Sylvain Château is the Co-founder and COO of Beyond Ratings. Château started his career in strategy consulting at Booz Allen Hamilton and Roland Berger, and rapidly moved to the world of entrepreneurship. He developed Enerdata, a leading international provider of energy data and modeling for over 180 countries, for 10 years, as the CEO and major shareholder. He accompanied the management transition when the company was acquired.
Christopher P. Skroupa: Can ESG practices be used in sovereign investment performance assessment?
Sylvain Château: Investors in Brazilian sovereign debt would probably have liked to anticipate the huge turmoil caused by the corruption affair that involved Petrobras and the political family backed in 2014.
Brazilian Credit Default Swaps (CDS) boomed in parallel with this unprecedented corruption affair. If links had been more directly made between political governance loopholes and the performance of Brazilian bonds, investors could have anticipated this CDS surge.
Skroupa: Why is this link between financial and extra-financial Environment, Social and Governance (ESG) analysis not more systematically made if there is additional information to leverage?
Château: The ESG assessment has been initially designed to develop ethical or conviction investment. New factors have been considered to lead these analyses, which were not included in the classic financial analysis. At country level, there are hundreds of these factors that are publicly available. They are mostly used to exclude least virtuous countries – i.e. those still applying the death penalty – and more generally to help investors align their investment decisions with convictions or ethical issues. As a result, these ESG factors are often not primary concerns on a financial materiality level. However, there are striking examples which demonstrate how the risk signals embedded in ESG factors could have been very helpful to consider when investing in sovereign bonds.
Skroupa: How can these links between financial and extra-financial analysis be created? How can the connection between political governance loopholes in Brazil with the CDS evolution be made? What about trying to connect the dots to provide an augmented financial analysis that leverages ESG factors?
Château: At Beyond Ratings, we have developed a new methodology to assess the materiality of ESG factors. The objective is to better discriminate sovereign risks & performance among 170 countries, leveraging the right ESG indicators. Starting from 300 ESG indicators, we use statistical models to simulate the historical correlation of these factors with the evolution of countries’ GDP. It allows us to identify which criteria has an impact, and what is the optimal weighting of these factors to best correlate with the GDP evolution. We then calculate a sustainable GDP by country, that represents an adjustment of the reported GDP to account for the country’s ability to generate a level of ESG performance relatively to countries with a similar level of economic development. For the upper-middle income group of countries, the sustainable GDP adjustment proves to vary significantly among countries (-10% to +25%).
This ESG performance assessment is also available on a more granular level, on the E, S or G pillar, and for 12 categories by pillar.
Skroupa: How Does this ESG material assessment compare with financial risk assessment?
Château: A key outcome of this methodology is to identify specific ESG criteria that do have a material impact for a given level of development expressed in GDP/capita. The relevant ESG factors of advanced economies – i.e., Organisation for Economic Co-operation and Development countries – are very different from those in a less advanced country. For an investor, it allows them to determine which criteria are likely to contribute to the future development of a country. On a risk perspective, the integration of ESG factors contribute to better discriminate countries on the quality of sovereign debt. The following figure compares our sovereign risk score augmented with E factors vs. the average rating of the 3 majors credit rating agencies. Our risk score is more correlated to the 5 years CDS, especially when considering the emerging countries. The Beyond Ratings score largely anticipates the rating evolution of CRAs.
Skroupa: Can you describe how ESG factors can lead to increased sovereign investment performance?
Château: If we compare Brazil and South Africa on their E performance, we observe significant differences. The calculated Environmental Sustainable GDP of Brazil and South Africa are respectively +16% and -12% vs. their reported GDP. While these 2 countries have similar level of GDP / capita, both countries belong to the upper-middle income group, they are facing very diverse patterns on their environmental issues. The following figures describes these differences.
South Africa suffers from a water scarcity issue. The recent drought that occurred in Austral Africa reflects this weakness, with an expected pressure on the South African GDP this year. For an investor, these differences can be used to better track risk signals and anticipate their impacts on market metrics. And potentially modify the weighting of sovereign bonds portfolios.
Skroupa: Are the sovereign-related ESG factors an explanation factor of the performance?
Château: This new methodology of ESG materiality assessment allows us to broaden the spectrum of risks that can impact the economic performance of countries. It highlights which ESG criteria do have a material impact, and demonstrate the historical correlation of these factors with the economic growth. But we do not pretend to demonstrate a causality factor of investment performance. The GDP/capital of the USA is 50% higher than Italy’s, but the life expectancy of women is 5 years lower: life expectancy is not a cause of the difference of GDP/capita! But It provides new insights on top of a fundamental economic & financial analysis. Selected ESG factors can be used as advanced signals of asymmetry that can transform into higher or lower growth potential, and creditworthiness. By highlighting new correlation factors that are not integrated by the market, we provide investors an edge.
Skroupa: Does ESG material assessment of sovereign asset class include nonlinear extreme risks?
Château: The overall performance of sovereign bonds depends on many criteria. Among them, some risks are nonlinear and can have dramatic impact on the future GDP growth, such as stranded assets, extreme climate events, or carbon taxes. Consider carbon border taxes. In France, the carbon intensity of locally emitted CO2 amounts to 6 tCO2e/capita. But if we reintegrate the carbon content of all goods imported to France, this carbon intensity becomes more than 10 tCO2e/capita. If a carbon border tax is decided and implemented with a high carbon price, the cost structure of many business sectors will be impacted, both in France and in its trade partners, resulting in business adjustments. Knowing the level of exposure of these economies to this carbon risk can help anticipate the impacts of such a new carbon tax on the performance of an investor’s assets. Climate risks, with singular extreme events, can also have potentially huge impacts on the value chain of several business sectors. The recent massive floods in Texas will have a significant impact on the GDP of the USA this year. The time horizon of the materiality of these risks remains a debated issue, with a degree of uncertainty on when these non-linear risks can impact investments’ performance, and to what magnitude. In the case of Texas floods, the impact is definitely short term.
Skroupa: How do investors determine the best countries to invest in while keeping ESG in mind?
Château: Our objective is to disclose potential risks that are not yet visible on investors’ radar when they take an investment decision, and seize a related investment opportunity. By integrating new risk signals from ESG factors, investors can modify their allocation to better match with their investment strategy, and diversify their universe to new countries that present interesting risk/yield profile. This material approach of ESG is not exclusive from the historical practices of ESG assessment, more orientated towards the ethical or conviction aspects. At Beyond Ratings, we believe that we participate in the next phase of financial risk assessment, leveraging the untapped information signals of ESG factors. More and more investors are integrating these ESG factors when they identify a correlation factor with financial metrics. Not necessarily because they are responsible investors. But because they found a meaningful signal that optimizes their performance.