Emerging Markets ESG Intelligence series

Hello everyone.

Thank you for joining us here at Invesco’s EM ESG Intelligence Centre, where we look to advance ESG integration in fixed income by highlighting critical developmental areas in asset management’s approach to its incorporation, particularly focusing on investment arenas tied to developing countries and regions where ESG factors and their potential impact are magnified because of their relative economic and locational disadvantages compared to developed market peers.

My name is Gerry Evelyn, and I am the Client Portfolio Manager for the Global Debt Team. We manage over USD6bn in international fixed income and are passionate in view that real time and continuous engagement, as well as ESG, are critical non-financial factors and tools that, if properly employed, can be additive to optimising investment performance and risk mitigation strategies in emerging market fixed income.

M-a-t-e-r-i-a-l-i-t-y.

Materiality.

What a word.

The concept of materiality in ESG is important.

If we think about this concept along a gradient, defined by degrees of severity, those ESG factors – indicators – that rank most critical to achieving set sustainability goals, that too impact investment performance, are  assessed in some real time, determined, systematic way.

And so it follows that standardising ESG materiality frameworks creates consistency, transparency and comparability across managers. Organisations like SASB and the GRI contribute to better standardisation and materiality frameworks across corporate issuers.

However, standardised ESG materiality frameworks for sovereign issuers are still fairly undeveloped.

Why is this the case?

Let me pose a few questions to you.

Over what time horizon should climate change and adaptation be assessed in value? Five years? Ten years? Or net zero 2050?

How do you measure the social impact of water scarcity, or declining biodiversity, on a targeted population?

With this last challenge in question, how is a country’s long-term sustainability agenda maintained, and continuity established, through revolving term-limitations that trigger changes in administration and political direction?

The answers to these questions, as we know, are not singular. They are not standardised. And so each country, specifically developing countries, have unique characteristics that should be analysed, both in absolute and relative terms, to their economic and regional peers.

We argue that the solution here is assessing material ESG indicators through a dynamic materiality framework that is customised by country, and reassessing and recalibrating it based on a defined, medium-term frequency.

The dynamism here is driven by the managers and the research or economic team.

Their qualitative analysis can augment traditional quantitative ESG scoring models, thereby improving the accuracy of overall results.

The Russia-Ukraine invasion bears light on the importance of making more progress towards developing dynamic sovereign ESG materiality frameworks.

Assessing the ESG merits of a corporation must go beyond just colour-coding revenue streams into shades of green, shades of brown and shades of blue. Particularly in emerging markets.

See, in EM, the country of domicile – the sovereign itself – and its relative sustainability strengths and weaknesses too should be factored into all ESG scoring assessments, to better inform the portfolio construction process, and ultimate investment performance outcome.

M-a-t-e-r-i-a-l-i-t-y.

Materiality.

Think about this concept through a dynamic lens and at the country level, and we will revisit it again in another episode down the road.

Oh, I almost forgot.

Drop us a comment or a view that you have related to this topic.

We aspire to lead thought together with you, our audience.

Bon voyage, mes amis.

Hello everyone

Thank you for joining me today. My name is Gerry Evelyn and I am the client portfolio manager for the global debt team. We manage over $USD 6 billion in international fixed income, and we are passionate around ESG and its growing adoption, acceptance and integration into asset managers’ investment processes.

To be, or to not be, engaged? That is the question. Today’s episode focuses on ESG engagement.

What is it? ESG engagement we define as a connection point and bilateral interaction made between an investment manager and a target company or sovereign entity. This is centred around sustainability objectives, their refinement, and ultimate achievement.

In non-fancy terms, it is when investors get together with issuing entities to discuss ESG issues specific to the company, with the goal of improving that entity’s sustainability profile and overall investment potential.

It is a concept more known and visible in equities – primarily through general proxy voting initiatives. Because shareholders enjoy equity – interest in the company – ESG in this asset class is fairly straightforward. However, on the fixed income side, ESG engagement is less clear. Unlike equity, fixed income investors are not shareholders but creditors. Because of this, engagement on ESG in fixed income is not binary and there aren’t proxy votes of aye’s or nay’s and majority wins like equities.

Instead, it entails proactive, collective and consistent dialogue between managers as well as corporates, sovereign policymakers and local market officials. We believe that engagement continuity is critical to the achievement of positive sustainability outcomes and enhanced investment performance in the asset class. This increased need for continuity in fixed income is magnified when investing in emerging markets. Information there is even less transparent and sustainability risks across environmental, social and governance factors are higher relative to developed markets.

Think about it. Without ESG engagement, how can an investor be reasonably confident that the investment – the capital allocated – is having the desired impact on sustainability objectives set by a company or country? Without it, we cannot track movement, progress: it is indeed necessary.

Let’s use a real-world example to highlight the importance of engagement. It’s like a subway train. Many trains operate solely on electric power. They get the electricity from the third rail or electrical line which is present along the track. Transformers transfer the voltage from the lines and the electrical current enables the motors on the wheels to move. Without engagement, there cannot be movement. Not for the subway train, nor for ESG.

To be, or to not be, engaged. Being engaged is the answer.

Thank you for this quick moment of your time mes amis. Until next time, think about the power and the possibilities of true ESG integration when investors are engaged.

Gerry:

Hello and welcome to the Global Debt team’s ESG Intelligence series. My name is Gerry Evelyn, and I am the Senior Client Portfolio Manager for the team. Joining me today are Senior Portfolio Manager, Wim Vandenhoeck and Director of Fixed Income Research, Claudia Castro.

In this installment, we would like to discuss our team’s approach to integrating financially material ESG factors when investing in EM sovereigns.

In emerging markets, given well known data challenges and an income skew favoring richer developing nations in many ESG scoring systems, we believe that a comprehensive approach is necessary when determining a countries true forward looking sustainability trajectory. Our robust framework is anchored by three critical pillars: Quantitative analysis, Qualitative assessments with an emphasis on sustainability momentum and potential, and consistent country engagement. We believe that combined, these three pillars provide a more in depth and contemporary snapshot of a country’s ESG profile that when integrated into the investment process can enhance portfolio selection and contribute to better investment outcomes.

Economist Claudia Castro will now discuss our differentiated qualitative approach to ESG focusing on our trend assessments: momentum and potential and their impact on our country assessments. Claudia…

Claudia:

…Thank you, Gerry.  Unlike the equity side and the corporate bond side where a gold standard approach to ESG has been defined with ESG benchmarks, no single framework has been hailed as the gold standard for sovereigns – and as Gerry mentioned just now, there are a few factors such as data lags and inconsistencies in collecting data that are challenges. 

In talking with clients over the last few years the bar has been raised to depart from a simple application of a ranking framework that often penalized issuers unintendedly. Two reasons are important to create this new framework; One, sovereign bonds have a broader mandate to finance society’s wellbeing in terms of public services like health and education. Second, these Emerging Market countries already face a higher cost of financing for being financially constrained.

We have built a framework that is robust, repetitive and has been very well received by due diligence of institutional investors and consultants globally. It is a two pronged approach that incorporates and adjusts for the different stages of sovereign development i.e., income and wealth differentials.

It takes a holistic view combining historic data which is a structural assessment and is quant based and adds in an event based qualitative overlay. This qualitative overlay incorporates forward looking information for each E S and G factor. That’s how we derive a measure of momentum, for example enhancing the ESG profile of a lower income country with a low score in case of positive momentum.

This qualitative process is driven by our ESG philosophy – materiality and momentum. Materiality in the context of sovereign debt means we identify events or macroeconomic developments that may impact the country’s position across the ESG pillars, and, as a result, require us to change its overall ESG grade. Momentum means we consider whether the underlying dynamics of the issues faced by a country are likely to strengthen or weaken its ESG standing in the future.

My colleague Wim will talk about how we incorporate this framework into our investment process.

Wim:

Thank you, Claudia.

As Investment managers we want to ensure that our investors are appropriately compensated for risk. We believe that this ESG sovereign framework allows us to not only capture these ESG trends, allows us to actively invest in them but also allows us to engage with those sovereign counterparties. In the end we want to make sure that we deploy capital to those countries that are working hard to improve their ESG standings.

Let us be a bit more explicit and look at this chart;

The easiest way to think about this is a simple carrot and stick approach in determining the exposure to a country. This chart has valuation on one axis and ESG profile on the other. The Overweight and the Avoid quadrants are easy to understand; If the ESG momentum or potential of a country is positive and valuations are cheap based on fundamentals, we tend to have at least a benchmark position but most likely are overweight. On the other hand, if the ESG momentum or potential is negative and valuations are unattractive, we will be underweight. The interesting quadrants are the other two; in the Moderate quadrant where you have positive momentum, but valuations are unattractive, we will reduce our overweight and tend to position the country closer to benchmark. The last quadrant is the hardest one where you have attractive valuation but a weak ESG profile. This one will require us to increase our engagement with the issuer. An effort that may lead to better outcomes over time and can be affected by changes in political cycles. Industry groups have formed over the last few years to try and standardize a ‘collective approach’ to engagement, which puts coordinate pressure on a country.

In a next episode, Claudia and I will take you through our engagement template and a live example. Thank you for tuning in!

Hello Everyone,

Thank for you for joining our latest installment of ESG Intelligence:  Climate Adaptation.  My name is Gerry Evelyn, and I am the Senior Client Portfolio Manager for the team.  We manage over 6bb in international fixed income and are passionate around Sustainability and Impact in Emerging Markets.

So- Climate Adaptation:  The ability to change processes, practices and structures in response to actual or expected impacts due to climate change.  Recent climate data suggests that the pathway to limiting global warming to 1.5C is narrowing and narrowing quickly.  Our base case internal research has temperature warming of 3.9C by the turn of the century which exposes all of us to deleterious climate effects: declining biodiversity and crop yields, increases in coastal flooding, economic disruptions potentially leading to a meaningful curtailment in global GDP, and lastly the human and social toll.  Given this, we believe that greater emphasis will be placed on institutional capital mobilization towards Adaptation targeted financing opportunities in developing countries, specifically, as emerging markets will be unduly affected by the impacts of climate change relative to its developed peers.

The investment spending gap between what is minimally needed to transition to a sustainable world and what is currently being mobilized exceeds $2.5tr per annum and this number is unfortunately expected to grow.  Though filling this gap may appear daunting, we believe that a supportive regulatory backdrop, greater institutional client awareness and interest, and the anticipated growth of the blended finance space aligning public development focused entities with private capital in de-risked investment vehicles with a stated sustainability impact objective will help to catalyze climate flows and aid in overall global climate resilience.  In addition to impact, carefully vetted investment opportunities can also provide differentiated sources of income generation and performance at market competitive rates.

Climate Adaptation and Climate Mitigation must be thought of in parallel.  Optimistically speaking, though there currently remains a climate problem …we argue that there, too, exists a potential climate solution.

Id like to now hand over to Senior Portfolio Manager Wim Vandenhoeck who will discuss in more detail the benefits of blended finance in emerging markets and how private capital can make an impact.  Wim.

___

Wim:

Thank you, Gerry.

Many of the Least Developed Countries and Small Island nations are highly vulnerable to climate change. Their communities ultimate survival will often require significant and rapid deployment of capital. While their climate footprint may be small and therefor their contribution to climate mitigation will be small, their adaptation to changes in weather patterns may be a matter of survival.

Of course, the challenge is funding. Economic distress and limited public budgets make needed investments almost impossible. Now, some money for these vulnerable underfunded communities is available via Development Financial Institutions (known as DFIs) but not nearly enough. The mobilization of private capital is not only desired but critically needed.

So, how do we entice private capital?

Currently only few institutional investors tend to look at these markets given the uncertainty and therefore required upfront expense needed to make an informed decision. Large asset managers like ourselves, however, can build partnerships and create solutions to arrive at a risk-return profile that institutional investors typically target.

New, innovative blended finance structures aim to close the existing funding gaps by combining investments from the public sector with private capital. This can only be done in a closed-end fund structure with a long term commitment incorporating varying investor risk/return options. For example, knowledgeable investors with impact mandates favor a higher risk and higher return profile while private investors will accept a lower return for lower risk.

We strongly believe that by combining public and private investors with various credit sensitivities in blended vehicles, we can scale the absolute impact made towards urgent Environmental and Social objectives.

Claudia, Portfolio Manager on our Global Debt Team, will address how we can evaluate investment opportunities for adaptation impact - and how we foresee benefits of local engagement.

Claudia…

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Claudia:

Thank you, Wim.

In terms of solutions..

This means talking about challenges other than the failure to mobilize private capital - we need to address also how we arrive at adaptation solutions that are market-ready.

Currently adaptation solutions are challenged by the absence of appropriate frameworks for climate risk assessment, by weak commercial readiness and by lack of market transparency and impact reporting.

To accelerate climate action, we need to match solutions that tackle those challenges with the large vulnerabilities and needs of different countries and economic sectors.

We use a consistent process to select and evaluate solutions thus continuously validating our objectives and ensuring good governance.

Overall, a targeted approach that addresses these challenges, with strong monitoring and evaluation, will deliver solutions with an inclusive focus on gender and on vulnerable populations.

Moving on to engagement.. 

Our local engagement strategy throughout the life cycle of the investment allows for results that will have a specific and measurable climate change impact.

Engagement is essential to understand the near-term adjustments in ecological, social, or economic systems - both to moderate damage and to benefit from opportunities now - but also engagement is needed to deliver on the required measurement of impact and ultimately on the sustainability of the investment.

Indeed, not only we seek to improve climate adaptation outcomes, we need to measure the reduction in climate vulnerability experienced by beneficiaries, and ensure such benefits are distributed equitably.

Adapting in clever ways through clever solutions can not only give us a safety net but it can also potentially reduce future damage - we seek to answer not the "should" we invest in adaptation but the "how" through speed and scale.

From our perspective, we seek to enable a paradigm shift with our goal to support long-term adaptation to climate change where it is most needed - validating that investing in such projects is feasible, combining public and private investors at acceptable risk, with increasing assurance on the performance of such assets, with direct and indirect beneficiaries and a multiplier effect from positive impact.

In the next installment we will introduce a live example of our investment approach to investing in Adaptation with impact.  Thank you for joining us!