Over half of sovereign wealth funds now have a top down policy as ESG spreads to fixed income

A major global study has found ESG adoption is rapidly gaining traction among sovereign investors and Central Banks. The Invesco Global Sovereign Asset Management Study, which surveyed 139 individual sovereign investors and Central Bank reserve managers, showed nearly two thirds (60 per cent) of sovereigns now incorporate a top-down ESG policy – up from 46 per cent in 2017.

ESG is also increasingly a preoccupation of Central Banks, with 20 per cent now incorporating a policy, up from 11 per cent in 2017.
 
While equities have been the initial starting point for ESG implementation, this year’s study found of the sovereign wealth funds that incorporate ESG at the asset class level, 65 per cent are now applying ESG considerations into their fixed income portfolios.

The findings highlight a marked evolution in terms of both uptake and sophistication of ESG policies.  In 2017, the study highlighted the polarisation between sovereigns with regards to ESG, with supporters moving to further embed and integrate ESG in investment processes while non-supporters waited for evidence on investment implications. Two years on, ESG for many is now front of mind, with supporters becoming more focused in their approach, adding dedicated teams and deepening the integration of ESG into their investment processes. ESG implementation remains most prevalent among Sovereigns in the West (76 per cent) but it is now also common in the Middle East (67 per cent) and Asia (59 per cent) following an increase in adoption.
 
The absence of quality ESG data remains a key issue, with 52 per cent of sovereigns citing quality data and ratings as the main challenge in incorporating ESG. This issue is compounded when extending ESG principles to fixed income, for example the difficulties applying an engagement approach as a debtholder when many issuers are governments. (Figure 4)
 
Green bonds are seen as an easier way of taking ESG considerations into fixed income by both sovereigns and central banks. Though only 20 per cent of central banks have a formal ESG policy many believe they have an obligation to include ESG in their investment process and invest in green bonds as a result.  These provide an opportunity for yield enhancement within the government and multi-lateral bond sector, making it a natural extension for Central Banks. Nearly one third (28 per cent) of Central Banks and nearly half (45 per cent) of sovereigns are currently invested in green bonds. However green bonds have their own problems, in particular lack of supply and liquidity which inhibit large exposures. (Figure 5)
 
A major trend highlighted by the 2019 study is the shift in focus toward “E” environment initiatives. Asset owners have, in the past, focused on “G” governance factors such as board composition and the ability to flag controversies. These are now relatively easier to measure and monitor. Sovereigns in particular, are now looking to environmental concerns, with “climate change/carbon emissions” the single most important ESG issue.
 
Sovereigns are approaching environmental factors with an increased level of sophistication compared to 2017. The perceived increased frequency of physical climate risks such as hurricanes, heatwaves, earthquakes, and wildfires has precipitated some to pinpoint the risks of such events to assets such as infrastructure. These risks are now also being considered for assets located in emerging markets, which until recently was considered near impossible by many given a lack of information and transparency. 
 
This leaves “S” social factors as the main remaining barrier requiring definition and measurement.  While some ESG leaders think of “S” as the risk of loss of social licence, for most sovereigns’ social factors have yet to become a practicable means of evaluating risk/return.
 
Alex Millar (pictured), Head of EMEA Institutional Distribution Sales, Invesco, says: “Our authoritative annual study of global sovereign asset managers shows that ESG policies continue to gain traction among sovereign investors and central banks. The fact that over half of all sovereign managers now incorporate official ESG policies reflects advancements in investors’ understanding of how to derive value from their application.
 
As the adoption of such policies in the construction of portfolios continues to develop, we expect to see application spread across asset classes. This year’s study shows this process is already beginning to take place, with sophisticated adopters moving beyond equities into fixed income, and even, in some cases, real estate and infrastructure.
 
Another striking trend is the dominance of environmental concerns over governance and social. While there are many contributing factors to this rise, it is a clear and heartening signal that governments and investors are beginning to take environmental concerns – and particularly climate change – very seriously.  Sovereigns’ and central banks’ commitment to investing responsibly is clearly deepening. As an industry, we should be working hard to support institutions in their desire to incorporate ESG by offering enough investment products to meet the demand.