Environmental, social and governance (ESG) factors are being recognized in fixed income investing as value-added indicators of potential economic performance. In the latest edition of “Global Macro Shifts,” the Templeton Global Macro team outlines how it integrates ESG factors into its research process. The team has developed a proprietary ESG scoring system called the Templeton Global Macro ESG Index (TGM-ESGI), to assess current and projected ESG conditions in various countries, and to facilitate macroeconomic country comparisons around the world. This document is a summary version of the full research-based briefing, which can be found in its entirety at the Global Macro Shifts homepage.

Overview

The world of finance professionals has recently begun to attribute much greater and explicit importance to the environmental, social and governance (ESG) factors in investment decisions.

Interest has also increased within sovereign governments, emphasizing the effect that ESG has on macroeconomic performance. This should not be surprising. Economists and historians have for a long time recognized and debated the importance of environmental factors and of social and political institutions for the long-term economic development of countries. Some of the early theories—going back all the way to Machiavelli in the sixteenth century—assigned great importance to the role of the environment, stressing that geography and climate determined the success of agriculture, the prevalence of diseases, and other determinants of economic growth. The role of environmental factors has been explored more recently by Jared Diamond in his 1997 best-seller Guns, Germs and Steel, and by Jeffrey Sachs in a 2001 paper (Tropical Underdevelopment, National Bureau of Economic Research).

The importance of institutions has been studied and documented even more extensively. To give but two examples: Harvard political scientist Robert Putnam has argued that the very different economic performances of Italian regions can be traced to the respective strength of civic institutions all the way back to the Renaissance (Making Democracy Work, 1993). In Why Nations Fail (2012), Daron Acemoglu and James Robinson argued that economic and political institutions are by far the single most important driver of economic performance.

In our view, any macroeconomic analysis and investment strategy focused on long-term, fundamentals-driven performance should incorporate ESG factors as a key pillar of its analysis. ESG speaks to an economy’s potential as an investment destination and the sustainability of that investment. Not only does industry research support the effectiveness of incorporating ESG analysis,1 we have also found it to be a critical prong of our research process.

Consider:

  1. The quality of governance, and of political and economic institutions, plays a crucial role in macroeconomic performance, particularly in emerging and frontier markets. Robust governance contributes to the quality, stability and predictability of the policy environment and typically goes hand in hand with stronger potential growth, as well as greater resilience in the face of domestic or external challenges. It contributes in an important way to determining the risk of financial and economic crises. A new administration that has the ability to radically shift policy direction can be reason to enter or exit a market. Some governance factors such as corruption and attitude toward foreign investment also present large risks through political scandals and policy changes that complicate investments.
  2. Social conditions influence a wide variety of political issues, including stability and the policy mix, while also directly impacting a country’s macroeconomic developments through competitiveness and efficiency. Although many social factors affect long-term growth potential, they can also have significant short-term impact. Lack of social stability can lead to armed conflicts or create opportunities for savvy political forces, oftentimes to the detriment of the population. At the same time, factors such as wage pressures and infrastructure development have real effects on both domestic and external activity.
  3. Environmental factors also have an important role, particularly in emerging and frontier markets that tend to have looser regulation and more limited ability and resources to react. Natural disasters like droughts, floods, earthquakes and hurricanes can have devastating economic and human consequences. Other than the human costs, they can spark disruptions in energy, food and material availability that cause issues like skyrocketing inflation or supply chain disruptions. Unsustainable practices and pollution can cause social instability, and cleanup costs can cut into an economy’s growth potential.