Taking another look at ESG integration in sovereign investments

Drawing on four years of experience in implementing Environmental, Social and Governance (ESG) considerations into sovereign models, our fixed income Portfolio Managers and Sustainable Investment team have released an enhanced Model which strengthens our integration of ESG considerations into both our investment research and investment decisions.

The new Model effectively excludes a significant number of countries, representing 18% of sovereigns across our defined universe of developed and emerging markets¹. Below, we highlight the differentiating aspects of Carmignac’s approach².

Our objective was not to replicate existing models, as credit rating agencies already incorporate some ESG considerations into country credit profiles, and third party data providers offer sovereign scoring.

Our proprietary Model allows us to benefit from a tailored approach to the integration of ESG into investment decisions. This not only ensures alignment with Carmignac’s ESG stance³ but also enhances our research process.

The chart below⁴ illustrates Carmignac’s ESG sovereign scores compared to countries’ credit ratings. We observe that:

• As expected, there is some alignment between the credit ratings and our proprietary ESG scores. Developed Market countries are more densely clustered towards higher credit ratings and higher ESG scores. This is due to their higher GDP per capita levels.
• However, this is different for Emerging Market countries, as their ESG scores are more spread out.
• Interestingly, a number of higher-rated Emerging Market countries have a lower ESG score than lower-rated countries, and vice versa. We believe this can be explained by our methodology, explained further below.

Before getting into the details of our approach to sovereign scoring, we outline the two key reasons that support Carmignac’s decision to put in place an ESG sovereign scoring Model.

The same set of KPIs applies to developed and emerging markets. One exception is made in the case of Climate Action Tracker’s alignment of country climate action with Paris Agreement KPI within our Preparedness and contribution to the climate transition sub-pillar, which we apply to developed markets only due to data availability considerations.

We do not score countries based on arbitrary thresholds but have chosen instead to use a normal distribution model which we use to assess the performance of countries relative to one another within the chosen universe of investable countries.

We assign the Governance factor a more significant weight of 40% while the Environmental and Social factors are each assigned a weight of 30%. This better reflects Carmignac’s conviction that a country's governance stability and quality is fundamental to the management of country credit risk. It also aligns with the views most recently expressed by Edouard Carmignac in his January 2025 letter⁸, emphasising the growing importance of considering geopolitical factors in investment decisions.
Lastly, we believe that solid governance is the foundation for the effective management of Environmental and Social financial risks and outcomes.

As illustrated in this chart⁹, wealthier countries may have more resources, leading to higher ESG scores, while lower-income countries may face greater challenges in implementing policies which would result in a lower ESG score.

Our proprietary Model allows us to undertake a case-by-case analysis rather than applying a set of common rules that may favour wealthier countries. One key element of our Model is that it seeks to account for the economic development stages of countries. This is to ensure our approach captures the growth potential, dynamics, and progress of countries that are improving their environmental impact on the planet, their social impact on their population, as well as their overall governance.

We seek to address the income bias in the following three different ways:

• The KPIs: the choice of KPIs significantly influences country scores. Although we use the same set of KPIs across developed and emerging countries, we considered the potential for income bias in our choices. For instance, when assessing a country’s contribution to climate change and environmental degradation, we included both production-based and consumption-based greenhouse gas and carbon emissions per capita data.

• The scoring methodology: 50% of the score of emerging market countries is determined by their performance trajectory. This allows us to factor in the efforts made by emerging markets to improve their ESG performance, and not just rely on static and often backwards-looking data. For developed markets, a larger portion (75%) of the score is based on their current ESG performance (“static score”).

• The Kuznets curve overlay¹⁰: The Environmental Kuznets Curve (EKC) theorises that, in the initial stages of modernisation, as Gross Domestic Product (GDP) increases, negative environmental externalities also increase. Then, when GDP hits a certain point, environmental impact should plateau and begin to decline as it decouples from economic growth. This relationship is common for all countries albeit they differ in terms of their time horizons and stages.

While the EKC does not play out in its entirety for all countries, our internal research shows it remains a relevant approach to factoring in income bias.

We apply the Kuznets methodology to our Environmental KPIs (Contribution to Climate Change sub-factor only) as well as our Social KPIs. Countries are rewarded based on their distance to the curve with those above the curve being sanctioned and those below it being rewarded. By calculating the distance between the nearest line on the curve to the point we can calculate distances, rank the distances and score accordingly. This results in a weighted adjustment of our Environmental and Social scores.

While ESG data availability and quality has improved, we also acknowledge the limitations of a quantitative approach to sovereign scoring and the difficulties in capturing all various ESG aspects into one single Model.

Similar to our corporate issuer assessments, evaluating countries' ESG profiles is an important part of our investment process. Each year, our Fixed Income Portfolio Managers and Sustainable Investment team members collaborate to refine quantitative scores with qualitative insights, leveraging on their respective expertise. This joint review ensures scores accurately reflect ESG performance, impacting investment decisions. Adjustments are made during formal meetings, with final scores and rationales agreed upon. While quantitative updates are annual, qualitative tweaks are made as needed for significant events.