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The financial crisis that erupted in 2008 underlined the need to look beyond credit ratings and the classic set of fundamental data and prompted us to develop an analysis process for sustainability on a country level.
The result of this process is our Country Sustainability Ranking (CSR), which we have already been compiling, calculating and analyzing for a couple of years now. The primary aim of these scores is to provide useful information which contributes to better investment decisions. We can now confirm that the use of RobecoSAM’s CSR has enriched our investment process. In a series of research notes we plan to describe a range of aspects that we have encountered in developing our scores and that we hope will help the reader incorporate country sustainability information into their investment process.
What is the Country Sustainability Ranking?
It is a ranking of countries, based on their sustainability scores. These scores are established using our own selection of data on environmental, social and governance characteristics for each country. The Country Sustainability Ranking is an addition to our corporate rankings and captures information on sovereign risk and opportunities. The ranking is an instrument to enhance disciplined and timely discussions on country risks and to help make well-informed decisions.
Proprietary bottom-up approach
The word sustainable has becoming increasingly popular over the last few years, but what does sustainability mean? The concept of sustainability was popularized in the Brundtland report of the United Nations in 1987. This report defines “sustainable development” in the following way:
„Sustainable development meets the needs of the present without compromising the ability of future generations to meet their own needs.”
The term “needs” here allows for a broad interpretation, which we favor. Preserving the environment and promoting labor rights are part of this definition, but it does not end there. It also comprises governance characteristics such as avoiding situations where a government cannot implement necessary reforms because it is hampered by the vested interests of a small group, or is paralyzed by social tensions, preventing it from taking action. And it also means making sure that the costs of the aging population are not simply passed on to the next generation.
We decided to start with a new proprietary bottom-up approach, since this definition is not covered by off-the-shelf country Environmental Social Governance (ESG) data. Our process first focusses on sustainability data we think are relevant in an investment process, which we then use to construct a new, broader, framework from scratch.
The details of the dataset will be discussed in later papers, but below are a few remarks on the individual components.
CSR information leads to better-informed decisions
The score alone does not form the basis of an investment decision, but is rather a source of information that helps to distinguish risks and opportunities without being solely dependent on the data provided by rating agencies. We would always recommend using this information in conjunction with other relevant data to make investment decisions. Examples being expected changes in the economic cycle, credit risk and credit-risk expectations, and equity and bond valuations that are priced in by the market.
Analyzing score ranking updates is the starting point of our discussion on the credit profiles of individual countries. Changes in scores lead to discussions on the underlying developments and these enrich our knowledge of the countries in which we invest. This is the most valuable aspect for us. A weak score on the sustainability metric gives an indication of the additional risks involved when investing in a certain country. This might be a reason not to invest there, but it is also possible that other characteristics compensate for this risk, or that the market has already fully priced in additional risks via higher bond yields, or lower equity valuation, for instance. The importance of the sustainability profile and the conclusion for investment decisions will differ from case to case and from individual to individual. For us, the country sustainability scores are an instrument to enhance disciplined and timely discussions on country risks and to help make well-informed decisions.
Country Sustainability Ranking Q1 2013
Based on these data we have calculated scores per country. We can use these to compare countries and monitor their development over time. The resulting ranking (as per the end of 2012) is shown in the chart below.
We have compiled the ranking for 41 countries. An important factor for selecting countries is data availability. Another is the choice of a universe of countries which is more relevant from an investor perspective (generally the larger markets). Many components of our database already contain data on a much broader group of countries. Expanding the universe to a larger group will be the next step in our research.
The scores work in the following way: 10 is the best possible score and 1 the worst. As one can see, in practice the best country does not achieve a score of 10, because there are no countries that score 10 in all sub-indicators. And the worst country score is not as low as 1. If we expand the universe (as planned) to include new countries, this will probably enlarge the range of results.
Sweden and Switzerland score best, while the Philippines and Russia have the lowest ranking in our universe. Basically Sweden has very high scores across the board.
It scores well on social factors like: labor participation, education and income equality. The scores on governance factors like rule of law, corruption and quality of institutions are also very high. Sweden even scores reasonably well on environmental factors such as use of renewables and CO2 emissions, where many developed countries have weak scores. Within the emerging markets universe, a country like Mexico scores relatively well. In spite of the negative headlines, the country has high scores for social and political stability. This information helps to put headlines in the right context and identify investment opportunities.
Russia’s poor position in the overall ranking is primarily the result of its weak scores on a number of governance aspects. The worst examples are political rights, civil liberties, rule of law, regulatory quality, corruption perception and ageing. The social scores are stronger, but perhaps positively distorted by the very low number of strikes. Russia has very weak scores for environmental issues like CO2 emissions, waste management and implementation of environmental policy.
CSR in practice: The French case.
Here is an example based on Robeco’s experience. From the start of the EMU (European Monetary Union) until well into the early days of the euro crisis, French government bonds and German Bunds traded in a very close range. As late as mid-2011, French 10-year government bonds were still priced with a yield spread of only 20bps above their German counterparts, while France and Germany were both AAA-rated by all three major rating agencies at that time. However, the sustainability scores of the countries told a different story. Although France scored reasonably well on many factors, there were some worrying aspects, especially in the governance part of the profile. For instance, the implementation of necessary reforms to curb costs relating to an ageing population showed France lagging relative to other AAA countries. A combination of these types of examples showed a governance profile that was clearly weaker than that of other AAA countries like Germany, while this was not reflected in yield spreads. It took a year, but eventually there was a correction in French bonds to reflect this.
In January 2012, French 10-year bonds were priced at a spread of circa 150bps above German Bunds. At this point, the yield spread offered a sufficient premium for the additional credit risk and there was no longer a clear case to trim back investments in French government debt. This is an example of how we see the integration of sustainability analysis in investment management: weighing a well-informed risk assessment against the compensation offered for these risks.
CSR research notes to be released in 2013
There are many more details to discuss. In the coming months we will issue a series of research notes focused on this topic. The following notes are scheduled to be released in the coming year.