Our research shows that factors including physical climate risk, natural resource management, social stability, the quality of education, income inequality, rule of law, labor rights, voice and accountability are leading indicators of creditworthiness of emerging market issuers. Understanding how these factors affect issuers is critical to our ability to assess their probability of default and potential changes in credit spreads through time — however, materiality is key to this assessment of these risks.
This paper explores how we consider material ESG factors, including climate change, in our investment approach to emerging market debt (EMD), and some of the related questions regarding the energy transition in emerging markets.
Our Approach
1. Assess and model material risk factors using our ESG dashboard
Using an array of metrics, we have constructed an ESG dashboard which our analysts and portfolio managers may use in the investment decision–making process. This tool allows our portfolio managers to understand the range of material risks and opportunities beyond financial reports, allowing them to track and compare ESG performance across issuers over time on a consistent standardized basis and relative to the level of development of a country. When using the dashboard, our focus is typically on two key questions:
a. Relative performance: Which issuers fare better (or worse) on ESG factors relative to their peers or in the case of sovereigns, relative to what their level of development would suggest?
b. Directionality: Which direction are ESG metrics trending in?
The ESG data we rely on in our dashboard is compiled from a variety of credible data sources chosen for their broad availability across emerging markets as well as their depth and spread across time.
Traditional ESG data sets tend to use static weightings for environmental, social and governance factors — for example, using equal weightings of 1/3, 1/3 and 1/3. Our ESG dashboard on the other hand applies weightings and relevance to factors derived from quantitatively back-tested correlations over time. Since materiality is not a static phenomenon, we consistently run these regressions to determine if spread materiality is changing and subsequently consider these changes in our weightings.
While there is broad consensus in emerging market investing that governance is the most important pillar, social factors, such as education and health are also crucial with environmental factors slowly increasing in relevance. We currently use base weightings of 15%, 35% and 50%, respectively, for environmental, social and governance factors in our dashboard which our analysts can adjust further to accurately reflect their perceived level of relevance to each issuer.
Our ESG dashboard allows our analysts and portfolio managers to understand the range of material risks and opportunities beyond financial reports. ESG data is compiled from respected data sources with breadth and depth across EMs.