Finally, the underlying data is a bottleneck. Most underlying data comes from the international public sector or large NGOs. As illustrated in Figure 3, an analysis of the World Bank’s Sovereign ESG data portal shows that the median lag for social and governance data is three years, and the median lag for environmental data is five years. In 2021, the latest environmental datapoint would commonly be from 2016, which, in our view, is too late to be considered very useful. That said, big data approaches offer a potential path forward, but in our view, they are not a panacea.

Emso’s history of incorporating ESG into its investment process dates back many years, but has recently accelerated. As a component of fundamental fixed income investing, Emso has since our inception in 2000, put an emphasis on understanding governance factors. In recent years, we have tried to thoughtfully incorporate further select ESG factors into the research and investment process. We formalized our dedication to ESG with our first ESG policy in 2014 that guided incorporation of at least a minimal level of ESG into our investment process. We further codified our ESG integration by becoming a UN PRI signatory in 2015. Emso’s approach to ESG factors has evolved over the ensuing years as we have worked to devise a robust and substantive approach to ESG investing the emerging markets fixed income space.

Historically, Emso has focused on incorporating ESG factors that are financially material for asset prices, with a particular focus on governance factors over time. Taking an empirical approach to using ESG data has improved model accuracy across many of our medium-term fair value models, thereby enhancing our investment process and ultimately, we hope, our investment outcomes.

In line with the World Bank’s recommendations, our approach is forward-looking and emphasizes a country’s momentum. The framework that we utilize in our mandates which have an explicit ESG overlay allows for the inclusion of improving ESG stories that are not part of the J.P. Morgan JESG EMBI Index (JESG EMBI) if we believe that their ESG scores will improve above the threshold for inclusion in six to 12 months. The ingrained income bias with ESG scores tends to unduly reward high-income countries at the expense of low-income countries which are on the right track and, frankly, should be rewarded with marginal capital inflows. For example, despite the impressive efforts of the Angolan government to combat corruption and deliver meaningful structural reforms to the economy under its International Monetary Fund (IMF) program, Angola remains excluded from the JESG EMBI because it started from such a low base, and the data is lagging. We also believe that, within a total return framework, we should have the ability to short countries where the ESG scores are likely to deteriorate. For example, despite a clear deterioration in governance in Lebanon, it remains part of the JESG EMBI.

C. Where to go next in terms of ESG integration?

There is no free lunch; ESG as a factor in investing

We disagree with investors who propose that ESG considerations can always offer superior return performance, in addition to their positive impact: we believe there is no such thing as a free lunch. Adopting an ESG strategy will, by definition, decrease the size of the investment universe, reducing potential return drivers, at least over the short and medium term. For example, an investor may believe that taking a short position, or no position at all, in oil producers will produce higher risk-adjusted returns in the long term. However, they will have to accept a potential for short-term underperformance as oil prices fluctuate. Over a long-term investment horizon, we believe that giving ESG considerations a higher weight makes sense, but investors need to be aware that such considerations may not be reflected in asset prices anytime soon.

EM fixed income is still mostly pricing the capacity and willingness of a debtor to pay. To the extent that ESG considerations have an impact on these two factors, including them in any, whether explicitly an ESG overlay or not, could enhance investment returns, but there is no guarantee. Excluding poorly rated ESG issuers or overweighting positive ones is a style factor which historically has outperformed in some markets, while underperforming in others for many asset classes, including EM fixed income. Arguments made for ESG as a positive return driver in the short term are usually based on selective or limited data sets that do not have long enough cycles to assess. In EM fixed income, especially in local rates, ESG overlays that shift allocations to higher-rated issuers have also led to longer duration exposures, which has proved beneficial over the past few years, but not because of any ESG component.

Move towards outcome based instruments

At Emso, we are constantly on the lookout for better and more timely sources of ESG data. Data providers are putting increasing effort into providing improved ESG data for sovereigns and quasi-sovereigns. However, timely and relevant environmental coverage remains elusive. We are optimistic about geospatial technology which might significantly improve sovereign-level environmental data. Verisk Maplecroft, for example, have full spectrum coverage across all physical and natural capital risks at resolutions from <1km² to 22km². Larger firms are rapidly acquiring innovative ESG data start-ups. It will be important that new approaches are thoroughly vetted before being incorporated into existing product offerings and innovation is not halted prematurely. We remain very optimistic about the evolution and quality of ESG data, which means we would not want to tie ourselves down to any one data provider at this stage.

The rise of labelled bonds

Emso’s focus has so far been on integrating financially material ESG factors in its investment process across strategies. Labelled bonds, and sustainability-linked bonds provide a way to link investment with sustainability outcomes⁷. Whether green, blue, social, sustainable, or sustainably-linked, these instruments have seen a surge in investor interest over the last 18 months, but the lack of standardization and third-party monitoring still raises challenges of greenwashing and verification. These bonds cannot promise sustainability outcomes and a lot of work remains to adapt labelled bonds to a sovereign context.

Investor engagement the next frontier

Academic literature⁸ suggests that investor engagement is the most effective tool for driving the sustainability outcomes that end-investors increasingly expect. There remain open questions as to the most appropriate and effective areas for sovereign creditor ESG engagement, but we believe that progress is being made⁹. Traditionally, investors met mostly with economic policymakers in a finance ministry and central bank. Some sovereign debt issuers, proactively trying to adapt to the shift in investor sentiment towards sustainability, are beginning to facilitate investor dialogue with a wider set of policymakers on sustainability issues¹⁰.

Emso is currently actively involved at the working group level in the Investor Policy Dialogue on Deforestation (IPDD) which is a collaborative investor initiative established in July 2020 to engage with public agencies and industry associations in select countries on the issue of deforestation. Investors within this group recognize the crucial role that tropical forests and other types of natural vegetation play in tackling climate change, protecting biodiversity, and ensuring ecosystem services. As of July 2021, IPDD is supported by 54 global institutional investors from 18 countries. The coalition now represents approximately USD 7.2 trillion of AUM. The goal of the initiative is to coordinate a public policy dialogue on halting deforestation and to raise awareness within the investor community about deforestation trends and its impact. It also intends to present a stronger representative voice to regulators. The initiative started with Brazil, and as of January 2021, has expanded to include Indonesia.

E. Conclusion

At Emso, we will continue to strive to develop new and innovative ways to incorporate ESG across our strategies. We believe that our research presents a valid assessment of the potential trade-offs of ESG strategies. Our ESG framework has focused on integrating financially material ESG factors into the investment process. We integrate the data into our investment process via an econometric modelling framework that we believe allows us to improve investment outcomes. However, we acknowledge this approach utilizes ESG more as a risk mitigation tool than delivering on the UN’s SDGs or the Paris Climate Agreement targets. We believe that rather than overpromising what ESG led strategies can deliver, it is more fruitful to engage with asset owners on what goals they are planning to achieve (outcome based or financial materiality) and at what cost over the relevant investment horizon.

Looking ahead, we have taken stock of Emso’s Sovereign ESG framework to see how it aligns with the World Bank’s Sovereign ESG 2.0 framework. We are encouraged by the World Bank’s recommendation as it is very much in line with the direction that we are already heading. However, the World Bank’s approach also highlights ample room for improvement and suggests where we might want to go next. Data availability will remain an outstanding issue in our view, and it is useful to reiterate the need to avoid the ingrained income bias. Moreover, we think that the rapid surge in labelled bonds presents interesting, more outcome-based, opportunities for EM ESG investing. We see the most room for improvement in engagement; particularly between sovereigns, quasi-sovereigns, and investors.  We see the work the IPDD is doing as a useful model, and we are looking for other areas where we can draw on their lessons and use it in other countries and contexts.

Finally, we believe that taking short positions in poor ESG performers is an important approach to reduce the costs of an ESG overlay; why should we only focus on “improving stories” when additional alpha opportunities can be identified by, for example, highly-rated ESG issuer reversing course? We see a role for taking short positions in any ESG based absolute or total return strategy.