory changes (capital charge reductions), and investment mandates may not be the most direct and these mechanisms can also help channel capital to more effective way of achieving sustainable outcomes, it has sustainable projects. an overriding benefit of being scalable, given its large size and the importance of the asset class.6 Box 1.3 provides Figure 1.4 presents an overview of the current ESG more context to the challenge of measuring impact when investing ecosphere for sovereign bonds. A utopian investing in the sovereign fixed income asset class. world in which all investment in sovereign debt is driven by Figure 1.3 shows that certain asset classes are highly sustainability considerations is not realistic, but stakeholders scalable in terms of the size of the asset class but are less have been aspiring to an investing world where investment effective at achieving measurable sustainable outcomes, decisions can contribute more meaningfully to sustainable while others are less scalable but more effective at outcomes. The changing financial sector ecosphere (also achieving sustainability outcomes. Sovereign labeled evident in the JPM client survey) and the “build back better” bonds, for example, are effective at achieving measurable vision that many have embraced worldwide now present a transparent sustainable outcomes, but their potential for unique opportunity to address the key shortcomings of the scalability is curtailed. Traditional development finance current Sovereign ESG 1.0 and broaden out the investment likewise has a strong emphasis on achieving sustainable “sweet spot.” The next section presents in greater analytical development goals, but its concessional nature limits its detail the main structural issues in the current sovereign scale and ability to close SDG funding gaps. Finally, it’s ESG framework. > > > FIGURE 1.3 Th sc l bilit nd ff ctiv n ss sp c This r ph positions v rious inv stm nt products ccordin to th ir sc l bilit ( . . sov r i n bonds h v wid lob l cov r ) nd ff ctiv n ss ( . . proc ds of r n bonds r rm rk d for r n proj cts). Public-priv te sust in ble projects Soverei n bonds Sc l bilit Soverei n l beled bonds Development fin nce Eff ctiv n ss Source: World Bank staff illustration. 6 The impact of sovereign ESG investing on sustainability outcomes is a function of scalability multiplied by the effectiveness at achieving sustainable outcomes. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 29 >>> B O X 1 . 3 Measuring the Impact of Sovereign ESG Measuring impact in sovereign ESG investing is challenging but given the market’s enormous scale, the effort is worthwhile. If ESG is to assume its role as an output measure, it is important to clarify its relevance and attributability for the impact considered. Using sovereign ESG for impact investing faces a trade-off between relevance and attribution. Country- level scores are highly relevant for the valuation of country-level instruments such as government bonds. It is difficult, however, to attribute recent environmental improvements across a country to an allocation of new outside capital via sovereign bonds or some other investment vehicles. At the same time, impact can be better assessed on a smaller scale, such as from project- level financing, but it is questionable how relevant sovereign-level ESG indicators are to achieving this impact. The sovereign debt asset class has the overriding benefit of being scalable. Many of the Sustainable Development Goals (SDGs) require public sector intervention (and therefore public sector financing), and closing these funding gaps and maximizing impact will involve recognizing the need to balance scale with effectiveness.a In addition, labeled instruments are an attractive instrument both for sovereigns to attract new capital to ESG-related projects and for impact-focused investors. The composition and structural nature of both local currency and hard currency sovereign bond markets, however, mean that for lower-income and lower-middle-income countries, the asset class is likely to have only a marginal benefit. Inclusion of the SDGs in the sovereign ESG investing framework is challenging and often involves tradeoffs. An investment may, for example, focus on promoting inclusive and sustainable economic growth or fostering innovation, but this could also inadvertently increase country and gender inequality or lead to biodiversity loss. Furthermore, indices such as the sovereign SDG indices from the Sustainable Development Report are highly correlated with a country’s level of income and thus suffer from the ingrained income bias discussed in the next section. a. For example, traditional development finance has a strong emphasis on achieving sustainable development goals, but its concessional nature limits its scale and ability to close SDG funding gaps. Closing such gaps and maximizing impacts will involve recognizing the need to balance scale with effectiveness at achieving suitable outcomes. > > > F I G U R E 1 . 4 ESG inv stin c n r sult in mor m sur bl nd imp ctful outcom s s inv stm nt ppro ch s conv r . Oth r lon -t rm fin nc d proj cts Oth r lon -t rm fin nc d proj cts Sust in bl / ESG Tr dition l Tr dition l inv stin ESG inv stin Utopi n world: inv stin inv stin ll inv stm nt in sov r i n is Show R sponsibl sust in bl conv r nc R sponsibl inv stin inv stin Imp ct Imp ct inv stin inv stin R t of conv r nc incr s s Curr nt b ckdrop ESG 2.0 World A sust in bl world without constr ints Source: World Bank staff illustration. Note: Overall institutional assets ( about US$100 trillion) versus ESG-themed strategies (about US$40 trillion) versus impact investors (about US$750 billion). These figures represent all assets under management (AUM), so the ESG-focused sovereign bond mandates are less, but given the AUM are likely significant. ESG = environmental, social, and governance. 30 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Structural Challenges in Sovereign ESG 1.0 >>> Key Takeaways 1. Sovereign ESG scores are strongly correlated with a country’s level of income, which may result in capital allocations toward richer countries at the expense of poorer ones, perpetuating an ingrained income bias cycle. 2. There is lack of agreement on how to measure sovereign environmental performance. Sovereign ESG scores are designed to quantify a country’s one’s investment objective as well as across countries with resilience to material ESG risks. While data providers different levels of development. Box 1.4 provides a more offer different ways of conceptualizing their sovereign ESG in-depth discussion on the ingrained income bias. products and different aggregation methodologies, they tend to focus on providing aggregated data points that have some The implication of the ingrained income bias for sovereign demonstrated financial materiality in addition to standard ESG scores is that they largely reflect a country’s level sovereign credit risk analysis. Furthermore, market practice of development and economic diversification, and incentivizes portfolios with higher, aggregated ESG scores. as such, countries have little ability to change their This approach only considers ESG as in input but does not scores in the short term. As we explore in more detail necessarily consider how an investment contributes to ESG in Gratcheva, Emery, and Wang (2021), financial and outcomes. Moving toward this approach of sovereign ESG nonfinancial measures of national income, such as measures investing would require structural changes to the current of sustainability, seem to measure an unobservable third framework. variable: development. While there is a correlation between higher scores and higher incomes, a certain income in no The Ingrained Income Bias Enabling way prevents countries from improving on their scores with environment the right policies in place. It follows that even at the same level of development, technical capacity building could help Sovereign ESG scores7 have a strong and statistically improve governance, environmental sustainability, and social significant positive relationship with a country’s justice issues. This should act as a strong encouragement to income (figure 1.5). Gratcheva, Emery, and Wang (2021) even lower-income countries, that concentrating efforts on found that in contrast to corporate ESG scores, aggregate improving ESG issues can help weight capital allocations to sovereign ESG scores have a high level of correlation relatively better ESG “performers.” between providers; they also found that a key driver of this is a strong positive correlation to a country’s level of income.8 Market practices that explicitly or implicitly target Indeed, one could argue that because governance is a portfolios with higher aggregate ESG scores may have key weighting in ESG ratings (Bouyé and Menville 2021), the perverse impact of increasing SDG funding gaps that pillar drives this natural correlation or income bias and (figure 1.6). Many ESG-adjusted benchmark indices are also further that, because the governance indicator is explicitly tilted in that they use ESG scores to increase the aggregated included in sovereign credit analysis to varying extents, ESG scoring versus a traditional benchmark, which results the inclusion of it in ESG rating scores could be viewed as in a direct manifestation of the “ingrained income bias” on a contributing to a “double count.” It furthermore raises the relative basis (Boitreaud et al. 2020). fundamental question of whether the materiality of E, S, and G pillars (and hence weightings) should differ depending on 7 Sovereign ESG scores are different from credit ratings in that they are not regulated. Also, unlike credit ratings, whose accuracy can be measured quantitatively against future default rates (even though they are also opinions), there are no agreed-upon objective definitions of what ESG sovereign scores are supposed to measure. 8 Other commonly used measures of sustainable development and resilience, such as the SDG index, the Yale Environmental Performance Index (EPI), and the Notre Dame Global Adaption Initiative Index (ND GAIN), demonstrate a similar strong relationship with a country’s level of income. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 31 > > > F I G U R E 1 . 5 Sov r i n ESG scor s h v stron incom bi s Av r ESG scor s cross s v n ESG provid rs r hi hl corr l t d with GNI p r c pit cross 133 countri s. Th r r ssion lin xhibits si nific ntl positiv slop . ESG scor Av r GNI p r c pit corr = 87.9% Low incom Low r middl incom Upp r middl incom Hi h incom Source: World Bank staff illustration. > > > FIGURE 1.6 Fi ur Sov r i n ESG 1.0 m wors n SDG fundin ps Inv stm nt ccordin to ESG 1.0 scor s m wors n SDG fundin ps b inc ntivi in c pit l to flow tow rds w lth countri s. t ESG scor r A Low incom Low r middl Upp r middl Hi h incom incom incom Source: World Bank staff illustration. Note: ESG = environmental, social, and governance; SDG = sustainable development goal. 32 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> B O X 1 . 4 What is the Ingrained Income Bias? A key empirical finding from the World Bank’s research is that sovereign ESG scores, along with other commonly used indices of sovereign level sustainability and resilience, highly correlate with a country’s level of income. Gratcheva, Emery, and Wang (2021) describe the empirical finding that countries scoring high in ESG scores tend to also rank high in income and development level. This is not surprising since high labor participation and access to electricity, political stability and rule of law, carbon dioxide emissions, and forest depletion do not exist in a vacuum. These indicators are both inputs and outputs of long-term growth and development. This phenomenon, the ingrained income bias (IIB), is not limited to ESG 1.0 scores, because the IIB is ingrained in any type of cross-country analysis that compares development- related indicators.a Not accounting for the IIB leads to two important consequences: • The income bias leads to perverse investment outcomes. Tilting investment portfolios toward higher ESG scores is equivalent to rewarding rich countries for their prosperity. • The “ingrainedness” leads to disheartening policy incentives. Policy efforts in the short run are unlikely to affect a country’s income level, which is the result of decades or centuries of development.b Figure B.1.4.1 illustrates the correlation of wealth and a number of ESG indicators. > > > F I G U R E B 1 . 4 . 1 Incom p rm t s l r rr of sust in bilit indic tors . Incom nd w lth ccountin N tur l, produc d nd hum n c pit l fi ur s r pr s nt d in tot l (tr nsform d with b s -10 lo rithm) or p r c pit numb rs. N tur l c pit l is l st corr l t d with GNI p r c pit . N tur l c pit l (tot l, lo 10) 14.0% N tur l c pit l (p r c pit ) 31.4% Hum n c pit l (tot l, lo 10) 59.0% Produc d c pit l (tot l, lo 10) 66.7% Hum n c pit l (p r c pit ) 78.3% Produc d c pit l (p r c pit ) 81.1% Source: World Bank staff. a. In econometric terms, these types of analyses suffer from endogeneity or, more specifically, omitted variable bias. See Wang (2021) for an in-depth discussion. b. While future research can properly assess whether financially material ESG risks are in fact highly correlated with a country’s level of income, it suffices to say that it is plausible for two reasons: (a) wealth has long been recognized as a key factor driving sovereign credit risk (Cantor and Packer 1996) and (b) higher-income countries have greater resources to mitigate ESG risks. A higher-income, better-diversified country may, for example, may have more resources for reinforcing critical infrastructure to be more resilient to increasingly extreme weather events that flow from climate change. Such investments in risk mitigation may help the country avoid disruptions to economic activity or the fiscal costs of rebuilding, both of which may be relevant to financial assessments of sovereign credit risk. >>> A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 33 >>> B O X 1 . 4 continued > > > F I G U R E B 1 . 4 . 1 continued b. Incom nd sov r i n ESG provid rs. Th E, S,G nd combin d ESG scor s r corr l t d with GNI p r c pit to v r in d r s, d p ndin on th ESG provid r. Th S scor s r most corr l t d with littl v ri tion cross provid rs, whil th E scor s r l st corr l t d with l r discr p nci s b tw n provid rs. A r t E scor 58.5% ris s st co sk l M s I SC tic in SA Su b s Ri tin Ei (m n) M p o R Ro R SA s Vi d s on o n M tic sc ti ris b R l B isk Ro ond Ei in pR o I st SC Su A r t G scor Vi B R M 69.8% (m n) tic s Su nd SAM s in tin ris st R l o o isk B sc Ei pR o I b SC Ro A r t ESG scor Vi R M 83.2% (m n) s M ond SAM s tin tic ris SC R o l isk B sc Ei in pR o b Su I st Ro Vi R A r t S scor 85.2% (m n) Source: World Bank staff. Note: The E, S, and G scores and the combined ESG scores are correlated with GNI per capita to varying degrees, depending on the ESG provider. The S scores are most correlated with little variation across providers, while the E scores are least correlated with large discrepancies between providers. E = environmental; G = governance; GNI = gross national income; S = social. c. Incom nd sov r i n ESG provid rs. Th Sust in bl D v lopm nt Go ls Ind x, Y l Environm nt l P rform nc Ind x, nd Notr D m Glob l Ad pt tion Initi tiv Ind x r simil rl nd stron l corr l t d with GNI p r c pit . SDG ind x 84.7% EPI Ind x 86.9% ND GAIN Ind x 91.0% Source: World Bank staff. 34 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Structural Challenges in the Environmental The sovereign E pillar includes a host of information Pillar on a sovereign’s environmental condition and has the smallest weight in overall sovereign ESG scores. Empirical analysis of sovereign ESG scores shows This consolidated score may not only relate to the climate that there is little agreement on what constitutes good situation in a country but could also include information sovereign environmental performance. Gratcheva, on the current condition of a multitude of issues such as Emery, and Wang (2021) found that in contrast to the waste, water management, and natural habitat. It may also relatively high level of correlation for aggregate ESG scores, encompass information around risk mitigation and adaptation there is a markedly lower level of correlation between many decades into the future. In the JPM survey, more than environmental pillar scores, especially once the scores are 70 percent of respondents considered environment as the adjusted for income. This highlights that there is a lack of most underweighted pillar in overall sovereign ESG scores.9 consensus on how to measure sovereign environmental Governance is identified by half of survey participants as the performance. Additionally, the contrast between the high most important pillar. This constellation is however not set correlation of aggregate ESG scores and the low correlation in stone: 40 percent of respondents indicated that the most of the environmental pillar scores emphasizes that the important pillar may change depending on the underlying environmental pillar has a relatively low contribution to materiality. the aggregate scoring. Figure 1.7 illustrates the wide disagreement on the weighting of the E pillar among sovereign Obtaining data is a key challenge for the environmental ESG sovereign score providers. Typically, E, S, and G pillars pillar. Despite good progress in producing relevant data sets are approximately equally weighted with a small emphasis (World Bank sovereign ESG data portal, WRI data platform, on G, but the weighting schemes vary considerably among advances in geospatial data), significant shortcomings ESG providers. remain. Large data gaps and lags mean that it is often > > > FIGURE 1.7 Composition of Sov r i n ESG Scor s b Pill rs for M jor ESG Provid rs Whil on v r E, S, nd G pill rs r pproxim t l qu ll w i ht d with sm ll mph sis on G, th w i htin sch m s v r consid r bl mon ESG provid rs. Av r 29% 28% 43% V.E 33% 33% 33% Sust in l tics 15% 35% 50% Rob co 20% 30% 50% MSCI 25% 25% 50% ISS 50% 15% 35% FTSE Russ ll/ 30% 30% 40% B ond R tin s 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Envirom nt l Soci l Gov rn nc Source: World Bank staff. Note: RepRisk is excluded because of different methodology. ESG = environmental, social, and governance. 9 Dasgupta (2021) also notes the undervaluation of natural capital assets. The review calls for changes in the ways that society measures economic success to protect and enhance prosperity and the natural world. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 35 necessary to impute missing data or extrapolate data forward. countries with different geographies and history (measuring The median lag for the World Bank sovereign ESG data deforestation may be more applicable to a country with large portal environmental data, for example, is five years versus rainforests than to a country that is mostly desert). Moreover, three years for social and governance data (Boitreaud et al. quantifying the multifaceted environmental pillar on a per 2020). In addition, creating universal data sets is also difficult country basis in a comparable and meaningful way is a major because of the heterogeneity of environmental issues facing challenge. 36 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Sovereign ESG 2.0 >>> Key Takeaways 1. For Sovereign ESG to make meaningful contributions toward sustainability, the current framework needs to adjust course. Sovereign ESG needs more transparency in the scoring methodology and data sources. More transparency would allow investors to clearly follow their preferred investment approach, which may favor the ESG-as-output or ESG- as-input view, or a combination of both. 2. Additional clarity not only benefits investors but also facilitates a constructive dialogue between raw input data suppliers, ESG providers, rating agencies, and regulators. 3. A course-adjusted sovereign ESG framework needs to account for the ingrained income bias. Simple income adjustment techniques of ESG scores may not necessarily result in greater sustainability outcomes. Momentum and peer group scoring may be more effective in alleviating the IIB. 4. Data improvement and capital market development are key tools for understanding the market and transmitting capital to sustainable goals. In many instances, these areas act as key binding constraints, and policy makers and the investment industry need to renew efforts on both fronts. This section discusses how the sovereign ESG Transparent Investment Objectives framework needs to evolve and reposition itself. For the new Sovereign ESG 2.0 approach to ESG investing to End investors should be able to choose between using be successful, this section recommends five key areas that ESG as an input or an output in their sovereign ESG both the World Bank and other stakeholders need to focus strategies depending on their investment objectives, on in order to help contribute to a more robust framework: legal constraints, and desire to promote sustainability (a) clarity on investment objectives, (b) transparent methods, outcomes. This paper has illustrated that considering ESG (c) improved data, (d) incorporation of forward-looking as an input in the investment process will not automatically scenarios, and (e) lack of bias relative to a country’s level lead to more sustainable outcomes. End investors and asset of income. Box 1.5 provides an overview of the guiding managers need to clearly articulate (a) their financial and principles. sustainability objectives, (b) the mechanisms by which they will be achieving these objectives, (c) the metrics by which A new sovereign ESG investing framework is not only they will measure success or failure, and (d) the approach important for sovereign debt investing. ESG integration to balancing these objectives when they are not aligned. and an understanding of the associated risks have been Mechanisms for influencing sustainable outcomes derived primary considerations for constructing sovereign ESG bond from equity markets should not automatically be assumed indices and portfolios. Given the underrepresentation of low- to be directly applicable to sovereign fixed income, although and lower-middle-income countries in the sovereign bond they may provide a useful starting point for this thinking.10 market and the opaque relationship between bond prices The environmental pillar poses significant challenges given and ESG indicators, government debt securities may not be the many facets covered. Despite this, it is important that the most suitable instrument to achieve sustainability goals. claims of sustainable outcomes be transparent (figure 1.8). The relevance of Sovereign ESG 2.0 should therefore not The five major environmental themes from the World Bank’s be limited to capital allocations to the sovereign debt market sovereign ESG data portal are directly linked with at least but also should serve as a backdrop against which investors seven of the UN Sustainable Development Goals. This can assess regional, corporate, and project-level financing in close relationship highlights the importance of accurately both public and private investments. measuring environmental indicators. 10 In Can Sustainable Investing Save the World?, Kölbel and coauthors (2019) examine the mechanisms for investor impact on sustainability outcomes in the equity markets. They identify capital allocation, engagement and indirect impacts as mechanisms of investor impact on sustainability outcomes, and then they investigate the empirical evidence for the effectiveness of each mechanism. The paper provides a promising approach for beginning to formulate such a theory for the unique context of sovereign fixed-income investing. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 37 >>> B O X 1 . 5 Guiding principles for Sovereign ESG 2.0 Recognizing the challenges discussed in this report, we list guiding principles for Sovereign ESG 2.0. A framework built on these principles should provide a solid foundation for future developments and avoid the structural challenges of the current Sovereign ESG 1.0 framework. 1. Transparent investment objective What’s the investment objective: risk management or the promotion of sustainability outcomes? Align tools with objectives. End investors and asset managers need to clearly articulate (a) their financial and sustainability objectives, (b) the mechanisms by which they will be achieving these objectives, (c) the metrics by which they will measure success or failure, and (d) the approach for balancing these objectives when they are not aligned. 2. Transparent methods Is the framework transparent in terms of the methodology and underlying data sources employed? What are the lags and gaps in the underlying data, and what methods will be used to fill in missing data points? How is materiality defined and tested and under what time horizon? 3. Improved data A solid data foundation is crucial for Sovereign ESG 2.0 to promote sustainable development outcomes, and it allows for an operationalization of ESG investing. World Bank wealth data are a promising complement to existing ESG data sources. Wealth data have economic materiality and take a forward-looking perspective. Additionally, most data sets have a long history. 4. Forward-looking Given the nature of climate change, forward-looking assessments that incorporate possible adverse scenarios are needed. 5. Income adjustment How do the framework and the scoring methodology ensure that the analysis does not suffer from ingrained income bias? > > > FIGURE B1.5.1 K r s to focus on for Sov r i n ESG 2.0 2. Tr nsp r nt M thods 1. Tr nsp r nt 3. Improv inv stm nt d t obj ctiv Sov r i n ESG 2.0 5. Unbi s d 4. Forw rd- from incom lookin Source: World Bank staff illustration. Note: ESG = environmental, social, and governance. 38 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > F I G U R E 1 . 8 Sov r i n ESG nvironm nt pill r h s m n f c ts th t r difficult to m sur but r l v nt for SDGs Th fiv m jor nvironm nt l th m s from th Sov r i n ESG d t port l r dir ctl link d with t l st s v n of th Sust in bl D v lopm nt Go ls. This clos r l tionship hi hli hts th import nc of ccur t l m surin nvironm nt l indic tors. Emissions and pollution CO2 emissions GHG net emissions/removals Methane emissions Sust in bl Nitrous oxide emissions PM2.5 air pollution D v lopm nt Energy use and security Go ls Electricity production from coal sources Energy imports Primary Energy intensity Fossil fuel energy consumption Renewable electricity output & consumption Environment/climate risk and resilience Cooling Degree Days Droughts, floods, extreme temperatures Maximum 5-day Rainfall Heat Index, Mean Drought Index Food Security Agricultural land Agriculture, forestry, and fishing Food production index Natural capital endowment and management Forest area Adjusted savings: natural resources depletion Adjusted savings: net forest depletion Annual freshwater withdrawals Mammal species, threatened Environm nt l Terrestrial protected areas Marine protected areas Pill r Source: World Bank staff Illustration. Note: CO2 = carbon dioxide; ESG = environmental, social, and governance; GHG = greenhouse gas; PM2.5 = particles of less than 2.5 micro- meters diameter. The potential sustainability impact of an investing criteria into the same score may make the aggregated score framework is a function of its scalability multiplied by difficult to interpret.13 Instead, it would be better to have its effectiveness at impacting sustainability outcomes. separate scores in which the sought-after objectives are Investors should clearly define where their framework is transparent. This would allow investors to better assess the situated on these two axes and how that affects its potential impact their investments are having and to collect relevant for sustainability impact. To achieve greater scale, there are information to make informed trade-offs in line with their two necessary steps. preferences that balance financial returns and sustainability outcomes. First, the industry needs to begin devising better ways of identifying and quantifying impact in sovereign Second, for purposeful sovereign ESG strategies to debt investing. The issuance of labeled bonds and the become more broadly scalable, policymakers will need definition of the use of proceeds and allocation of equivalent to clarify and strengthen the legal basis for pursuing amounts toward sustainability projects is one way to impact objectives for investments. The EU has made achieve this (Boitreaud et al. 2020).11 Notwithstanding these steps toward this with its embrace of dual materiality (box positive developments, it would benefit the sovereign ESG 1.1). The UN Environment Program Finance Initiative ecosphere to begin thinking of ways to better quantify impact (UNEP FI), which has sponsored much of the research or sustainability materiality for broader sovereign debt into the legal basis for ESG investing starting with the 2005 investing.12 Dual investment objectives require considering Freshfields Report (UNEP FI 2005), is currently working on sustainability materiality as well, but mixing concepts with a report outlining the legal basis for impact in key investment both financial and sustainability materiality (“dual materiality”) jurisdictions.14 11 Challenges include the use-of-proceeds model and the associated administrative burden. 12 Key performance indicator (KPI)-linked bonds are a possible solution, but these instruments also pose nontrivial challenges to both investors and sovereign issuer alike. 13 This is in line with recent recommendations by the Organisation for Economic Co-operation and Development (OECD) for improving environmental pillar scores for corporates (Boffo and Patalano 2020). 14 See the UNEP FI website at https://www.unepfi.org/investment/legal-framework-for-impact/. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 39 Transparent Methods and Data Sources periods between data points, especially for environmental metrics. The varying degrees of agreement across E, S, and G pillars call for more transparency. As discussed in section Advances in geospatial data collection offer a promising 1.3, there is little agreement among the major ESG providers way forward, but they also require significant technical on the environmental score, while social and governance advances to be more broadly and publicly available. With scores enjoy a broad consensus. Understanding the reason the recent developments in remote sensing technologies, for this divergence is hampered by the opaqueness of satellite imagery has become more accessible to the wider methodologies. Revisions in definitions and models may public. This data source has already been applied in various furthermore cause large swings in ESG scores, which circumstances to quantify and verify environmental practices. represent a major challenge for downstream index providers The objective and globally consistent nature of earth and investors. More transparency in ESG providers’ observation data make them an attractive choice to improve approaches and the data sources employed would facilitate existing datasets. Depending on the indicator, weather a constructive dialogue between all stakeholders. Investors conditions, and geography, satellite mapping services can and asset managers entering sovereign ESG investing face deliver reliable updates as often as every week. inconsistent definitions and a lack of common terminology. The experience of corporate ESG scores cautions that an Machine learning methods can augment and improve incorrect ESG designation may lead to capital misallocations existing ESG data. Statistical methods can be employed and even regulatory repercussions. A transparent ESG 2.0 to downscale established ESG data to more relevant units. framework ensures consistency and makes it easier to adapt While sovereign ESG data can be spatially disaggregated future taxonomies. over states and municipalities, the main benefit of machine learning methods is to augment the temporal dimension. A Investor engagement with sovereigns is becoming promising application is to nowcast the most recent values of increasingly important.15 While this is challenged by the otherwise missing values. Using the same toolbox, higher- delay in E data, engagement with sovereigns can be an frequency earth observation data can also estimate quarterly effective tool in seeking greater transparency from sovereigns or monthly ESG data from their annual counterparts (figure on sustainability issues. ESG disclosures are thus becoming 1.9). This introduces seasonal patterns, quantifies short-term an increasing focus with investors when issuers come to impacts of disasters, and allows a monitoring of deforestation market, as well as in the period after and prior to coming to trends and land degradation that is timelier. While data gaps market.16 This is also discussed in chapter 2. and lags are most severe for environmental data, alternative data approaches may also help augment data on social and Data Quality governance indicators. Figure 1.9 illustrates how subannual numbers (quarterly, monthly) can be obtained from annual A solid data foundation is crucial for sovereign ESG 2.0 wealth statistics on a subnational level (first administrative to promote sustainable development outcomes. Recent level). The example here is calculated for the Cagayan Valley performance-type ESG scores require more frequent and in the Philippines. In this region, annual cropland wealth is recent data coverage. A reliable data environment also distributed throughout the year and the country based on makes the construction of rules-based investment indices agricultural production data and agronomic satellite imagery. feasible. While sharing many challenges that corporate- This method ensures that numbers are consistent (that, level ESG data also faces (consistency, reporting biases), for example, the sum of quarterly numbers equals annual some problems such as coverage limitation and aggregation numbers). decisions only emerge on the sovereign level (WWF and World Bank 2020). A recent study (Herzog et al. 2020) evaluates underlying data production and management issues and gives recommendations for improving the accessibility, quality, and coverage of sovereign ESG indicators. Among the key shortcomings is the low data frequency and long time 15 The World Bank is in the early stages of leading a project to introduce a TCFD for sovereigns. The framework would provide guidance for voluntary, consistent, climate- related financial disclosures that would be useful to investors, lenders, and insurance underwriters in understanding material sovereign climate risks. The criteria encompassed in the TCFD for sovereigns framework is likely to be broader than the TCFD for corporates in two key ways, as the framework will include nature-related risks alongside climate-related risks and go beyond financial risks to include relevant nonfinancial risks. The World Bank is in the early stages of a pilot project and expects to release a report later in 2021. This initiative, if it gains traction, would be a welcome information source for investors while being voluntary and self-reported. 16 See Principles for Responsible Investment, “ESG Engagement for ESG Investors,” https://www.unpri.org/sovereign-debt/esg-engagement-for-sovereign-debt- investors/6687.article and “World Bank Releases Guide for Sovereign Issuers to Engage with Investors on Environmental, Social and Governance (ESG) Issues,” news release, November 9, 2020, https://www.worldbank.org/en/news/press-release/2020/11/08/world-bank-releases-guide-for-sovereign-issuers-to-engage-with-investors- on-environmental-social-and-governance-esg-issues. 40 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > F I G U R E 1 . 9 Illustr tion for incr sin t mpor l fr qu nc nd sp ti l r solution of w lth d t . Th x mpl illustr t s how cropl nd w lth of th Philippin s c n l v r ricultur l production d t nd ronomic s t llit -im r to incr s t mpor l fr qu nc nd sp ti l r solution. Annu l (from w ith d t ) 20 Th Philippin s 10 C n V ll (R ion II) US$ trillion, const nt 2018 US$ 0 2008 2010 2012 2014 2016 2018 Qu rt rl 6 4 2 0 2008 2010 2012 2014 2016 2018 Monthl 6 4 2 0 2008 2010 2012 2014 2016 2018 Source: World Bank staff illustration. Note: The numbers serve illustrative purposes only and are subject to change. Wealth Data been determined by looking at statistical relationships in past data. With the consequences of environmental degradation World Bank wealth data are a promising source for and climate change looming on the horizon, E indicators additional data insight. Box 1.6 provides an overview of need to represent not only the value of the environment the World Bank’s work on wealth accounting and how this today but also the value of its protection and the costs of work provides a firm foundation for advancing the sovereign its loss for future generations. Looking at nature from this ESG framework. The purpose of wealth data largely overlaps perspective also sheds light on the risks and opportunities with the goals of sovereign ESG scores. For example, that stem from natural assets. As the Bank for International Sustainalytics has built its ESG framework around wealth Settlements (BIS) suggests (Bolton et al. (2020), there is data. The economic materiality, forward-looking perspective, a need for an epistemological break from past modes of and long history of consistently curated data suggest that assessing risk toward forward-looking methods. wealth data are a rich data source for sovereign ESG scores. Wealth data address two major shortcomings of current Income Adjustment sovereign ESG data. First, wealth data assign an economic value to environmental resources. Exclusively relying on Sovereign ESG 1.0 is structurally challenged by the latter overemphasizes the environmental materiality “ingrained income bias.” The ingrained income bias is but does not account for economic relevance. Second, the the highest ESG-related concern of 25 percent of JPM’s comparatively long history of wealth data also allows focus EM survey respondents. Recognizing and adjusting for this on recent developments in environmental performance. This bias is a key requirement for Sovereign ESG 2.0. Ideally, perspective is robust to the ingrained income bias since ESG scores should give an accurate representation of a focusing on more recent performance can help to adjust for country’s sustainability that is not primarily a result of its the income bias. level of income, but removing this bias is no simple exercise because any adjustment method rests upon assumptions Forward-Looking Methods about what “good” ESG scores are. The risks from climate change are likely to be larger in the Many practitioners have advocated adjusting income future than in the past. Traditionally, financial materiality has by using a regression adjusted for GDP per capita.17 17 The widely used ND GAIN Index also reports GDP-adjusted index scores at https://gain-new.crc.nd.edu/ranking/delta/vulnerability. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 41 >>> B O X 1 . 6 Sovereign ESG 2.0 and Wealth The World Bank’s wealth accounts aim to provide a more holistic accounting of a country’s wealth that also includes a country’s stock of human and natural capital. They may prove a useful tool for Sovereign ESG 2.0. Taking better and more frequent stock of the environment is not enough to construct meaningful ESG 2.0 scores. Wealth data are uniquely suited to informing sovereign ESG calculations because they express the lifetime earnings of a country’s assets in dollar values (Lange et al. 2018, 2021).a The wealth approach is inherently forward-looking, which distinguishes it from pure stock-taking exercises. Relying on raw environmental inputs (like forest cover) only and not accounting for their economic importance (forest wealth-producing capacity) does not accurately describe the long-term relevance of the resource (Gratcheva and Wang 2021). Furthermore, wealth accounting is built on a robust and methodologically well-founded framework for thinking about environmental sustainability, and it already has a long history of curated data that is comparable across countries and years since 1995. Environmental materiality does not imply economic materiality. Figure B1.6.1 illustrates this discrepancy. The horizontal axes depict the environmental data (agricultural and forest areas as percentages of total land area). The vertical axes show the corresponding wealth variables, expressed in dollar values. The graphs cover 145 countries with data from 2016. The low correlations show that the economic valuation of agricultural wealth is largely unrelated to the sector’s geographic size. This similarly holds true for forest assets to a lesser degree. Thus, relying on environmental indicators only may not paint a complete picture for economic decision-makers. Wealth data contain additional information not captured in raw environmental data. Since wealth accounts are constructed to measure economic materiality and long-term sustainable growth potential, their integration into sovereign ESG scores is strongly recommended. > > > F I G U R E B 1 . 6 . 1 Environm nt l v rsus conomic m t ri lit Th hori ont l x s of both plots show nvironm nt l v ri bl s, whil th v rtic l x s show th ir w lth ccountin count rp rts, xpr ss d in doll r v lu s. Sinc th r is littl ssoci tion b tw n both, r l in on Environm nt l indic tors onl m not p int compl t pictur for conomic d cision m k rs. corr l tion = 20.9% corr l tion = 46.3% 13 12 12 11 A ricultur l w lth (lo 10) 11 10 9 10 8 9 7 8 6 0 20 40 60 80 0 20 40 60 80 100 A ricultur l r (% of l nd r ) For st r (% of l nd r ) Low incom Low r middl incom Upp r middl incom Hi h incom Source: Gratcheva and Wang 2021. a. Human capital, for instance, is calculated as the discounted expected lifetime earnings of a population. A similar rationale applies to natural resources. A country’s fossil fuel wealth, for example, is calculated as the discounted value of future resource rents up to the point that this nonrenewable resource is depleted. Renewable resources distinguish themselves in that their discount horizon depends on the rate of extraction versus replacement. 42 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT This method orthogonalizes (or decorrelates) ESG scores The two plots in figure 1.11 show the before and after with respect to a country’s level of income by estimating the of a regression-based income adjustment. While this regression ESG = a + income • β + u, where ESG is an ESG income adjustment mechanically removes the linear income rating across countries and income is a variable such as log bias, the right graph shows that a nonlinear income bias still GDP per capita. The regression residuals are then used to remains. construct income-adjusted ESG scores. The intuition behind this is that given the high correlation of ESG scores with Approach 1: Benchmark against peer groups income, countries should be judged based upon their ESG performance versus their income-predicted level of ESG Measuring performance relative to comparable country performance. peers accounts for the ingrained income bias. Many practitioners advocate methods that assess countries with Although simple and implementable, regression-based respect to a relevant peer group. Similarly, the Regulatory income adjustment may lead to overcorrection. We Indicators for Sustainable Energy (RISE)19 framework explore this approach empirically in our report (Gratcheva, benchmarks countries against a selected peer group at a Emery, and Wang 2021). A key empirical limitation to this similar level of development. This removes the IIB within the approach is that the relationship of ESG scores with income group since all members likely share common development is not linear, and the residuals demonstrate a consistent trends, geographical conditions, and other cultural and U-shaped “smile” with higher scores at the low- and high- societal factors. This allows for meaningful performance income levels.18 This nonlinearity may mean that information measurements relative to the peer group average instead relevant to sustainable development is potentially stripped of an absolute target. For applications with regional focus, out during the adjustment process. We propose two other benchmarking is a simple and insightful option. approaches that may serve the goals of income adjustment better, but these approaches may suffer from the likely ad The benchmarking approach comes with drawbacks hoc nature of uniform operationalization and implementation and should be complemented with other methods. among the investor community. Common critique points include the subjective nature > > > F I G U R E 1 . 1 1 P rsist nc of in r in d incom bi s, v n ft r lin r incom imp ct is r mov d from th d t Ori in l scor xhibit Lin r incom bi s Incom - limin tion r v ls qu dr tic incom bi s ESG scor Av r -2 -1 0 1 -2 -1 0 1 GNI p r c pit GNI p r c pit Non-lin r Lin r Low Low r middl Upp r middl Hi h incom bi s incom bi s incom incom incom incom countri s countri s Source: World Bank staff illustration. Note: ESG = environmental, social, and governance; GNI = gross national income. 18 This may be related to the concept of the Kuznets curve. 19 See https://rise.worldbank.org/. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 43 of peer group selection and the sensitivity of the results Linking sovereign ESG indicators with recent with respect to the group composition. Furthermore, the sustainability improvements sends an encouraging intragroup comparability comes at the expense of intergroup message. One of the main consequences of IIB (see box comparability. This method, then, accounts for the IIB in a 1.6) is that its deeply embedded nature discourages any transparent and plausible manner, but it only paints part of short-term policy measures to improve sovereign ESG the picture. It should be complemented with other methods scores. Even if such measures were to improve sustainability, such as momentum-based indicators. these advancements are unlikely to have any noticeable impacts on the sovereign’s level of income. Because of IIB, Approach 2: Emphasize momentum or recent they are also unlikely to significantly affect sovereign ESG performance scores as currently measured. If sovereign ESG scores do reflect recent progress toward SDGs in a material manner, Progress toward sustainability goals within a recent time though, ESG can then be an effective instrument to reward frame contains valuable information for ESG scores. or penalize such endeavors. More than 65 percent of the investor survey participants agree or strongly agree that sovereign ESG scores should weigh The main obstacle for operationalizing these methods recent successes or setbacks in sustainable development is its requirements for recent and frequent input data.21 rather than long-term trends. Recent performances in Ideally, ESG scores are computed using records measuring ESG-relevant areas (growth in protected areas, declines in sufficiently long historical periods with high enough economic inequalities, stronger legal rights) may be more frequency, but this is not how it actually works. The breadth informative than their long-standing counterparts (area under and depth of the data landscape dictates the feasibility of protection, level of economic inequality, strength of legal recent performance-type ESG ratings. While the quality of rights). Looking at flows rather than stocks is an effective fast-moving data is improving, the continued prevalence way to address the IIB.20 of significant data gaps and lags means that momentum techniques must currently still rely heavily on the subjective expert judgment of analysts. 20 Looking at changes alone does not entirely account for the IIB since the rate at which changes happen depends on the country’s level of income and development. 21 See https://github.com/worldbank/ESG_gaps_research/blob/master/docs/ESG_gaps_research.pdf. 44 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> B O X 1 . 6 Putting Emphasis on Recent Performance World Bank research outlines a momentum-based approach. The approach described in Gratcheva, Gurhy, and Wang (2021) removes the IIB by favoring in-country over between- country comparisons. Instead of comparing countries with each other through scoring or rankings, the authors assess how the recent growth in, for example, renewable natural capital affected sovereign bond yields. This is done for each country on a level playing field by comparing a country with itself at an earlier point in time. The resulting parameters are financially meaningful as they describe the sensitivity of sovereign borrowing costs with respect to environmental performance. Putting a dollar value on 1 percent growth in natural capital for sovereigns paves the way for its incorporation into ESG 2.0 scores. Gratcheva, Gurhy, and Wang (2021) and Wang (2021) examine the role of natural capital in sovereign bond yields using a cross-section of 37 countries comprising 20 A-rated countries (average long-term debt rating between AAA and A−) and 17 B-rated countries (ratings between BBB+ and BB−) over the time period between January 2009 and December 2018. The authors estimate the effect of 1 percent growth in natural capital on the 10-year bond yield from two perspectives. When comparing bond yields with natural capital across countries, a positive association emerges: countries richer in natural capital tend to have higher borrowing costs.a While this could be explained through the natural resource curse or long-term growth arguments, the authors strongly caution against drawing any conclusions based on pure cross-country analyses because of the ingrained income bias. Instead, the authors advocate in-country comparisons that measure the effect of recent environmental performance on recent changes in bond yields. This brings countries onto a “level playing field” and removes the ingrained income bias. After adopting the appropriate statistical framework, the authors find a negative relationship: as a country grows richer in natural capital, borrowing costs tended to drop. This finding is robust against the inclusion of various macrofinancial controls, wealth variables, and common bond factors. After decomposing natural capital into renewables and non-renewables,b the authors find that growth in renewables lowers borrowing costs in B-rated countries. Similarly, agricultural and forest wealth lower bonds yield the most in B-rated countries. This is likely because these are economically worthwhile investments for countries that rely more on these resources for growth. Protected areas, which predominantly expanded in A-rated countries, are more likely luxury investments, as they are costly and nonproductive. Growth in this type of renewables would hypothetically raise borrowing costs in B-rated countries, since they have the highest opportunity costs in terms of foregone agricultural or forest rents. a. Gratcheva, Gurhy, and Wang (2021) and Wang (2021) use the 10-year bond yields as proxies for long-term government borrowing costs. b. Renewable natural capital can be generated or replaced as fast as it is being used. It includes living species and ecosystems that use solar energy and photosynthesis, as well as nonliving items such as groundwater and the ozone layer. Nonrenewable natural capital is either irreplaceable or can only be replaced over geological timescales by, for example, fossil fuels, soil, and minerals. Nonrenewable natural capital exists in finite amounts on Earth. Once consumed or used, it cannot be replaced. Capital Markets Development The level of capital market development (figure 1.12) is The prevalence of benchmark investing in the sovereign also a binding constraint because less developed capital EM universe (figure 1.13) means that only a few EM markets will likely not provide the direct mechanisms for sovereigns can attract meaningful flows to their local investors to invest in. The least developed capital markets currency sovereign debt market. For example, only 11 are often in countries where the SDG funding gaps are percent of local currency sovereign bonds outstanding are largest (figure 1.12). This represents a key binding constraint included in the main EM sovereign bond indices on average, in operationalizing a sovereign ESG 2.0 framework and compared to 84 percent for equivalent hard currency debt more vigorously attacking the key limitations of the current (figure 1.14). This implies a need for continued efforts to sovereign ESG 1.0 framework. develop local capital markets and create an environment that can attract investors and capital on scale as the A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 45 > > > F I G U R E 1 . 1 2 Ov rvi w of C pit l M rk t D v lopm nt < 0.046 0.046 to 0.124 0.124 to 0.300 0.300 to 0.392 0.392 to 0.676 > 0.676 No data available Choropl th clust rs r b s d on th Fin nci l M rk t sub-ind x of th IMF’s Fin nci l D v lopm nt ind x. Nascent Basic Intermediate Advanced 78 Countries 54 Countries 36 Countries 15 Countries Depth VERY SHALLOW SHALLOW LESS DEEP VERY DEEP Access INACCESSIBLE LESS ACCESSIBLE ACCESSIBLE VERY ACCESSIBLE Efficiency INEFFICIENT LESS EFFICIENT VERY EFFICIENT Source: World Bank 2020. Note: IMF = International Monetary Fund. government debt market is often the most developed part JPMorgan Chase Institute) will likely continue to grow to help of a local financial system. It is normally also the first market EM issuers access capital markets, which will help provide that a foreign investor would be attracted to in a developing fertile ground for innovation, use-of-proceeds tracking, and economy, and it also acts as an enabler to attract private impact measurement. sector capital. For some countries, issuing labeled bonds could contribute to the development of the local capital The issuance of sovereign labeled instruments can play market and attract new ESG-focused investors. a key role in, but sovereign issuers need to carefully weigh the advantages and disadvantages of going down MDBs continue to play an important role with respect this avenue (World Bank 2020). Sovereign labeled bond to financial sector deepening, contributing to efforts to issuance accounts for less than 1 percent of the outstanding support sustainable growth in developing countries. For sovereign bond universe, so it is still unclear to what extent example, the joint World Bank-International Joint Capital labeled instruments can be scalable in the sovereign Market’s Program is a key part of World Bank-IFC efforts context. Labeled bonds can be a useful instrument for to develop domestic capital markets with this initiative allowing investors to measure their investment impact and focusing on strategic advisory programs and demonstration encouraging issuers to be more purposeful and transparent transactions to support the development of domestic capital with what they finance. It can also be a good start toward markets, thereby unlocking synergies and helping to create engaging with investors on ESG. The issuance of sovereign systemic market impact. The World Bank FCI and Treasury labeled issuances can also bring governance benefits and global practices also provide technical assistance and act as an important signal that could help local corporates advisory services on bond market development as well as on issue and expand investment opportunities for foreign thematic sovereign bond issuance. In addition, cooperation investors. between MDBs and private institutions (IFC and Amundi, 46 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > > > > F I G U R E 1 . 1 3 Low r incom countri s F I G U R E 1 . 1 4 EM b nchm rk indic s pl k sov r i n bond m rk ts still sm ll rol in c pit l lloc tion- m n EM countri s do not m t inclusion crit ri 4000 80 90% 3500 70 80% 70% 3000 60 60% 2500 50 50% 2000 40 40% 1500 30 30% 1000 20 20% 500 10 10% 0 0 0% LIC loc l LIC fx LMIC loc l LMIC fx Estim t d Av r of m in xt rn l Av r of m in curr nc curr nc curr nc SDG fundin sov r i n d bt indic s sov r i n d bt indic s ps b tw n now nd 2030 no of countri s (LHS) % of univ rs ind x (RHS) Source: World Bank staff illustration. Note: EM = emerging market; fx = foreign exchange; LIC = low-income countries; LMIC = low- and middle-income countries; SDG = sustainable development goal. In less developed markets, however, it may be better ESG investors can also play an important role in helping for the sovereign issuer to concentrate efforts on to develop local capital markets. Their investment developing the local sovereign debt market while also activities, while often symbolic, can have a catalytic effect including sustainability considerations. This would on governance and thereby indirectly contribute to a more include the preconditions of market development such as sustainable future over the medium to longer term. Investors institutional setting and governance, which also indirectly should bear these aspects in mind when considering impact incorporate ESG aspects. Some issuers in less developed and accompanying investment mandates. markets have issued token sizes in local currency, which has attracted little additional foreign inflows but often steady publicity. At the same time, such efforts have necessitated significant operational efforts from often under-resourced debt management offices. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 47 48 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Conclusions Our report has highlighted that the sovereign ESG The guiding principles identified provide a solid foundation framework needs to evolve. There are no quick and for future work, and the World Bank will continue to play a easy solutions to the issues identified in this paper, but proactive leading role. The paper highlights that sustainability transparency around the topic is needed. While investors is a complex topic and that the current sovereign ESG and asset managers are likely to increasingly focus on ESG framework may in fact disadvantage poorer countries. The investing in all asset classes, the substance and nature of Sovereign ESG 2.0 framework helps deal with structural this investing must be transparent. challenges such as the ingrained income bias and the lack of clarity around the environmental pillar. It’s also important Up until now, ESG investing in sovereign bonds has that Sovereign ESG 2.0 acknowledge any shortcomings in a almost solely focused on using ESG factors as an input clear transparent way. in the investment process, which emphasizes minimizing ESG-related financial risks on the investment portfolio. As Policy makers and key stakeholders need to be cognizant policy makers and investors focus more on the role that finance of the structural challenges in the current sovereign can play in achieving a more sustainable future through ESG framework. MDBs and governments of advanced implementing the Paris Agreement, actioning of the SDGs, economies will continue to need to support middle- and low- and so on, using ESG factors as an output that prioritizes income countries in their efforts to make their economies more impact measurement will probably become more prevalent. sustainable. This may or may not be through the sovereign debt market. While sovereign ESG investing is certainly one The approach of using ESG as an output is important lever to attract ESG-orientated capital, other methods, such because it allows investors to understand the impact of as taxation and regulatory changes, can also help and be their investments, and this may result in even more capital relatively more effective in lower-income countries. being attracted by ESG-focused investment mandates. This effort could create a virtuous cycle over time, which is The next part of this report presents the results from a especially important for EM countries where the marginal JPM survey on ESG investing in sovereign EM external financial and nonfinancial impact of investment decisions and local currency debt. It is seminal as it’s a real time may even be greater. For many investors, having the ability window into the current ESG investing landscape in EM to see how their investments have an impact is an important sovereign debt. Above all else, the survey highlights the and sometimes required part of their investment mandates. evolving nature of this topic, the many opportunities and challenges, and the fact that many investors, even in the EM The World Bank will continue to work with key sovereign debt asset class, are reconsidering their reason stakeholders on the issues identified in this paper. for existence, which presages a “new dawn” on the horizon. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 49 2. 50 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> J.P. Morgan ESG Investor Survey* >>> Key Takeaways 1. J.P. Morgan’s Emerging Market (EM) Research Team and Global Index Research Group conducted a survey of dedicated EM investors to gain an insight into their experience with sovereign ESG strategies. survey of dedicated EM investors to gain an insight into their experience with sovereign ESG strategies. Investors with a total of assets under management (AUM) of nearly US$650 billion participated in the survey at a response rate of 70 percent, indicating a high level of interest by managers looking to grow their environmental, social, and governance (ESG)-aligned funds. 2. Investors that manage ESG-aligned funds are primarily motivated by their own respective mission statement rather than the evolution of the regulatory landscape. Most investors consider ESG integration to be within their fiduciary duty. 3. There is a growing emphasis on the E and S elements, but G remains the most important when conducting sovereign assessments. 4. Investors agreed that better ESG fundamentals should lower sovereign credit risk, but there remains some uncertainty whether implementing ESG would sacrifice returns. Investors believe that sovereign ESG should support the development journeys of EM countries rather than rewarding only high performers, highlighting a key tension within current frameworks. 5. Investors overwhelmingly rely on external data vendors to assess ESG factors, MSCI and Sustainalytics being the most commonly used providers. 6. 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. 22 * (c) JPMorgan Chase & Co., all rights reserved. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 51 Overview J.P. Morgan’s Emerging Markets (EM) Research Team The survey was small by design, our intent being and Global Index Research Group conducted a survey of to start with a small sample size with the potential to dedicated EM investors with sovereign debt strategies. grow in the future. The survey was designed to take the The survey aimed to gauge investor opinions on a range temperature of a relevant group in order to better understand of topics related to environmental, social, and governance investor attitudes toward sovereign ESG approaches and (ESG) strategies, focusing specifically on EM sovereigns to begin the conversation regarding both challenges and rather than corporates, including but not limited to their ESG opportunities. The survey received a response rate of 70 investment and sustainable finance investment philosophy, percent, representing investors with almost US$650 billion in the materiality of ESG factors, the trade-offs between assets under management (AUM), indicating the high level fiduciary duty and sustainability goals, and issues around of interest by managers looking to grow their ESG-aligned ESG scores for EM sovereigns. funds. More details on their characteristics are in Table 2.1. >>> T A B L E 2 . 1 . Survey participant characteristics Dedicated Emerging Markets AUM US $645 bn Real Money 96% Hedge Fund 2% Asset Owners 2% # Responses from Europe 51% # Responses from US 35% # Responses from Asia 14% Source: J.P. Morgan. Top Takeaways of the Survey Purpose of EM Sovereign ESG Investors are driven by their own respective mission statement in regard to ESG strategy rather than The manner in which ESG has been transplanted from in response to regulation. We acknowledge that the the corporate world and repurposed for sovereigns development of a mission statement, which investors most creates challenges for investors and sovereign issuers. frequently ranked as the most important driver of their ESG In the corporate sphere, ESG investment appropriately considerations, is often informed and shaped by regulation. rewards companies with the best ESG outcomes, but this From the survey results, though, we infer that regulatory fails to translate well to sovereigns, where it risks reinforcing advances serve mostly as a backstop for ESG laggards, gaps in sustainable development instead of closing them. while for those more advanced in the ESG journey, it serves ESG scores in EM are historically lower on average than their to formalize existing practices. In Europe, where regulatory developed market peers, and the divide will remain unless frameworks are the most advanced, investors did not cite ESG sovereign frameworks evolve (we note that the three- major concerns over the extent of regulation, but they also year average J.P. Morgan ESG score for EM economies did not classify it as a primary driver of their ESG process. is 40 but double that for developed market economies). To that end, investors believe that sovereign ESG frameworks Two-thirds of the survey participants believe that it is should support sustainable development journeys and do their fiduciary duty to integrate ESG factors across all a better job of accounting for recent ESG successes and of their respective funds. That said, we received some setbacks. pushback. Some 6 percent of respondents did not consider 52 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT ESG integration as an obligation to their end investor. Such EM Sovereign ESG Approaches divergence highlights a regional divide in which European investors, who are likely influenced by European Union (EU) Nearly two-thirds of the respondents believe ESG regulation, overwhelmingly consider ESG to be within their considerations represent less than 20 percent of their fiduciary duty, a sentiment not shared by a handful of US and overall sovereign analysis. This likely reflects both the Asian investors. The results show that 90 percent of client nascent nature of sovereign ESG approaches and data quality interest and inflows currently originate from Europe, followed and coverage issues. Data transparency is essential with by North America (6 percent) and the Asia-Pacific region (4 investors considering timeliness, methodology limitations, percent). and coverage as the main concerns surrounding ESG data for EM sovereigns (readily available environmental data at Three-quarters of the investors are adamant that ESG the sovereign level is deemed most lacking). More broadly, funding should support the sovereigns facing the lack of ESG standardization was seen as the top long-term greatest sustainable journeys as opposed to sponsoring challenge. Across all regions, investors are relying on the only those currently with strong ESG credentials. World Bank’s Governance Indicators as a supplement to EM Investors would prefer to close existing gaps in sustainable sovereign ESG analysis. development, but hurdles to this include income and reporting biases, as well as data deficiencies. Disconnects between There is a greater emphasis on the E and S in ESG investor intentions and current ESG frameworks illuminate strategies, but G remains the most important when the need for improvement on a number of issues, including conducting sovereign assessments. One-quarter of data provision, scoring, and engagement. We expect the investors selected “social” as the most underrepresented sector to evolve to better address these shortcomings as the pillar in sovereign ESG data. Along with issues reaching shift away from purpose-neutral toward purposeful investing consensus on qualitative factors, these data challenges gains momentum around the world. could contribute to the difficulty in integrating social factors into sovereign assessments. The lion’s share of participants believed that improving ESG fundamentals will lead to lower sovereign credit risk. The least common ESG strategy for investors was “1.5 There are few studies at this time showing a strong correlation or 2°C alignment/transition risk assessment,” with only or causation between ESG fundamentals and credit risk. The 16 percent of investors applying this strategy. This result role of governance factors in complementing financial and is to be expected, because despite the increasing urgency macroeconomic metrics in sovereign credit analysis is better of climate risk, obtaining data to integrate climate change understood. The materiality of environmental and social risk at a sovereign level remains a challenge. This result factors is not as well documented, yet events such as climate also tracks with the answers to Q15 “Which pillar (if any) disasters or the COVID-19 pandemic have underscored the of ESG is underrepresented due to data challenges at the fact that ESG can materially affect the long-term profile of EM sovereign level,” to which over 70 percent of investors an issuer. selected environment. In Europe 19 percent of investors selected this strategy, followed by 17 percent in the US. No Nearly half of the investors surveyed are unsure if Asian investors surveyed selected this strategy. implementing ESG sacrifices returns. J.P. Morgan research using JESG data has found that EM sovereigns United Nations Sustainable Development Goals (UN prove to be clear beneficiaries of ESG alignment. The JESG SDGs) do not necessarily fit within the ESG sovereign Emerging Markets Bond Index (EMBI) has consistently frameworks but are viewed as complementary by the performed better than the baseline EMBI Global Diversified majority of investors (59 percent). About one-third of with over 50 basis points (bps) of annualized outperformance investors, most of which were European, responded that the over the past seven years. Financially distressed EM 17 UN SDGs are integral to ESG analysis. While at a high sovereigns such as Venezuela and Lebanon have incidentally level the UN SDGs might be considered separate, investors shown lower ESG scores and hence have been excluded or may select relevant goals to consider as inputs to their ESG underweighted in the JESG EMBI, helping the ESG-aligned assessments. This survey result appears to validate a key index’s relative performance and resiliency. The unique premise of our report “ESG Investing and Development benefit of the methodology is brought out by the fact that the Finance in Emerging Markets: ESG and SDG Frameworks JESG indices have been almost perfectly correlated to their Increasingly Overlap in EM” (Oganes et al. September 2020). respective baseline benchmarks since inception, thereby ensuring that it meets its overarching objectives in being Most investors agree that issuer engagement is critical replicable with liquidity. to any ESG strategy; surprisingly, however, more than half of the respondents are not engaging with DMOs A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 53 (debt management offices). Despite the desire to engage of generally accepted accounting principles. Importantly, on ESG topics, the investors felt that without coordination and investors see the value in engaging with both issuers and collaboration on topics and desired outcomes, engagement ESG vendors to facilitate improvements in disclosures and was ineffective. Because of the multitude of sovereign ESG methodologies and to further enable the consideration of approaches taken by the investment community, the view is ESG factors. that from the DMO perspective, there is too much confusion. What is needed instead is more coherent and targeted More than 70 percent of European investors incorporate engagements. In follow-up discussions of the survey results four or more third-party ESG vendors. This is unsurprising, with some respondents, it was proposed that J.P. Morgan as it is widely recognized that European investors are the could be an effective conduit between EM policymakers and most ambitious and sophisticated in sustainable investment. investors to improve engagement through such forums as Second, as sovereign-level ESG data still lag behind roundtables and conferences focusing on ESG. corporate-level data, it seems intuitively obvious that those clients that hold strong ESG ambitions would be willing to Thematic Bonds finance and seek out ESG data from multiple sources. The incorporation of a variety of third-party ESG vendors Virtually all investors believed that sustainable furthermore allows for the derivation of a superior bespoke instruments are pari passu to conventional securities ESG model, which ought to be better aligned with one’s ESG and consider them worthy of inclusion in all funds investment intentions. regardless of ESG alignment. Investors confirmed that in their view, the underlying credit risk of the issuer does not MSCI and Sustainalytics were most commonly named by change depending on the use of proceeds. As a result, the investors across all regions as the ESG data providers bond will be included in any mandate regardless of ESG best placed for sovereign ESG integration. A third top inclusion if the bond is financially attractive. Indeed, some provider, though, was Verisk Maplecroft, considered by those managers may actually avoid sustainable instruments on using this vendor as the best because of their customizable financial grounds, because they typically trade tighter than approach. At this stage, a minority of vendors are deriving the rest of the curve. an EM sovereign ESG approach entirely in-house, probably because of the still nascent nature of ESG strategies in the Scrutinizing the use of proceeds of sustainable asset class and ongoing data challenges. instruments is critical to avoid greenwashing. We found through the survey that while the majority of investors expect Roughly 80 percent of investors believed the credit the use-of-proceeds approach to be used appropriately, most rating agencies (S&P, Moody’s, and Fitch) will start still rely on the issuer to provide ex post reporting. Sustainable to play a larger role in providing ESG transparency. bond verifiers (“second-party opinion” providers) ensure that Rating agencies have invested more in their ESG analytic a sustainable bond is in line with market expectations and capabilities by acquiring ESG vendors. Moreover, investors industry best practice through annual reporting. Similarly, believe credit agencies are best placed to standardize the the Climate Bond Initiative (CBI) takes this a step further by current ESG rating landscape. Present ESG vendors face offering a green bond certification, certified climate bonds. several criticisms, many in relation to a lack of clarity and Green bonds that meet CBI’s Climate Bond Standards are transparency around underlying ESG rating methodologies. proven as scientifically aligned to the goals within the 2015 Despite the necessity of ESG data and methodology Paris Agreement. As all sustainable bond markets mature, standardization, one question about the developing ESG we foresee a growing demand for issuers to showcase their market stands out: should the emphasis be on more sustainable credibility through such assurances and bond transparency, or should it be on standardization? certifications. The vast majority of investors across all regions do not ESG Data manage their investments against an ESG benchmark. Since indices act as a unit of relative financial performance, Despite the limitations of ESG data from third party investors rarely deviate from their chosen index at a fund’s vendors, 90 percent of investors use at least one third- inception because they seek to demonstrate a credible party vendor. Investors generally tend to accept that the historical track record. Consequently, the migration of market for ESG data has some way to go before it becomes existing fund benchmarks to comparatively new ESG indices as rigorous and comprehensive as financial data. The can be problematical for several reasons; nonetheless, we development and coordination of reporting standards and are witnessing an increasing uptake in benchmarking against frameworks and the potential regulation of ESG data vendors ESG indices within newly launched funds as investors themselves will go a long way to facilitating the development continue to improve their ESG qualities. 54 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT More than 50 percent of respondents chose “improving to understand the material changes in ESG performance, ESG research output” and “ESG regulatory alignment” such as a deterioration in greenhouse-gas emissions or the as desired enhancements to J.P. Morgan’s ESG index occurrence of a controversial event. We see this receiving offering. The investment community is increasingly more momentum in 2021, a development spurred on by demanding greater “translation” in what is meant by the upcoming UN Climate Change Conference (COP26) changes in issuer ESG ratings. It is no longer sufficient and the ongoing implementation of sustainability-related to explain that an issuer’s ESG rating has improved or regulation such as the EU Sustainable Finance Disclosure deteriorated by a certain degree. Instead, investors want Regulation. Survey Results Answers to the 33 survey questions follow. > > > > > > Q U E S T I O N 1 : Wh t is th prim r driv r for th Q U E S T I O N 2 : Do ou consid r ESG int r tion consid r tion of ESG within our sov r i n inv stm nt p rt of our fiduci r dut ? proc ss? 100% Or ni tion’s mission st t m nt Fiduci r dut 80% Risk m n m nt/ compl m nt to cr dit r tin s 60% Cli nt d m nd N w lph opportunit 40% Ali nin inv stm nts with sust in bilit o ls M rk tin opportunit / void 20% f llin b hind comp titors R ul tor ch n 0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% EU US Asi No Y s, but onl for m ESG- li n d funds % r nk d numb r 1 (most import nt) Y s, cross ll m n d fund str t i s Source: J.P. Morgan. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 55 > > > > > > Q U E S T I O N 3 : To wh t xt nt do ou r with Q U E S T I O N 4 : To wh t xt nt do ou r with th st t m nt: “Impl m ntin n ESG str t th st t m nt “sov r i n ESG ppro ch s should s crific s inv stm nt r turns comp r d to m rk t support thos issu rs who h v th r t st sust in bl b nchm rk”? d v lopm nt journ to ccomplish r th r th n thos th t r b st ESG p rform rs?” Unsur Unsur Stron l dis r Stron l dis r Som wh t dis r Som wh t dis r N ith r r nor dis r N ith r r nor dis r Som wh t r Som wh t r Stron l r Stron l r 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Source: J.P. Morgan. > > > > > > Q U E S T I O N 5 : To wh t xt nt do ou r th t Q U E S T I O N 6 : In our opinion, wh t should sov r i n ESG scor s should w i h r c nt succ ss s sov r i n ESG ppro ch prim ril c ptur ? or s tb cks in sust in bl d v lopm nt r th r th n Qu ntific tion of… lon -t rm tr nds, such s incom nd w lth? ...m t ri l sov r i n cr dit Unsur risks m n tin from nvironm nt l, soci l, nd ov rn nc f ctors" Stron l dis r ... countr ’s Som wh t dis r sust in bilit ffort" N ith r r nor dis r ... countr ’s sust in bilit profil " Som wh t r Unsur Stron l r 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Source: J.P. Morgan. 56 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > > > > Q U E S T I O N 7 : As it curr ntl st nds, wh t Q U E S T I O N 8 : In our inv stm nt d cision/ p rc nt of our EM sov r i n AUM h s xplicit v lu tion fr m work for EM sov r i ns, wh t w i ht do ESG consid r tions? ESG consid r tions c rr s oppos d to tr dition l fin nci l f ctors? 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% 0-20% 20-40% 40-60% 60-80% 80-100% 0-20% 20-40% 40% or hi h r Unsur Source: J.P. Morgan. > > > > > > Q U E S T I O N 9 : For EM sov r i n bonds, wh r do Q U E S T I O N 1 0 : B th nd of 2021, d dic t d ESG ou think ESG consid r tions r mor m t ri l for funds will r pr s nt wh t p rc nt of our ov r ll EM v lu tions/inv stm nt d cisions? sov r i n str t ? Pl s s l ct ll th t ppl 90% Short r-d t bonds 80% Unsur 70% 60% Hi h r-r t d bonds 50% Low r-r t d bonds 40% Equ l cross t nors 30% Equ l cross r tin s 20% 10% Lon r-d t d bonds 0% 0% 20% 40% 60% 0-20% 20-40% 40-60% 60-80% 80-100% Source: J.P. Morgan. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 57 > > > > > > Q U E S T I O N 1 1 : To wh t xt nt do ou r Q U E S T I O N 1 2 : Wh t ESG str t i s do ou with th st t m nt "improvin ESG fund m nt ls incorpor t with our EM sov r i n d bt inv stin ? will l d to low r sov r i n cr dit risk? Pl s s l ct ll th t ppl 50% 1.5 or 2°C li nm nt/ 45% tr nsition risk ss ssm nt Imp ct/communit 40% inv stin 35% Norms-b s d scr nin / xclusions 30% Sust in bilit -th m d inv stin 25% Positiv /b st in cl ss 20% 15% En m nt/st w rdship 10% Exclusion r scr nin 5% ESG int r tion 0% Stron l Som wh t N ith r Som wh t Stron l Unsur 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% r r r nor dis r dis r dis r Source: J.P. Morgan. > > > > > > Q U E S T I O N 1 3 : Is our ESG fr m work Q U E S T I O N 1 4 : How do ou vi w th incorpor tion propri t r nd cr t d in-hous or b s d on of UN Sust in bl D v lopm nt Go ls (SDGs) within n xt rn l third-p rt ESG d t provid r(s)? EM sov r i n ESG fr m work? W do not h v n ESG fr m work B s d on sin l third-p rt ESG d t provid r B s d on s v r l third-p rt ESG d t provid rs All ESG d t nd r s rch us d r propri t r nd cr t d in-hous B s d on combin tion of d t from third-p rt d t provid r(s) nd in-hous r s rch 0% 10% 20% 30% 40% 50% 60% 70% 80% Int r l S p r t but S p r t from th ESG compl m nt r fr m work Source: J.P. Morgan. 58 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > > > > Q U E S T I O N 1 5 : Which pill r (if n ) within ESG Q U E S T I O N 1 6 : Which pill r (if n ) of ESG is is most import nt wh n conductin EM sov r i n und rr pr s nt d du to d t ch ll n s t th EM ss ssm nts? sov r i n l v l? 60% 50% 40% 30% 20% 10% 0% Gov rn nc E, S, nd G E, S, nd G Environm nt Soci l pill rs r pill rs r consid r d consid r d b s d on qu ll Environm nt Soci l Gov rn nc m t ri lit Source: J.P. Morgan. > > > > > > Q U E S T I O N 1 7 : How fr qu ntl do ou n Q U E S T I O N 1 8 : Wh r do ou s th m jorit of with EM sov r i n d bt m n m nt offic s cli nt int r st/inflows ori in tin from? (DMOs) on ESG topics? Onc r ESG is not topic of conv rs tion Onc month Onc qu rt r Not nou h nd lookin to cr t proc ss for mor fr qu nt n m nt 0% 10% 20% 30% 40% 50% 60% North Am ric Europ Asi -P cific Source: J.P. Morgan. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 59 > > > > > > Q U E S T I O N 1 9 : Ar sust in bl instrum nts Q U E S T I O N 2 0 : To wh t xt nt do ou r th t ( r n, soci l or sust in bilit link d) int r t d in th “us of proc ds” of sust in bl instrum nts m nd t s NOT li n d to ESG? chi v s th int nd d imp ct is v r import nt? 100% No, t pic ll don’t inv st in sust in bl bonds s th tr d 80% ti ht to th r st of th curv 60% No, would onl consid r th s instrum nts for ESG initi tiv s 40% Y s, s th r p ri p ssu to 20% conv ntion l sov r i n s curiti s 0% 0% 20% 40% 60% 80% 100% Stron l Som wh t N ith r Som wh t Stron l Unsur r r r nor dis r dis r dis r Source: J.P. Morgan. > > > > > > Q U E S T I O N 2 1 : How do ou conduct x-post Q U E S T I O N 2 2 : How m n third-p rt ESG monitorin of "us of proc ds"? v ndors do ou lic ns ? 16 14 12 10 8 6 4 2 0 1 2 3 4+ Non (bl nk) In-hous t m R li nc on th issu r No. of r spons s Ext rn l comp n W do not monitor US Europ Asi Source: J.P. Morgan. 60 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > > > > Q U E S T I O N 2 3 : Which ESG d t provid rs r Q U E S T I O N 2 4 : Do ou suppl m nt d t from ESG b st pl c d for sov r i n ESG int r tion? v ndors with ddition l countr -l v l public sourc s within our EM sov r i n ESG ppro ch? No. of r spons s No. of r spons s 18 30 16 25 14 12 20 10 15 8 6 10 4 5 2 0 0 Bloomb r MSCI Oth r R prisk Sust in- V risk (bl nk) ND-GAIN Oth r World B nk Y l (bl nk) (pl s l tics M pl croft Ad pt tion (pl s Gov rn nc Environm nt l sp cif ) Ind x sp cif ) Indic tors P rform nc ind x Ind x (EPI) US Europ Asi US Europ Asi Source: J.P. Morgan. > > > > > > Q U E S T I O N 2 5 : Do ou b li v cr dit nci s Q U E S T I O N 2 6 : Wh t r our m in conc rns will h v l r r rol to pl oin forw rd in surroundin v il bl ESG d t for EM sov r i ns? providin EM sov r i n ESG r tin s, comp r d to xistin third-p rt ESG d t provid rs? No. of r spons s 40 Tim lin ss 35 M thodolo limit tions 30 Cov r R l v nc / ccur c 25 W lth bi s of sov r i n 20 ESG scor s Tr nsp r nc 15 Scop 10 R ion l inconsist nci s Histor 5 L r v ri tion 0 b tw n d t upd t s No Ys (bl nk) 0 2 4 6 8 10 US Europ Asi Source: J.P. Morgan. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 61 > > > > > > Q U E S T I O N 2 7 : Do ou m n to n ESG Q U E S T I O N 2 8 : Wh t r th m in hurdl s ou b nchm rk? find in m n in to n ESG b nchm rk? Pl s s l ct ll th t ppl . No. of r spons s 40 60% 35 50% 30 40% 25 20 30% 15 20% 10 10% 5 0 0% No Ys (bl nk) ESG L ck of D t Turnov r Oth r m thodo- industr tr nsp r nc (pl s lo i s st nd rd- sp cif ) US Europ Asi i tion Source: J.P. Morgan. > > > > > > Q U E S T I O N 2 9 : Which J.P. Mor n ESG (JESG) Q U E S T I O N 3 0 : How c n J.P. Mor n improv Ind x do ou us s b nchm rk? th JESG Ind x Suit oin forw rd? Pl s s l ct ll th t ppl . 80% 80% 70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0 0 JESG GBI-EM JESG EMBI JESG CEMBI JESG JACI Improv ESG En m nt Incorpor t Furth r Oth r ESG r ul tor with xistin mor ESG minimis (pl s r s rch li nm nt v ndors to v ndors turnov r/ sp cif ) r port improv ESG vol tilit output product off rin Source: J.P. Morgan. 62 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT > > > > > > Q U E S T I O N 3 1 : How c n J.P. Mor n h lp Q U E S T I O N 3 2 : How r ou inv stin in compl m nt our EM sov r i n ESG n l sis? incr sin our ESG c p biliti s? Pl s s l ct ll Pl s s l ct ll th t ppl . th t ppl . 100% 100% 75% 75% 50% 50% 25% 25% 0% 0% Forw rdin Th m tic Enh nc d ESG-focus d Non of ESG ESG Bud t ESG risk ESG- Th r is no -lookin r s rch d t m rk t th bov d t h dcount d dic t d miti tion r l t d imm di t polic nd on ESG coll ction nd cr dit to ESG s st ms/ v nts n d for conomic topics str t -r l t d pl tforms ddition l n l sis bodi s ESG of ESG inv stm nt initi tiv s Source: J.P. Morgan. > > > Q U E S T I O N 3 3 : Wh t is our r t st ESG conc rn oin forw rd? R nk d, 7 = most import nt, 1 = l st import nt 7 6 5 4 3 2 1 0 L ck of ESG Gr nw shin Do s not h v L ck of suffici nt Too littl Too much D tr cts from st nd rdi tion int nd d r l r sourc s to r ul tion r ul tion fiduci r dut world imp ct int r t ESG compr h nsiv l Source: J.P. Morgan. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 63 Looking Ahead: A Green Light at the End of the Tunnel The survey uncovered gaps in existing sovereign ESG Sovereign ESG strategies would benefit from greater frameworks, yet we believe there is a green light at end conviction that investments need not sacrifice returns, of the tunnel. ESG analysis is inherently more complex but this requires more concrete evidence. Our survey at a sovereign level compared to the corporate level. uncovered some evidence among investors that ESG- Frameworks that reward best-in-class ESG performance risk focused strategies can be positive or at least neutral for restricting capital to EM issuers that need it to improve. The returns compared to a benchmark, while only a small portion data are often patchy and slow moving, and engagement thought that ESG strategies might sacrifice returns. As with sovereign issuers requires further coordination from more funds incorporate ESG strategies and sovereign ESG investors in order to be effective. Despite these challenges, approaches mature, the larger sample of data will likely add though, the survey emphasized that investors are strongly to the evidence. On the positive side, while there is little engaged in developing solutions and are deploying resources conviction at this stage, investors are actively engaged in to strengthen their analysis for Sovereign ESG 2.0. testing their approaches and sell-side research firms may possibly be able to add to the conversation. Positive evidence Investors are focused on correcting sovereign ESG’s in this regard will further contribute to mainstreaming shortcomings to direct flows to countries better on the sovereign ESG approaches. basis of sustainable development needs and trajectory. Investors are aware that prevailing ESG approaches for Investors are interested in greater engagement and sovereigns can end up reinforcing rather than correcting more closely tracking the impact of ESG investments. As gaps in sustainable development by directing investment discussed, participants expressed a need for a coordinated flows to strong performers, which tend to be wealthier process for engaging DMOs to pool the differing ESG priorities countries. At the same time, investors understand that across the investor base into a coherent approach. Firms capital is required for the neediest countries to improve like J.P. Morgan, which already serve as effective conduits their ESG performance. Correcting ESG scores for this to DMOs in EM countries, can facilitate such engagement income bias by adjusting for a country’s wealth or income through roundtables and conferences. Likewise, investors is one such solution, an approach broadly endorsed by are focused on avoiding so-called greenwashing to ensure participants in the survey. Similarly, investors would like thematic bonds (green, social) achieve their intended to incorporate a more forward-looking approach to ESG impacts. Better ex post use-of-proceeds monitoring through analysis by weighing recent country-level successes or engagement with issuers or employing internal or third- setbacks. The strong endorsement by the investor base party resources will likely prove to be a growing area for the reflects a desire for ESG assessments that are more timely, investor base. that move beyond more static scoring, and that reward countries for positive steps taken in their sustainable Europe is the overwhelming source of client interest development journey (or penalize backsliding). We believe and inflows, but client interest from Asia and the United that ongoing engagement from the investment community States shows potential. The Biden administration’s will help the market to overcome such hurdles to better commitment to climate change and the environment is direct ESG investment flows in emerging markets. likely to ignite momentum on ESG topics for US investors, and a broader approach to fiduciary duty could foster the While issues of coverage, methodological differences, development of impact-driven investment strategies. and timeliness in ESG data need to be addressed, the Domestically, the new administration is expected to cultivate investment community is aware of these gaps and a political environment in which ESG investing can flourish. is putting resources to work to close them. As borne The reintegration of environmental standards (diluted or rolled out in the results, governance is weighed most heavily back under the Trump administration) and the promotion of a in sovereign ESG analysis and best understood in credit more institutionalized regulatory framework will support this analysis. Environmental and social data tend to be patchier process. The influence of the new administration should also or nonstandardized at the sovereign level in ways that spill over externally, with the rejoining of international efforts complicate their integration into ESG analysis. This speaks like the Paris Climate Agreement expected to reinforce global to the need for buy-side and sell-side firms to invest in data cooperation around climate issues (Dubourg and Hecker provision and research across the whole spectrum of ESG 2020).  The US Treasury and Federal Reserve also have analysis, which are two of the top issues for future focus signaled greater emphasis in their approaches to climate identified by the participants in our survey. change. More broadly, greater transparency around ESG 64 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT data and frameworks is needed to encourage these flows numerous questions in the survey about instances when the from underrepresented regions. wording was too ambiguous or the format of the question was not the most appropriate for encouraging proper investor We intend to repeat this survey in coming years to response. Going forward, future surveys will incorporate this chart developments in EM sovereign ESG strategies. feedback to improve the value and transparency of this work Throughout the survey process, we collected feedback on further. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 65 66 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> References Boffo, R., and R. Patalano. 2020. “ESG Investing: Practices, Progress and Challenges.” OECD, Paris. Boitreaud, Sebastien, Ekaterina Gratcheva, Bryan Gurhy, Cindy Paladines, and Andrius Skarnulis. 2020. “Riding the Wave: Navigating the ESG Landscape for Sovereign Debt Managers.” EFI Insight-Finance, World Bank Group, Washington, DC. Bolton, Patrick, Morgan Després, Luiz Awazu Pereira da Silva, Frédéric Samama, and Romain Svartzman. 2020. The Green Swan: Central Banking and Financial Stability in the Age of Climate Change. Basel, Switzerland: Bank for International Settlements. Bouyé, Eric, and Diane Menville. 2021. “The Convergence of Sovereign Environmental, Social and Governance Ratings.” Policy Research Working Paper 9583, World Bank Group, Washington, DC. Cantor, Richard, and Frank Packer. 1996. “Determinants and Impact of Sovereign Credit Ratings.” FRBNY Economic Policy Review 2 (2). Dasgupta, Partha. 2021. The Economics of Biodiversity: The Dasgupta Review. London: HM Treasury. Dupré, Stan, Jakob Thomä, Sophie Dejonckheere, Remco Fischer, Christopher Weber, Cynthia Cummis, and Aman Srivastava. 2015. “Climate Strategies and Metrics: Exploring Options for Institutional Investors.” UNEP FI, Geneva; World Resources Institute, Washington, DC; 2° Investing Initiative, Paris. Gratcheva, Ekaterina, Teal Emery, and Dieter Wang. 2021. “Demystifying Sovereign ESG.” EFI Insight-Finance, World Bank Group, Washington, DC. Gratcheva, Ekaterina, Bryan Gurhy, and Dieter Wang. 2021. “1% Growth in Natural Capital: Why It Matters for Sovereign Bonds.” EFI Insight-Finance, World Bank, Washington, DC. Gratcheva, Ekaterina, and Dieter Wang. 2021. “Natural Allies: Wealth and Sovereign ESG,” In The Changing Wealth of Nations 2021: Managing Assets for the Future. Washington, DC, World Bank Group. A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 67 Herzog, Tim, Andres Casteneda Aguilar, Tony Fujs, Andrei Ilas, and Hiroko Maeda. 2020. “An Analysis of Coverage Gaps in Sovereign ESG Data.” White paper, World Bank, Washington, DC. ISS (Institutional Shareholder Services). 2019. ISS ESG Country Report 2019: The State of Play in Country ESG Performance, Sanctions, and Climate. Rockville, MD: ISS. Kölbel, Julian F., Florian Heeb, Falko Paetzold, and Timo Busch. 2020. “Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact.” SSRN. Environment 33 (4): 554–74. Pelenc, Jérôme, Jérôme Ballet, and Tom Dedeurwaerdere, 2015. “Weak Sustainability versus Strong Sustainability.” Brief for GSDR, Global Sustainable Development Report, United Nations, New York, March 11. Schanzenbach, Max M., and Robert H. Sitkoff. 2020. “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of SDG Investing by a Trustee.” Standard Law Review 72 (2): 381. PRI (Principles for Responsible Investment) and UNEP FI (United Nations Environment Programme Finance Initiative. 2019. “Fiduciary Duty in the 21st Century.” United Nations, Geneva. Wang, Dieter. 2021. “Natural Capital and Sovereign Bonds.” Working Paper Series No. 9606. World Bank Group, Washington, DC. WWF (World Wildlife Fund) and World Bank. 2020. “Spatial Finance: Challenges and Opportunities in a Changing World.” EFI Insight-Finance, World Bank Group, Washington, DC. 68 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT >>> Appendix A Glossary of Terms >>> G LO S SA RY O F T E R M S Sovereign ESG scores Environmental, Social, and Governance indicators that reflect a country’s sustainability. ESG 1.0 The sovereign ESG framework that has been used by financial institutions and rating agencies to quantify a country’s ESG performance. The resulting scores are predominantly concerned with financial materiality and “ESG as input” and are affected by the IIB. ESG 2.0 An ESG framework complementary to ESG 1.0 that emphasizes both transparency of methodology as well as environmental and financial materiality. It is adjusted for the IIB. Impact investing An investment paradigm that provides capital to projects, firms, or other organizations in order to have measurable impact, which usually pertains to beneficial social or environmental effects. Financial materiality Variables that are relevant for financial decision-making, such as investment allocation, portfolio construction, and risk management, among others. One example of this is the correlation of ESG factors with market returns. Environmental materiality Variables relevant to achieving environmental goals that aim at protecting natural assets, fighting pollution, and maintaining the sustainable use of resources. Examples include deforestation rate and greenhouse gas emissions. Dual materiality Variables that are relevant for achieving both environmentally and financially material goals. Wealth accounting data A data set and methodological framework that quantifies the economic value of natural, produced, and human capital in dollar values as part of a country’s balance sheet. The goal of wealth accounting is the forward-looking measurement of a resource’s importance for long-term sustainable economic growth. Forward-looking risks Such risk incorporates future outcomes and developments into present decision making. >>> A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 69 >>> G L O S S A R Y O F T E R M S (continued) Ingrained income bias Observed phenomenon among sovereign ESG scores that (IIB) predominantly assign better scores to high-income countries. This income bias may skew investment incentives by favoring countries that are more prosperous. The ingrained nature of the bias may also create negative policy incentives since income levels make ESG scores difficult to change in the short run. Income adjustment Scoring methodology that accounts for the IIB such that the resulting scores do not predominantly reflect the income level of the underlying countries. Scalability effectiveness An abstract space to position the ability to scale up financial space products in increasingly effective ways in order to implement sustainable development solutions. 70 >>> EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT 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. F 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 A NEW DAWN – RETHINKING SOVEREIGN ESG >>> 71