ESG Integration in Sovereign Portfolios Long-term value creation

By Aegon Asset Management

November 2018 Authors: Emanuele Fanelli, Responsible Investment Manager Jesus Martinez, Portfolio Manager

Aegon Asset Management Netherlands believes environmental, social, and governance (ESG) factors are an important component of sound fundamental credit analysis that can drive alpha and help manage risk in our clients’ portfolios. Though historically not always referred as ESG, understanding country governance has always been a critical part of sovereign investing and the ESG underlying concepts have helped define our investment methodology for decades, being an important and evolving part of our investment process today.

Therefore we have been conducting in-depth analysis of the opportunities and challenges related to ESG integration in sovereign portfolios. We believe that ESG integration is more than a tick-the-box exercise, and that instead, it should be a comprehensive analysis that is fully part of the investment process. Consequently, we explored the current standing of research, tools and data available and the usefulness of country ESG scores computed by specialised providers.

These exercises proved ESG integration to be a value-adding tool to the investment process, and showed that neither the methodologies currently used to build ESG scores, nor the data points used to construct them, are always transparent. Therefore we have built a proprietary score to help us better understand the ESG risks at the country level across our portfolios.

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2 Current state of play

Our analysis of the current state of affairs in ESG integration in sovereign portfolios covered three topics: the existing academic and industry research, the data and scores provided by specialised vendors, and the inclusion of ESG in mainstream credit ratings.

Academic and industry research Data and scores ESG integration in sovereign debt portfolios, in its explicit The current state of play is catching up on that of other asset form, is a relatively recent focus of both academia and the classes, but some gaps can still be identified. This applies industry, and as such, there is little research on the topic. particularly to the quality of the underlying data. It is in large Nevertheless, there is a small but increasing body of literature part reported by governments themselves, which becomes indicating optimistic prospects regarding the materiality of an issue as the independence and assurance of the reporting ESG risks to sovereign creditworthiness1. In certain instances, organ decreases. Moreover, many of those underlying data are ESG factors have shown a positive correlation with economic estimates of an unobservable data point. Also, ad hoc changes growth and fiscal health. In particular, reports2 suggest in methodology cause jumps in the time series. Finally, the that the ESG score of a country has a strong negative timeliness of the data is another issue when it comes to using relationship with the credit spread and the CDS spread of it as an investment tool: the data series are usually updated the country, indicating that default risk decreases as the once a year. As a result, relatively aged data is presented as up ESG performance of the country improves. Generally, large to date. bodies of development economics literature link the economic performance of a country to its governance, its environmental Specialised ESG data providers run into similar difficulties. management and its social stability3. The problems identified in the underlying data translate to the scores, details of the methodology are obscure, and Figure 1: Relationship between spread and ESG score (2017). providers use a one-size-fits-all approach: the same scoring methodology is applied to all countries, regardless of the state 10001000 of development or other factors.

800800 Traditional credit ratings

600600 We also investigated how ESG is integrated in traditional credit ratings. Credit-rating agencies have taken steps towards 400400 clarifying how ESG factors enter credit analysis4, and those welcoming improvements are made visible thanks to regulatory 200200 pressure in Europe and the work of the PRI ESG in Credit Rating Credit spread Credit Initiative. Nevertheless, discrepancies between this approach 0 and our needs still exist, mainly in the time horizon considered, 5 -200-200 as well as in the formal, quantitative modelling of ESG risks . Furthermore, the update of the rating usually happens -400-400 after the fact, once financial markets have assimilated new 0 1010 2020 3030 4040 5050 6060 7070 8080 9090 100100 information. As a participant in the PRI’s ESG in Credit Ratings ESG score Initiative, we are collaborating with credit rating agencies and other stakeholders to ensure that ESG factors are effectively Source: Aegon Asset Management incorporated into credit rating models for sovereign as well as corporate issuers.

1. The focus always includes governance, while social and environmental factors are less often included. 2. Crifo, P., Diaye, M.-A., & Oueghlissi, R. (2014). Measuring the effect of government ESG performance on sovereign borrowing cost. Cahier de Recherche 2014-04. 3. See for instance: Acemoglu, D., & Robinson, J. (2012). Why Nations Fail: The origins of prosperity, power and poverty. Crown Business. For a more general outlook on the relationship between ESG and the economy, see: Raworth, K. (2017). The Doughnut Economics: Seven ways to think like a twenty-first century economist. Vermont, US: Chelsea Green Publishing. 4. See: Moody’s Investor Service. (2018). Environmental, social and governance risks influence sovereign ratings in multiple ways; S&P Global Ratings. (2017). How does S&P Global Ratings incorporate environmental, social, and governance risks into its ratings analysis. 5. UN PRI (2018). Shifting Perceptions: ESG, credit risk and rating – Part 2: Exploring the disconnects.

3 ESG performance in practice

Some of the shortcomings we identified can only be avoided by reforming data reporting processes and timeliness, which can be considered a far-fetched objective for the time being. Nevertheless, some issues can be addressed by developing an internal methodology to evaluate the ESG performance of sovereign issuers. Based on the results from our analysis presented above, internalising the process allows us to best capture our current objectives regarding ESG integration. We do so with the overarching goal of identifying the financial impact of ESG factors on sovereigns’ creditworthiness.

Additionally, we believe that a score assessing the materiality The first step towards building an ESG score is the collection of ESG factors should take into account the intricacies of of data. We include data points from publicly available sources how each dimension might affect the country differently and such as international institutions, e.g. the World Bank or in a dynamic way. Naturally, it is impossible to reflect these the World Economic Forum, and NGOs like Reporters Sans complexities in one single number, and claiming to do so would Frontières and Freedom House. Combining various sources of defeat the benefits of a simple, carefully-designed score. It data also allows us to widen the range of topics covered by is however possible to build a score incorporating a certain our raw dataset. To quantify ESG risks, we aggregate the raw flexibility, allowing for integration of the different impacts of data into several sub-indicators, capturing particular aspects measures on various sovereigns. This is what we set out to do. of E, S and G factors. These are the factors whose materiality is determined: the larger the impact on the credit spread of the Financial materiality country, the higher the final weight in the ESG score. Traditionally, governance factors are considered more important, relative to social and environmental ones. While The computation of those sub-indicators also helps to avoid there is broad consensus regarding the essential role of statistical complications arising from the large number of institutional development in economic performance, it is less variables, while keeping a level of detail sufficient for a obvious how social and environmental factors represent a risk statistical analysis of materiality. After aggregating those into to the fiscal health of a country. Extreme cases of Caribbean separate environmental, social and governance scores, these and South-East Asian countries threatened by rising sea eight numbers are weighted based on materiality for each levels or extreme weather events, and Middle-Eastern nations level of development and combined to form our final ESG shaken by the Arab Spring are clear-cut. It is more difficult score (Figure 2). to assess the direct effect of those factors on less exposed countries. In any case, it is well-recognised that such links between environmental and social factors and credit risk are increasingly relevant in the long term.

Figure 2: Aggregation process: non-exhaustive list of data, indicators and scores

Environmental score Social score Governance score

Climate Basic needs Institutional strength • Air pollution • Infant mortality • Level of democracy • Environmental treaties • Basic services provision • Rule of law • ... • ... • ...

Energy Peace and freedom Policy sustainability • Coal use • Level of peace • Regulatory quality • Energy intensity • Political rights • Trust in politicians • ... • ... • ...

Sustainable consumption Labour protection • Water productivity • Youth unemployment • Agricultural regulation • Social treaties • ... • ...

Source: Aegon Asset Management

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4 Tailored to development While non-material factors are still included, their final weight A closer look at development economics shows that a one- is substantially lower. This allow us to track the evolution of the size-fits-all approach to ESG factors does not suit the reality weights as the materiality could very likely change over time. of how these factors influence the ability and willingness to Thus, the final score is focused on those indicators that matter repay debt of countries at different stages of development. in terms of credit risk. For instance, a natural disaster affects differently a developing country such as Indonesia with fragile infrastructure and small Figure 3: ESG weighting tailored to stage of development financial resources to repair it than a developed one like the Netherlands with mechanisms in place to minimise damage 1 and plentiful public coffers. 0.80.8 It is also important to recognise that the materiality of ESG factors does not necessarily follow the established dichotomy 0.60.6 between emerging and developed markets. Therefore, we decided to customise our proprietary methodology based on the more disaggregated World Bank country income group 0.40.4 classification: low-income, lower-middle-income, upper- middle-income, high-income. 0.20.2

The relative materiality of each factor differs by income 0 group. Governance, ranging from the quality of institutional LowLow Income Lower-MiddleLower-middle Income Upper-MiddleUpper-Middle Income HighHigh Income frameworks to respect for the rule of law tends to be more Income Income Income Income material to less-developed countries, while environmental Environment Social Governance factors are most material in upper middle income countries, as Source: Aegon Asset Management they are more reliant on the exploitation of natural resources and exposed to the associated risks. Interestingly, social factors such as income inequality and youth unemployment are the most significant factors in high-income countries, which is visible in the rise of populist political parties as a consequence of increased social discontent.

5 More than a number

ESG scores ESG momentum The distribution of scores (Figure 4) does not yield surprising The momentum in ESG scores nuances this story (Figure 5). results; it confirms the link between ESG performance and While developed economies are pretty much stagnant at high development. Developed countries make up almost 80% of levels of ESG score, variability increases as the average income the top 50 countries in terms of ESG score, with Nordic nations of the region decreases: leading on all fronts. Sub-Saharan countries, however, are relatively equally distributed below the 60-mark, accounting for Figure 5: Distribution of ESG momentum, by region (2017) the majority of countries scoring below 30. -0.1-0.1 -0.05-0.05 00 0.050.05 0.10.1 0.150.15

Figure 4: Distribution of ESG scores (2017). AsiaAsia and and the the Pacific Pacific

4040 CentralCentral Eurasia Eurasia 3535 Developed Countries 3030 Developed Countries

2525 Latin America and Latin America andthe the Caribbean Caribbean 2020 Middle EastMiddle and North East Africa and 1515 North Africa

1010 Sub-SaharanSub-Saharan Africa Africa

55

00 Asia and the Pacific Central Eurasia Developed Countries < 20 20 to 30 30 to 40 40 to 50 50 to 60 60 to 70 70 to 80 > 80 < 20 20 to 30 30 to 40 30 to 40 50 to 60 60 to 70 70 to 80 >80 Latin America and the Caribbean Middle East and North Africa Asia and the Pacific Central Eurasia Developed Countries AsiaLatin and America the and Pacific Caribbean CentralMiddle East andEurasia North Africa DevelopedSub-Saharan Africa Countries Sub-Saharan Africa Latin America and the Caribbean Middle East and North Africa Source: Aegon Asset Management Sub-Saharan Africa Source: Aegon Asset Management • In the most extreme cases, such as in sub-Saharan Africa and in the Middle East, countries descending into (civil) war such as South Sudan, Syria or Libya drag down the momentum score of the region. • Apart from those countries, negative momentum experienced by the Middle East can be attributed to negative social changes, likely the aftermath of the Arab Spring. • On the other hand, countries that are starting to recover from violent conflict (Sudan), or simply open up to the rest of the world (Myanmar, Iran) see their ESG score increase dramatically. • In the case of Asian countries, similarly to central Eurasia and sub-Saharan Africa, the positive momentum is driven by improvements in governance.

Bearing in mind that this ESG score is built to reflect factors that are financially material to credit risk, those results provide an opportunity to allocate capital to countries that are emerging as well-governed, peaceful and sustainable, all of which are signals of good future economic performance.

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6 Bottom-up credit analysis This combination of bottom-up and top-down approaches Our ESG score therefore measures the ESG risk that each gives the investment team a full picture of the ESG risks and country faces given its level of development. Next to that, we their materiality to a sovereign issuer’s creditworthiness. use a measure of momentum in ESG, which captures trends in Further, the Responsible Investment Team advises the the ESG performance of a country. Together, these measures investment team during each stage of the process, exchanging provide us with a dynamic summary view of the ESG strengths views and providing insights into the risks identified, ensuring and weaknesses of sovereign issuers. The underlying data is that the investment team can gradually take more ownership always readily available; particularly poor performances, which of the process as their knowledge of the issues increases in might not be revealed in an aggregated score, are flagged each cycle. for further research. Sovereign credit analysts also conduct bottom-up research to complement and clarify the insights of our quantitative methodology.

Figure 6: Aegon Asset Management Netherlands ESG integration process in sovereign portfolios.

Material ESG Bottom-up • Prohibition to invest factors • Proprietary credit analysis • Bringing together in systematic human quantitative score ESG and traditional • Identifying and • Complementing the rights abusers • Summary ESG credit analysis into mitigating tail risks top-down approach • Considering information and an investment sanctions lists • Tailored to issuer's trends • Contextualising the decision development profile issues and ESG Score + materiality Investment Exclusion list Momentum decision

Regular discussions between Sovereigns and Responsible Investment teams to exchange views and provide input on issuer ESG profile

Source: Aegon Asset Management

7 Case study 1:

The outbreak of the sovereign crisis in 2012 caused Portugal In figure 8, it can be seen how labour protection and to be downgraded to below investment grade rating by all policy deteriorated significantly in 2012, mainly due to the three rating agencies. It took the country five years to regain implementation of reforms that were aimed towards achieving its former rating status, following a path of severe fiscal a more flexible economy, which led to a salary devaluation. adjustments. The investment grade rating was regained by S&P That effect was compensated by a general positive momentum and Fitch in 2017, and later by Moody’s in 2018. Since 2012, coming from several other indicators, such as basic rights and economic growth has been key in building both confidence needs or institutional strength. and stability in their bond market. The GDP growth of Portugal in the last 5 years has been increasing after an average of Figure 8: Evolution of the main ESG dimensions for Portugal as -2% in the years after the sovereign financial crisis. In 2017 compared to the credit rating evolution (2010-2017). GDP growth was 2.8%, achieving a stable (2013-2016) or decreasing (2016-2017) debt to GDP ratio. 2.02.00 9090

Institutional 8080 Credit rating deteriorated at a similar speed as Portugal’s strenght 1.51.50 Policy spread differential versus , peaking in the second half 7070

of 2011. Relevant short term indicators such as the ability of Freedom and the country to access wholesale markets indicated caution, 1.01.00 6060 peace Basic rights and investors adopted a cautious stand. However, our score and needs methodology showed a stable and relatively high score as 5050 0.50.50 Labour protection compared to other countries in the same income group. 4040 Responsible consumption 0.00.00 3030 Figure7: Comparison between the average credit rating of Energy Portugal (Moody’s, S&P and Fitch), our ESG score and the 20 spread of the yield between Portugal and Germany for 10 year 20 Climate -0.5-0.50 bonds (2010-2017). 1010 Average Rating (RHS, 100100 1,800 scaled 1-100) -1.0-1.00 00 9090 1,600 1,800 2011Jan-11 2012Jan-12 2013Jan-13 2014Jan-14 2015Jan-15 2016Jan-16 2017Jan-17 2018Jan-18 8080 1,6001,400 7070 Institutional strength Policy Freedom and peace 1,4001,200 Basic rights and needs Labour protection 6060 1,2001,000 Responsible consumption Energy Climate 5050 1,000800 Average Rating (RHS scaled 1-100) 4040 600 3030 800 Source: Aegon Asset Management 400 2020 600

200 1010 400 Since 2012, the reforms continued and affected several 00 2000 20112011 20122012 20132013 20142014 20152015 2016 20172017 20182018 aspects of the Portuguese economy. An example of that is the 0 AverageAverage Rating Rating (LHS, scaled 1-100) ESG ScoreESG Score (LHS, scaled Spread 1-100) vs GermanySpread vs Germany 10 10 years years steps taken into reducing the energy tariff deficit and increasing LHS scaled 1-100 the use of renewable energy, which starts to pay off since 2013 onwards. While most of these policy actions improved the Source: Aegon Asset Management long term sustainability prospects of the country, valuations remained expensive and ratings were kept low, increasing Such stability in our proprietary ESG score of Portugal does the attractiveness of Portuguese bonds even before market not reflect the reality of the underlying items that did move indicators started becoming more positive. during this turbulent period, smoothing out the result. This effect shows that a single number does not describe the complex reality of an issuer, and how necessary it is to evaluate and develop a professional judgement based on accurate and relevant data.

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8 Case study 2: , Germany and

The environmental score of Germany is much higher than that Firstly, while Germany’s environmental score is the highest, of France and Italy (Figure 9). Germany’s credit spread is also it scores poorest on some individual issues. In particular, the very low, while Italy’s is skyrocketing. This example shows that country still depends substantially more on lignite coal than active management is needed next to the score. its European peers. This very low score is compensated by high scores in most other variables, such as water productivity Figure 9: Environmental scores (France, Germany and Italy) or land conservation. France, on the other hand, performs relatively well on most indicators, while Italy performs very 100 well on the least material ones, but has an ambitious target to phase out all its coal power plants by 2025, for example. 90 By looking only at the big picture (Germany performing well environmentally), one might miss a material risk that is only seen in the more disaggregated data. Therefore, next to the 80 score, indicators are reported signalling whether there is a substantial problem in an underlying series. 70 Secondly, the yearly update of the ESG score fails to capture most of the developments currently taking place in a dynamic 60 way, such as the current deterioration of the rule of law in Italy 2010 2011 2012 2013 2014 2015 20162016 20172017 (through the disregard of EU law), or the hesitation to provide France Germany Italy humanitarian assistance by the current government driven by unsustainable level of illegal immigration and rise populist Source: Aegon Asset Management political parties. These cause spread fluctuations that cannot be anticipated by the ESG score. This can be expected, as ESG factors highlight longer-term risks that are not yet priced by the financial markets, but could be in the future.

9 Conclusion

Going through the process of creating a proprietary methodology to assess the ESG performance of countries sheds light on the complexities and opportunities of integrating ESG in sovereign debt portfolios. Due to the clear limitations to the quality and timeliness of raw data, this exercise clarifies the extent to which we can rely on quantitative methods and where additional bottom up credit analysis complement the ESG integration process.

Our proprietary ESG score provides a clear signal of countries’ This highlights the importance of developing our own ESG performance. The methodology has been constructed assessment process. It allows us to be in control of all around core ideas of development economics, in order to parameters, and thereby to know exactly what the score have more realistic and robust approach to ESG in sovereigns. and the momentum does and does not tell us. Such control Nevertheless it is not enough to simply look at the score to helps us pinpoint exactly where more bottom up qualitative make an investment decision. Instead we also consider the credit research is needed. This combination of quantitative ESG momentum, which is a useful proxy of improvement or and qualitative ESG tools, alongside traditional economic deterioration in ESG performance, and help us identify ESG factors, allows the analyst to develop their own view of the leaders and improvers. issuer’s creditworthiness, which ultimately drives the portfolio construction.

We use our investment management expertise to help people achieve a lifetime of financial security.

10 About Aegon Asset Management

Aegon Asset Management is a global, active investment manager. Aegon Asset Management uses its investment management expertise to help people achieve a lifetime of financial security, with a focus on excellence, trust and partnership. Institutional and private investors worldwide entrust Aegon Asset Management to manage approximately €325 billion on their behalf.

Positioned for success in its chosen markets (Continental Europe, North America, the UK and Asia), Aegon Asset Management’s specialist teams provide high-quality investment solutions across asset classes. Its clients benefit from the extensive international research capabilities and in-depth local knowledge of Aegon Asset Management as well as Kames Capital, its UK investment team, and TKP Investments, its fiduciary management investment team in the Netherlands.

Through the Aegon Group our heritage stretches back to 1844, meaning we understand the importance of long-term relationships, robust risk management and sustainable outperformance. A long and successful history of partnership with our proprietary insurance accounts has enabled us to establish experienced investment teams, a solid asset base and proven long-term track records.

For more information, visit www.aegonassetmanagement.com

Aegon Investment Management B.V. is registered with the Netherlands Authority for the Financial Markets as a licensed fund management company. On the basis of its fund management license Aegon Investment Management B.V. is also authorised to provide individual portfolio management and advisory services.

The content of this document is for information purposes only and should not be considered as a commercial offer, business proposal or recommendation to perform investments in securities, funds or other products. All prices, market indications or financial data are for illustration purposes only. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon Asset Management investment strategies.

Please note that performance figures are simulated. Simulated future performance is based on current and historical beliefs and therefore the simulated performance may differ from actual results.

Although this information is composed with great care and although we always strive to ensure accuracy, completeness and correctness of the information, imperfections due to human errors may occur, as a result of which presented data and calculations may differ.

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