Sovereign Risks and the Extra-financial Imperative

In this increasingly volatile global economy, corporate treasurers are looking to identify, manage and mitigate sovereign risks. However, depending solely upon rating agency sovereign risk ratings and analysis is often not sufficient for understanding the increasing complexity of extra-financial risk issues and how they can affect a company’s country risk for operations, financing, revenues and costs.

Treasurers need to go beyond the historical financial performance numbers available on past country performance, and examine the extra-financial issues that affect the company in the current and future marketplace and business environment. Typically, this analysis requires looking at a variety of non-traditional country risk issues, including environmental, social and governance (ESG) issues, natural hazards and climate change risks, and economic and demographic trends. Increasingly, they are also considering political, ethical and corruption issues as well.

Why are all of these important? It is because these issues can be financially material to a company’s projects or operations in a specific country. Furthermore, monitoring these issues is crucial to successful performance in a global economy where information travels at the speed of light and customers, stakeholders and shareholders are looking for responsible financial performance that produces reasonable returns at reasonable risks.

For too long, most asset managers regarded maximising the returns of investments as their fiduciary responsibility, and ignored the corresponding risks. While socially responsible investors have been among the forefront of those pushing for both returns and risks to be considered, increasingly mainstream investors are doing so as well. Treasurers have to understand how investors are integrating the real social and political costs of pollution, climate change, human rights and product stewardship into their financial analysis, and are looking for more information in financial reporting in profit and loss (P&L) and balance statements of companies that addresses these issues.

After financial disasters such as Long-term Capital Management, Enron, Tyco, Bear Stearns, Lehman Brothers, AIG and the sub-prime mortgage fiasco, mainstream investors are starting to realise the benefits of analysing both financial and extra-financial factors. This places the onus on treasurers to not only be aware of these issues, but also to incorporate them into traditional and emerging forms of financial filings, such as integrating reporting where annual company reports include both financial and extra-financial reporting.

A good example of the impacts of ESG issues on companies is an analysis that Maplecroft recently performed on comparing political and social risks in countries. When one plots the changes in political risk in countries versus the changes in social risks, an interesting pattern appears (see Figure 1). As countries improve their political freedoms and lower their political risks, there is often a corresponding increase in social benefits for society, and their economic performance improves as well. However, if you plot these changes over time (see Figure 2). It is evident that a number of countries (located in the oval area in Figure 1) in the past few years often had increasing social benefits, such as a more educated and IT-connected youth. However, at the same time the government was taking actions that actually increased political risks, leading to unrest, regime change, and economic difficulties as the country started to sink backwards rather than up the normal growth curve.

Figure 1: Political Risk Versus Social Risks

SocietalResilience_OppressiveRegimes

Source: Maplecroft

The shaded oval area indicates countries where, over time, relatively high social gains (an educated population and confident IT-literate youth) combine with oppressive governance to lead to a reduction in such gains and the risk of forced regime change.

Figure 2: Changes in Political and Social Risks

Social_Political_Credit

Source: Maplecroft

Figure 2 shows trajectories that specific Arab Spring countries and others have shown over time in terms of changing scores for political freedoms and societal risks. In most cases we see steady improvements in societal gains, relatively less in political freedoms, then a tipping point is reached and the economy trajectory then proceeds to go backwards/downhill, and the sovereign credit risk rating deteriorates, moving towards zero on both axes, particularly political risk.

Whether this situation improves or worsens depends on the extent of the government’s entrenched power and its willingness to use force, and the extent and pace of policy reform that a government is prepared to undertake. All these issues directly affect economic activity within that country, and treasurers should be watching and monitoring these political and social issues carefully to adjust their country risk management, mitigation and adaptation activities accordingly.

Another example is a recent study of the impact of ESG issues on the valuation of gold mining companies or projects published by researchers at the Wharton Business School1. Their research found that companies that understood and managed their ESG risks well within a country had a significantly lower market discount on the valuation of the gold that was in the ground, compared with mining companies/projects who manages those risks poorly.

The firms that were able to reduce conflict with their external stakeholders and win their co-operation improved their chances of implementing their business plan on budget and on time, and thus generated sustainable shareholder value. The firms with good ESG management had discounts as low as 12%, whereas the poorly-managed firms had up to a 72% discount in their valuation. Since the marketplace is recognising the impact of these issues on valuation, treasurers again need to act and respond accordingly. This could, perhaps, encourage better internal and external ESG management if their firm is in the bottom category of ESG risk management, and particularly if they operate in countries with high ESG risks.

A decade ago, socially responsible investing (SRI) investors were a minority, with a very small percentage of total assets under management, and their shareholder resolutions on extra-financial issues were lucky to get 2%-4% of shares voted at annual meetings. They tended to represent groups with specific moral values that guided their investment screening, which led them to exclude companies not meeting their values’ standards.

Increasingly, now both SRI and mainstream investors realise these extra-financial issues do directly affect the bottom line, revenues and costs of companies and projects, and are moving to ‘best-in-class’ investing, where companies are rewarded for recognising the opportunities and risks of ESG and other extra-financial issues and are downgraded for not managing these risks and opportunities. As a result, shareholder resolutions on ESG issues such as climate change and executive pay are now winning support from 40%-80% of shareholders, which indicates mainstream and SRI investors are in agreement on the financial importance of these issues.

Investment managers, driven by ultimate owners, such as pension funds, endowments and high-net worth individuals, are increasingly engaging with companies with high ESG risk profiles and low ESG risk management proficiency to change their ways before they become problematic investments, rather than just excluding them from a portfolio. Large asset managers, such as BlackRock, report that over 10% of the more than US$3 trillion of assets they manage have some sort of formal ESG screen now and many asset managers are informally incorporating ESG research into their investment analysis.

Conclusion

The hardest parts of extra-financial risk to manage are often the local country political and ESG risks, as many of them are beyond their direct control, and have to be managed with great finesse and delicacy. Areas where companies do have direct control, such as how they treat their employees and how they apply global environmental standards, can be easier to manage. The key for treasurers is to identify and manage risks professionally and proficiently in high-risk emerging markets countries, so that the higher economic returns and benefits of operating in fast-growing countries are not lost to poor risk management that can, in turn, lead to lower profits.

Today, treasury teams thus need to conduct both financial and extra-financial risk analysis, management and mapping aimed at identifying potential investment risks and opportunities for their organisations. They must then provide leadership in managing those risks and opportunities to provide a balance of risk and return per their company’s fiduciary responsibility, to meet their shareholder’s reward goals at a reasonable and responsible level of risk.

Increasingly, those investor goals include specific ESG and other extra-financial criteria as well as financial performance criteria. In the future, that responsible balancing of risk management and opportunity management will separate the winners from the losers, and eventually lead to more integration of ESG and extra-financial risk factors into the investment decision-making and financial reporting processes for all corporate treasurers.

1 Witold J Henisz, Sinziana Dorobantu, and Lite Nartey, “Spinning Gold: the Financial Returns to External Stakeholder Engagement” (Wharton School, 2010), Henisz et al (2011).

 

 

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