With pension portfolios continuing to diversify globally, the practical and political decisions made by heads of state matter to institutional investors more than ever.
But it’s a tall order to measure the risks around these decisions. In response to increasing demand for reliable data, Sustainalytics is revamping its risk ratings system for sovereign fixed income to include considerations around environmental, social and governance issues.
Previously, the tool focused on demand from European institutional investors looking to be well-informed on issues like sanctions or human rights violations. In the four years since it was launched, the demand for solid knowledge around ESG risk has broadened.
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The enhancement is aimed at helping investors understand what credit risks exist for specific countries related to ESG issues, says Vikram Puppala, director of country research at Sustainalytics. “Basically, we look at risks to countries’ long-term economic prosperity, by measuring wealth — not the traditional wealth, but wealth from a sustainability point of view, so human capital, natural capital, institutional capital. It’s not median household income . . . . We’re not looking at the traditional financial value of wealth.”
And the tool rates a country’s ability to manage that capital in a sustainable way, he adds. “Are you taking care of your natural resources? Are you taking care of your people? Are you taking care of your institutions? Are they deteriorating? Improving?”
Taking this less traditional view of wealth helps provide investors with a broader perspective on the risks of investing in a particular country, says Puppala, noting this goes beyond simple credit risk, which asks whether a country can repay its debts.
The ranking system measures various scenarios and how countries react to them to measure their ability to sustainably manager their own wealth. It looks at current measures, such as a market’s carbon intensity, stress on its water supply and quality of health-care services, among others. It also measures whether those measures are trending higher or lower and how it has developed or deteriorated over the past five years. And finally, it takes specific events into account, like the wildfires raging through the Amazon rainforest.
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Specific events are rated on a scale of one to five. Syria’s ongoing civil war is an example of a five, the worst an event can be, says Puppala. Sustainalytics also measures the breadth, depth and duration of the event. For Syria, the breadth of the event gets the highest rating because it affects the entire population, while depth would also be the worst, with the metric capturing the amount of harm done. Duration, in turn, gets the most severe rating as well, given the war has been ongoing for a decade.
Under this measurement system, Brazil’s current forest fires don’t rank as high, he says, given it doesn’t impact the entire population, fatalities are far more limited compared to a situation like Syria and the duration has been reasonably short. Given this, the event, so far, would receive a score of one or two. “Of course, we keep track of it, asking, ‘Is it getting worse? Are more more communities being impacted?'”
However, as businesses start pulling out of a country, that would translate into an escalation of the ranking, adds Puppala.
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