Editor’s note: this explainer by Nicholas Virzi is the first in a three-part series examining the implications of ESG factors with regards to national ratings and government policies. Read the second and third part of the series.
ESG is a framework used to assess the morally correct impact of an investment, whether it be in a company or a country. What is morally correct, however, is not universally agreed upon. That means some companies and countries find themselves presented in a negative light, even when their actions align with what they believe to be right.
ESG stands for the environmental, social, and governance factors that may impact the evaluation of an entity’s risk rating:
- Environmental: this focuses on how an entity performs as a steward of nature. This includes political considerations such as one’s climate-change policies, carbon footprint, energy usage, waste management, and resource conservation.
- Social: this also infers political considerations. Its key aspects include polemical issues such as labor practices, diversity and inclusion, human rights, and consumer protections.
- Governance: this includes issues like control of corruption, government efficiency, and government stability. Inherently political, this factor focuses on the system of practices, controls, and procedures used in the governance of an entity. These may impact the entity’s ability to make effective decisions, comply with extant laws, and meet the demands of stakeholders, as opposed to stockholders.
The Origins, Evolution of ESG
The following rating agencies incorporate ESG factors into their methodologies for calculating sovereign ratings, supposedly because ESG may impact fiscal performance and economic growth:
ESG springs from the concept of socially responsible investing (SRI) that emerged in the 1960s and 1970s. It pressured investors to incorporate touted political, social, and environmental factors into their investment decisions.
In 1997, the Global Reporting Initiative (GRI) was established, and thereafter developed widely used sustainability reporting standards to help organizations understand and communicate their ESG impacts. In 2000, the Carbon Disclosure Project (CDP) was founded to run a global disclosure system for investors to manage their environmental impacts.
Over the years, the United Nations has played a pivotal role in imposing ESG through initiatives like the UN Global Compact (2000) and the Principles for Responsible Investment (PRI) (2006). Further, the Sustainability Accounting Standards Board (SASB) was founded in 2011 to provide industry-specific standards for reporting on ESG factors deemed likely to affect evaluations of financial performance.
The ESG framework has gained significant traction over the past two decades. Regulators have increasingly pressured investors to accept the narrative of “sustainable and ethical business practices” and their supposed effect in driving long-term value and risk mitigation.
The ESG factors used by the country risk agencies to evaluate the overall profile of a country are supposed to provide investors with key insights into the financial viability of investing or operating in a particular country. ESG factors are incorporated into country risk evaluations in the following ways:
Environmental
- Climate change: assessing a country’s susceptibility to climate-change impacts, such as rising sea levels, extreme weather events, and temperature changes.
- Natural resources: evaluating how a country manages its natural resources, including water, minerals, forests, and biodiversity.
- Pollution: examining a country’s regulatory framework for controlling pollution of air, water, and soil.
- Renewable energy: analyzing the extent to which a country invests in and uses renewable energy sources.
Social
- Human rights: assessing the protection of human rights, including freedoms of expression, assembly, and movement, and a country’s stance on issues like child labor and forced labor.
- Health and education: evaluating the quality and accessibility of medical care and education systems, which impact workforce productivity and social stability.
- Labor practices: analyzing labor laws, working conditions, and employment practices, including diversity, equity, and inclusion, also known as DEI, another hot political issue.
- Social cohesion: the potential for social unrest or conflict to affect political stability and economic performance.
Governance
- Political stability: assessing the stability of the political environment, government effectiveness, and the risk of political violence or instability.
- Corruption levels: evaluating the prevalence of corruption and the effectiveness of anticorruption measures and institutions.
- Regulatory quality: analyzing the proficiency and predictability of the legal and regulatory environment, including property rights, contract enforcement, and business regulations.
- Transparency and accountability: assessing the disclosure of government operations and decision-making processes and the accountability mechanisms in place.
ESG Methodology
- Data collection: the agencies collect data from various sources, including international organizations (World Bank, IMF, United Nations, etc), NGOs, and proprietary data providers.
- Quantitative/qualitative analysis: ESG factors are both quantitatively measured (CO2 emissions, literacy rates, etc) and qualitatively assessed (governance quality, social cohesion, etc).
- Weighting and scoring: ESG factors are weighted and incorporated into the overall country-risk rating score. The weighting may vary based on the agency’s methodology and the specific context of the country being evaluated. This discretion opens the door for biases.
- Scenario prospecting: agencies often prospect different scenarios to model how different ESG-related events—such as natural disasters or political upheavals—could impact a country’s risk profile.
By incorporating ESG factors into country risk evaluations, rating agencies supposedly aim to provide a more comprehensive assessment of a country’s risk profile. The ostensible aim is to help investors make better-informed decisions.
On the surface, this all sounds well and good. The fact remains, however, that the premise behind the incorporation of ESG factors into country risk ratings remains controversial. To start, many countries with poor scores on each one of the ESG factors have seen their foreign investment soar in recent years. Further, the objectivity of the assignment of country ratings is subject to serious questioning.
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