Taking ESG into account for sovereign valuation metrics


The full research briefing is available below (PDF format). Media may reproduce our charts with attribution to Oxford Economics.

Key points:

Considering ESG as an input for portfolio investment in conjunction with typical valuation metrics reshuffles allocations relative to the benchmark index. Despite attractive spreads, ESG sensitive asset managers should be underweight bonds from Pakistan, Mozambique, Angola, and Egypt. Meanwhile, they should favour more expensive sovereigns, such as Costa Rica, Uruguay, and Jamaica.

We construct ESG-adjusted valuations for different types of investors: investors that ignore ESG in allocation decisions (ESG irrelevant), those that are relatively sensitive but still mainly based on traditional valuation metrics (ESG relevant), and those highly driven by it (ESG-critical).

We estimate the fair value of spreads using a panel model of our Sovereign Risk Tool (SRT). Next, we calibrate the adjusted valuations such that ESG sensitive investors are willing to pay, on average, 35bps (ESG-relevant) or 100bps (ESG-critical) more in spreads for better performance.

Latin America and Central and Eastern Europe’s valuations improve when adding ESG scores, as they outperform in the environmental and social components. However, Africa and the Middle East are penalised for higher climate risk and fewer civil liberties.

A widely recognised challenge for ESG metrics in the literature is that they suffer from a strong wealth bias, meaning that funding flows could deprive those most in need. To mitigate this, our base model controls for PPP-adjusted GDP per capita and GDP adjusted ESG indicators where available. Still, our results generally suggest investors should focus on wealthier economies.

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