Powering sub-sovereign investors with greater ESG disclosure
ESG data accessibility has become increasingly important for bond investors in the sub-sovereign space. Like other investments, provincial and municipal issuers are met with ESG opportunities and risks that need to be identified through proper analysis. But shortcomings related to ESG disclosure across Canada have made it harder to accurately screen sub-sovereigns. With data either undisclosed or loosely scattered across multiple sources, ESG oversight has become overly complex and ambiguous. To help bridge the gap, we’ve put together our own ESG framework for assessing provincial and municipal issuers in Canada.
The opportunity in the sub-sovereign market
The sheer size of Canada’s sub-sovereign bond market is a testament to its importance on the world stage. Home to nearly 40% of Canada’s population, Ontario alone has a net debt of $407.2 billion,1 making it the world’s largest sub-sovereign borrower. Add to this the important role Canadian sub-sovereigns play in investment portfolios and the need for investors to address ESG data limitations becomes even more apparent. Nonetheless, it’s worth talking about some of the nuances associated with sub-sovereign engagement.
Traditionally, ESG-focused bond investors would want the corporate issuers in their portfolios to improve their environmental, social, and governance practices. We’re looking for something similar and are calling for improvements in overall ESG performance and disclosure from sub-sovereign issuers across the country. After all, disclosure may help ward off uncertainty about risks and could be beneficial for the investing public at large.
Furthermore, it may be advantageous for governments when positioning themselves as leaders in ESG performance and transparency. But while there’s no disputing the fact that more clarity generally leads to better-informed investment decisions, why should enhancing ESG disclosure be a priority for governments?
Sub-sovereigns are on the front line of ESG issues
With weather-related shocks on the rise, as well as low-carbon transition commitments and policies looming that will fundamentally change the way people live, work, and move around cities, sub-sovereigns are on the front line of very real challenges. It’s for this reason that investors are adopting climate risk considerations in the management of their portfolios. Sub-sovereign issuers should be cognizant of this and make sure they’re providing the data and information that help investors understand the risks and opportunities they face.
Accordingly, a real opportunity exists for governments at the municipal and provincial levels in Canada to support strong and consistent ESG reporting, to raise the performance bar, communicate successes to different stakeholder audiences, and provide clarity for investors.
Enhanced disclosure, coupled with the execution of a sound ESG strategy, can help governments capitalize on direct investment opportunities. Ontario, for instance, issued its first green bond in 2014, and has since then become the largest issuer of Canadian dollar green bonds. Having allocated proceeds from these issues to projects centered around transportation, energy efficiency and conservation, and climate adaptation and resilience, Ontario has capitalized on raising funds at low interest rates and benefitted from green fund flows that have promoted direct investments in environmentally friendly projects.2
Sub-sovereigns stand to benefit from lower borrowing costs
Building climate-resilient infrastructure, investing in community enhancement programs, addressing natural disasters, and setting local regulatory frameworks that incentivize clean energy are just some of the ways governments are tackling ESG issues. As an investor, the goal is to hear what governments have to say about important issues impacting their jurisdictions and get a sense of what they’re doing to mitigate risks and spur positive change.
Governments that are performing well from an ESG standpoint but underreporting their efforts could potentially become global issuers of choice for green or social capital and benefit from lower borrowing costs, if they improve their reporting of sustainability expertise and how they’re putting that expertise into practice. Better ESG scores for sub-sovereigns indicate a stronger positioning to deal with the risks that are likely to emerge with respect to climate change, climate transition, and social and governance factors.
By upping the bar on ESG, governments may also benefit from potential improvements to their credit ratings and lower borrowing costs. Research for sovereigns has demonstrated that improved ESG performance leads to lower sovereign costs of borrowing and some of the same factors might also apply to sub-sovereigns.3
The understanding of how ESG issues are material for sub-sovereigns has been rapidly evolving and gaining a foothold in investment analysis. While backward-looking data may understate the degree of materiality, issuers with better ESG performance tend to be considered to have lower default risks due to their better risk management and long-term investment plans, which would make them better prepared to deal with material ESG issues in the future.
Addressing the stumbling blocks in the rating of sub-sovereigns
Data related to sub-sovereigns are, for the most part, backward looking and subject to improvements. However, even with the current data at our disposal, we were able to create our own proprietary framework and get a good idea of the ESG risks and opportunities associated with provincial and municipal issuers in the Canadian fixed-income market.
Step 1: Identification of financially material ESG issues
We identified some of the most material ESG issues based on the work done by the PRI Sub-Sovereign Debt Advisory Committee working group. Below are the main ESG factors considered in our analysis of provinces and municipalities:
· environmental – climate change, air quality, water resources, waste management, energy efficiency, biodiversity
· social – participation and activism, inequality and affordability, health and safety, education, and human capital
· governance – transparency of data, government structures, IT, and digital infrastructure
Step 2: Creation of a qualitative ESG rating structure
Inspired by the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) framework, we created a qualitative ESG rating structure that’s focused on four main pillars: governance, strategy, risk management, and metrics and targets.
Qualitative ESG assessment framework for sub-sovereign issuers
Pillar |
Qualitative indicator |
Governance |
|
Strategy |
|
Risk management |
|
Metrics and targets |
|
Step 3: Creation of a quantitative analysis framework
We also created a quantitative analysis framework based on the most relevant primary ESG data manually collected by our sustainable investment team. Not only did this exercise allow us to capture the actual performance of each issuer based on their most recent disclosures, but we were also able to assess the positive or negative momentum for each issuer over a four-year time period.
Highlighting some metrics used in the assessment of provincial issuers
The gathering of ESG criteria to conduct ESG rating assessments
Step 4: Assigning proprietary ESG scores to each sub-sovereign issuer
The fourth step consisted of assigning ESG scores to each sub-sovereign issuer based on the data collected and our methodology (step 2 and 3). This paves the way for apple-to-apple comparisons from province to province and municipality to municipality.
Comparing and contrasting ESG scores
Comparisons across provinces and municipalities
Environmental factors
|
Province A |
Province B |
Average
|
Climate risk – Manulife Investment Management score |
4 |
1.25 |
2.92 |
Absolute GHG emissions (MT C02e) – change (%) between 2005-2020 |
–7.60% |
+ 8.2 |
–13.80% |
GHG emissions intensity (MT C02e) of GDP (chained dollars 2012) – change (%) between 2005–2020 |
–63.8% |
–25.8% |
–40.9% |
GHG emissions intensity (MT C02e) per capita – change (%) between 2005–2020 |
–18.0% |
–10.6% |
–9.8% |
Social factors
|
Province C |
Province D |
Average (out of seven provinces) |
Inequality and affordability – Manulife Investment Management score |
3.0 |
1.75 |
2.25 |
Unemployment rate – December 2022 |
4.00% |
3.70% |
5.20% |
Unemployment rate – change (%) between 2019–2022 |
–0.80% |
–0.70% |
–0.73% |
Average income – 2020 |
$48,400 |
$51,900 |
$49,988 |
Average income – change (%) between 2017–2020 |
8.80% |
6.80% |
3.80% |
Average rent – October 2022 |
$952 |
$1,530 |
$1,220 |
Average rent – change (%) between 2019–2022 |
19.00% |
15.00% |
15.30% |
Average home price – 2022 |
$512,000 |
$1,105,400 |
$572,025 |
Average home price – change (%) between 2019–2022 |
42.30% |
40.80% |
36.50% |
Governance factors
Municipality A |
Municipality B |
Average (out of four municipalities) |
|
IT and digital infrastructure – Manulife Investment Management score |
2.5 |
1.75 |
1.17 |
Number of cybercrime incidents – change (%) between 2017–2020 |
89.84% |
339.57% |
167.89% |
Cybercrime incidents rate (per 100,000 population) |
88.24% |
308.10% |
153.32% |
Source: Manulife Investment Management. For illustrative purposes only.
Insights drawn from our ESG framework
Below are two case studies that highlight the additional information uncovered in our evaluation of provincial and municipal bonds.
Case studies: analysis of provincial bonds
We uncovered nuances between two provincial issuers on their climate risk management, which couldn’t have been discovered using commercially available ESG scores. This analysis also provided further support for our view on relative credit risk between the two provinces and helped inform decisions on relative value. In our view, climate-related transition and physical risks can have tremendous impacts due to disruption in tax revenues and potential increased costs related to the repair of infrastructure and emergency responses.
Service provider ESG ratings for provinces A and B – assessment of climate risks
Province A
- Service provider, ESG rating: AA
- ESG service provider environment, score: 6.9
Findings from Manulife Investment Management analysis
Province A (climate risk score: 4/4)
- Climate strategy in place since 2017, with annual reporting on their 25 climate measures
- Evidence of great progress on their 25 climate measures through transparent disclosure on an annual basis, which also includes consideration on the resilience of communities against the risks of flood, drought, and wildfires
- Despite a 2% population growth between 2017–2020, the province was able to decrease its GHG emissions by 16.46%.
- Decrease of its GHG emissions by 7.6% between 2005–2020.
Service provider ESG ratings for provinces A and B – assessment of climate risks
Province B
- Service provider, ESG rating: AA
- ESG service provider environment, score: 7.05
Findings from Manulife Investment Management analysis
Province B (climate risk score: 1.25/4)
- Introduction of a climate plan in 2015, but lack of disclosure and transparency after 2018
- Existence of policies and strategies in place, but no clear long-term roadmap
- Lack of relevant up-to-date data metrics and risk management process in place related to strategies and targets in place, making the credibility of those hard to assess
- Increase of its GHG emissions by 8.2% between 2005-2020, making it the worst province in Canada in terms of improvement
- While the province recognizes the risks related to frequent droughts, floods and forest fires, there’s no clear action plan to address those issues.
We also uncovered nuances between two provincial issuers on their risks related to inequality and affordability. In our view, growing inequality may have several adverse impacts on tax revenues and expenses for a province or a municipality. Within Canada, there’s evidence of inter-provincial migration from high cost of living (COL) provinces to lower COL provinces, which has an impact on population growth. As well, there’s a potentially larger demand on social services, and the capacity of a province to provide services such as healthcare and education, when affordability concerns are exacerbated. For example, teachers and healthcare workers living in cities and provinces with higher real estate and rental costs may move to other provinces or ask for higher wages to compensate for the higher COL.
Service provider ESG ratings for provinces C and D – assessment of inequality and affordability
Province C
- Service provider, ESG rating: AA
- ESG service provider social score: 6.4
Findings from Manulife Investment Management
Province C (inequality and affordability score: 3.0/4)
- Existence of a government action plan for economic and social inclusion, with 20 key action items for a total of $3 billion in investments
- Clear explanation of the financial and societal impact of the measures implemented to combat inequalities in the action plan, linked to a specific budget allocation
- Difficult to assess current progress, as the last full government publication on these topics was in 2020
- Current comparable data still provides some confidence in the measures implemented to address inequality and affordability.
Service provider ESG ratings for provinces C and D – assessment of inequality and affordability
Province D
- Service provider, ESG rating: AA
- ESG service provider social score: 6.3
Findings from Manulife Investment Management analysis
Province D (inequality and affordability score: 1.75/4)
- Existence of a government action plan on accessibility focusing on five priorities
- Publication of an annual report (2021–22), which provides reassurance that the government is monitoring progress. However, the annual report is pretty light in content, not providing tangible metrics for reassurance on the progress towards the five objectives.
- We couldn’t find specific metrics and data disclosed by the government in the annual report.
- Data collected via other sources show some concerns on inequality and affordability for the province.
Case study: analysis of municipal bonds
Cybercrime, an emerging threat, poses an increased level of risk, especially when conducted by state-funded entities looking to target other state infrastructure and systems. As a result, the main factors we look for on the IT and digital infrastructure front are investments in cyber security, ransomware protection, and policies that prevent, mitigate, assess, and respond to cyber security incidents. Assessing a municipality’s cyber security performance is challenging due to the lack of disclosure. However, we use the number of cybercrimes as an indicator to assess the magnitude of the risk.
Service provider ESG ratings for provinces E and F – IT and digital infrastructure assessment
Municipality A
- Not covered by ESG data service provider
Based on Manulife Investment Management analysis
Municipality A
(IT and digital infrastructure score: 2.5/4)
- Launch of a digital data charter in October 2020, which is intended as a governance framework to establish ethical criteria for the collection, management, and use of digital data by the various departments and districts of the municipality
- More specifically on cyber security, the municipality will be implementing controls to reinforce the security of personal data as well as renew internal knowledge information security, including the means of investigation following a breach in their defenses. The municipality is also committed to following best practices to make sure of the resiliency of information systems and critical infrastructure.
- The number of cyber security incidents has increased by 89.84% between 2017–2020.
Service provider ESG ratings for provinces E and F – IT and digital infrastructure assessment
Municipality B
- Not covered by ESG data service provider
Findings from Manulife Investment Management analysis
Municipality B
(IT and digital infrastructure score: 1.75/4)
- The municipality has a cyber security program to enable vulnerability assessment and penetration testing, which is composed of three core streams of activity: (1) Cyber Security Maturity Assessment, (2) Managed Security Services, and (3) Cyber Security Awareness and Training.
- While we welcomed the program on cyber security, the number of cyber security incidents has increased by 339% between 2017–2020.
Looking ahead
ESG issues are material for sub-sovereign bond issuers, and because more clarity generally leads to better-informed investment decisions, we’re calling for improvements in ESG disclosure. While we were able to make some progress internally by building our own framework, challenges in assessing sub-sovereign issuers remain:
- ESG matters could be material for one municipality or province and immaterial for others. Direct comparability of ESG factors, as a result, becomes challenging and inconsistent.
- ESG information isn’t reported with the same level of vigor as often seen in the private sector, where standards of practice are more mature. This can create a disclosure bias, where more disclosure is mistaken for better ESG performance.
- Self-reported ESG information is typically backward looking and disclosed annually. This creates a notable time lag, impacting the accuracy of any ESG assessment.
Partnering with municipal and provincial governments, rating agencies, and other investors to encourage more ESG disclosure for important stakeholders is critical to help promote positive change and support better investment decisions. It’s also in line with our fiduciary duty to our clients as an asset manager, as we seek outcomes that improve portfolio resiliency. This partnership has already started in 2022 and we intend to continue our efforts in 2023.
Going forward, we’ll also continue to refine our approach of integrating ESG information into our credit valuation of provincial and municipal issues, including weighing the impact of ESG issues on budgets and balance sheets and considering applications of ESG notching guidelines related to sub-sovereign issuers. After all, global systemic risks such as climate change and inequity pose a threat to our societies and the economy, and the time to invest with these considerations in mind is now.
1 Municipal Ratings Snapshot, National Bank of Canada, Financial Markets, January 2023 2 Province of Ontario Green Bonds, Ontario Financing Authority 3 Sovereign bond yield spreads and sustainability: An empirical analysis of OECD countries
Any ESG-related case studies shown here are for illustrative purposes only, do not represent all of the investments made, sold, or recommended for client accounts, and should not be considered an indication of the ESG integration, performance, or characteristics of any current or future Manulife Investment Management product or investment strategy.
MIM conducts ESG engagements with issuers but does not engage on all issues, or with all issuers, in our portfolios. We also frequently conduct collaborative engagements in which we do not set the terms of engagement but lend our support in order to achieve a desired outcome. Where we own and operate physical assets, we seek to weave sustainability into our operational strategies and execution. The relevant case studies shown are illustrative of different types of engagements across our in-house investment teams, asset classes and geographies in which we operate. While we conduct outcome-based engagements to enhance long term-financial value for our clients, we recognize that our engagements may not necessarily result in outcomes which are significant or quantifiable. In addition, we acknowledge that any observed outcomes may be attributable to factors and influences independent of our engagement activities.
We consider that the integration of sustainability risks in the decision-making process is an important element in determining long-term performance outcomes and is an effective risk mitigation technique. Our approach to sustainability provides a flexible framework that supports implementation across different asset classes and investment teams. While we believe that sustainable investing will lead to better long-term investment outcomes, there is no guarantee that sustainable investing will ensure better returns in the longer term. In particular, by limiting the range of investable assets through the exclusionary framework, positive screening and thematic investment, we may forego the opportunity to invest in an investment which we otherwise believe likely to outperform over time. Please see our ESG policies for details.
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