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Upward trend in euro area ESG scores is stalling

27-09-2016 | Olaf Penninga, Rikkert Scholten

After years of widespread improvements, the ESG scores of euro area countries have started to show a more mixed picture. This can be concluded from the latest update of the RobecoSAM Country Sustainability Ranking. The information obtained from the ranking is used in investment decisions for the Euro Government Bonds fund.

Speed read:
  • Sustainability differences between countries are growing
  • Reduced positions in periphery as ESG flashes warning signs
  • ESG analysis is an integral part of the investment process

RobecoSAM’s Country Sustainability Ranking evaluates 62 countries – 22 developed and 40 emerging markets – on a broad range of Environmental, Social and Governance factors that we consider to be material to the countries’ bond market performance.

The Country Sustainability Ranking summarizes a country’s ESG profile with a 1-10 score, in which 10 represents the best possible outcome. The table shows the results for the euro area countries. While in theory it is possible to reach a score of 10, in reality top-ranked countries like Sweden and Switzerland reach a score of around 8. For most EMU countries the scores are scattered around 7. This is around the average for developed countries. The euro periphery countries have a somewhat weaker ESG profile. Still, among the EMU countries Greece (5.4) is the only country with a score below 6. Countries like Poland or Hungary do better than Greece.

esg-scores-emu-countries.jpg
Source: RobecoSAM Country Sustainability Ranking, April 2016

Changes in scores are an important signal

Changes in the scores are useful signals to spot opportunities and to avoid risks.  Rising scores help us to early identify countries’ efforts for improvement in the fields of E, S and G. The results of these efforts may only be visible after some time has passed. After all, reforms require time and often hurt vested interests before bearing fruit. From an investment viewpoint we believe that opportunities exist where improvements are being made. By investing in these countries instead of avoiding them, we acknowledge the reform efforts and can profit from the resulting upside potential in the bonds. Waiting until the improvements have lifted the country to the level where it is ‘best in class’ would mean that most of the good news is already priced in.

Improvements in scores are more valuable for us when coming from a low starting point. Government bonds of lower scoring countries are often perceived to have ‘credit risk’ and this risk will influence their price. For highly scoring countries this credit risk is often perceived to be absent. This suggests a strong ESG profile is a safe haven characteristic in times of unrest, next to ‘traditional’ aspects such as low government debt and solid current account.

Alarm bells

Recently, differences between countries have been growing again and the trend of improvement has stalled for some countries. For countries with a lower score a stagnation in improvement can already ring alarm bells. Spain is an example of such a country. In contrast to Ireland, or Italy, the Spanish ESG score has not improved in the past years. A score of 6.2 is not dramatic, but it does raise questions on the reasons for the lack of improvement.

The details of the Spanish score show that especially in corruption, rule of law and political risk the Spanish profile has deteriorated in recent years. Events which have led to this decline in score are the Barcenas corruption scandal which directly involved the leadership and financing of the Partido Popular, the rise of anti-establishment party Podemos and the growing Catalunya independence movement. Finally, almost a year after the initial election, Spain is still not able to form a government with a clear majority. All of these developments have had direct implications for the stability of the country and for the ability to implement reforms which are needed to secure the longer term debt profile.

Greece is another example where the lack of convincing improvement in the score is alarming. Greece scores lower on aspects such as stability and accountability of the government. More than five years after the start of the crisis, Greece still shows hardly any improvements in these areas. For example, the tumultuous start of the Syriza-led government has caused significant unrest in Greece, although the lack of support for previous governments was also a source of instability. In addition the country has to face the difficult task of providing support to a large number of refugees, which has increased social tensions.

Periphery underweight works out well in the run-up to Brexit

In our recent positioning we have taken the lack of progress in the ESG profiles of most euro periphery countries into account. Since May 2015 we have reduced our overall allocation to periphery bonds in the fund. The rising political risks in Spain contributed to our decisions to underweight Spain in the autumn of 2015. In the second quarter of 2016 we reduced the investments in periphery bonds further. The fund benefited from this position when spreads widened in the run-up to the Brexit referendum.

An exception is Ireland, a prime example of a country for which the ESG profile has improved. Areas of improvement are among others: quality of bureaucracy, trust in the legal system, public support for the government and CO2 emissions. The broad based improvement has brought the ESG score to a level above that of a country like Germany. This was part of the investment thesis to increase positions in Ireland in spite of other risks like lower liquidity in this smaller market. During 2015 and in the first months of 2016 we maintained relatively large investments in Irish government bonds. We only recently reduced holdings after significant spread tightening.

Figure 1. Ireland ESG scores, spread and credit rating

ireland-esg-scores.jpg
Source: Robeco, Bloomberg

Conclusion

ESG analysis is an integral part of the investment process in the Euro Government Bonds strategy. After a period of broad based improvement, the ESG scores are starting to diverge again. Indeed many of the factors that are currently driving spreads in euro government bond markets have links with ESG characteristics , such as social unrest in many countries. For us it is clear that ESG risks matter.

Measuring Country Intangibles, June 2015, available on the RobecoSAM website

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