Political Monitor

Political risk, ESG and market performance

Financial Markets

Political risk, ESG and market performance

Overview

The United Nations Principles for Responsible Investment (PRI) have transformed the way institutional investors and listed entities think about governance and sustainable investment. This has added impetus to the search for new risk models that take account of factors not traditionally monitored in credit and equities analysis, including social and political trends that may alert investors to systemic risk.

The challenge has been establishing a clear link between responsible investment and performance outcomes and developing tools that quantify environmental, social and governance (ESG) risks. The following information addresses this challenge by examining recent findings on the link between governance and performance and then detailing the tools developed by Political Monitor - a political risk research & advisory firm - to identify, score and report on political risk in key markets.

Executive summary

There is now clear evidence of the link between responsible investment and performance outcomes. Recent research by the PRI Sovereign Fixed Income Working Group revealed correlations between ESG factors and credit risks. Those factors include corruption, poverty, unemployment rates, food security and population distribution.

However, quantifying ESG risks has been a challenge with many investors struggling to measure such risks and include this data in risk models. Political Monitor has overcome this challenge by developing a number of political risk scores that consider and quantify a range of social and governance issues providing insight into underlying social and political trends likely to shape markets.

One example of the benefits of this analysis was our January rating of Thailand as a relatively low political risk for Q1 2014; contrary to consensus forecasts. The Political Monitor score assessed that a number of underlying factors would limit the risk of the political crisis becoming a social & economic crisis. Since that rating the Thai benchmark index has increased over 10%.

Governance, risk and performance

Country risk

The Sovereign Fixed Income Working Group (SFIWG) – established by the UN Principles of Responsible Investing initiative – argues that investors can better gauge the risks of investment by considering social & political factors. The group’s research revealed correlations between environmental, social and governance (ESG) factors and credit risks.

Of particular note the group found:

  • corruption and sovereign bonds performance are clearly correlated
  • social factors – such as poverty, employment rates, food security, education levels & population distribution – are reliable measures of risk.

The data can also be used to anticipate future credit downgrades. The group noted comments from MSCI that a large discrepancy between ESG performance and credit ratings is a strong sign of future downgrades.

The SFIWG also found that countries with poor ESG ratings are likely to suffer greater loss as a result of unforeseen negative events. In particular, countries displaying poor ESG indicators are often more prone to shocks from natural, social or economic events, leading to greater credit risk.

The research and experience of working group members with regard to materiality indicates that ESG factors can be material to both creditworthiness and investment performance.

In a separate study the Chief Risk Officer forum (CFO) noted that the traditional focus on credit & financial risk was not designed to identify environment, social & political imbalances and that capturing this data will provide additional information about emerging issues & help to better understand geopolitical developments leading to disruptive transformations.

Market and company risk

The Political Monitor Australian Political Risk Index reveals an inverse relationship between political & policy uncertainty and market performance. As political uncertainty rises the ASX200 has trended downwards and vice versa.

However, this is not the only evidence of the relationship between political and social risks and economic and market performance:

  • An increase in economic policy uncertainty foreshadows a decline in economic growth and employment in the following months (Baker, Bloom & Davis, EPU)
  • Political risk measures are correlated with future equity returns (Harvey, National Bureau Economic Research)
  • Political risk is applicable in more than just developing economies despite the literature’s focus on these markets with issues such as taxation, transparency, demographics and social issues all affecting the corporate environment with clear links between the level of risk and operational performance in developed markets (Restrepo, Correia, Poblocian, Political Risk & Corporate Investment Decisions, 2012).

In Australia the importance of improving risk management, with a particular focus on the social and governance factors that shape political risk, has been recognised by the Australian Securities Exchange (ASX) with the release of the latest version of its Corporate Governance Principles and Recommendations

The new standard, which comes into effect on 1 July 2014 and sets out the corporate governance obligations of listed entities, features eight (8) principles including Principle 7: Recognise and manage risk. This principle highlights the importance of quality information for both managers and investors and that the failure of a listed entity to manage risk can adversely affect a broad range of stakeholders.

One key recommendation of the ASX Corporate Governance Council is … ‘a listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks.’

This makes the task of identifying and quantifying those risks critically important. Influencing factors are likely to include corruption, debt levels, unemployment rates, food security and population distribution. Each has the potential to affect a listed entity’s trading environment and projects.

The relationship between political risk and economic performance

Political risk is the second ranked concern for publicly traded companies … 

"Looking ahead, investors continue to be wary about the effects of systemic risk, politics and regulation on the world's markets and how they'll perform.” (BNY Mellon, Global Trends in Investor Relations, 2014).

In general political instability results in:

(a) lower economic growth (Aisen & Veiga, 2013)

(b) reduced private sector investment (Alesina & Perotti)

(c) increased inflation levels & volatility (Aisen & Veiga, 2008).

The economic effects of political & social instability remain for an observable period of 2 – 3 years. The key determinant of whether the effect of instability ceases at that point is the speed with which countries implement reforms & improve governance (Bernal-Verdugo, Furceri & Guillaume, IMF Working Paper, 2013).

An increase in economic policy uncertainty foreshadows a decline in economic growth and employment in the following months (Baker, Bloom & Davis, EPU).

The International Monetary Fund (IMF) estimates the economic loss to Libya, Egypt, Tunisia, Syria, Yemen, and Bahrain in 2011 at USD$20.56 billion as a result of political and social conflict.

The Political Monitor political risk methodology

Political Monitor takes account of a number of environmental, social and governance factors that can provide an early warning of emerging social and political unrest. These variables are applied across our country and in-country risk assessments.

Country risk

Political Monitor country risk scores provide a relative rating of risk for some of Asia’s most important economies. The scores track over 10 different variables for each country providing insight into the likelihood of social and political unrest.

The variables include social and governance indicators such as legitimacy of government, corruption levels, exposure to volatile food prices, elasticity of demand, poverty and core demographic trends.The scores provide unique insight into the political risk environment by focusing on social and governance trends rather than a singular focus on economic data.

In-country risk

The Political Monitor State Political Risk Index tracks over twenty key variables that reflect political risk in each jurisdiction. The variables are classified across four categories - Budget, Policy, Stability and Reputational risk.

The relative risk scores allow investors to assess comparative risk across the four categories and determine which states offer the best prospect of a ‘no surprises’, stable investment environment. For individual firms the index allows comparative analysis of which states are most at risk of introducing new revenue raising measures and regulations that may hamper business investment plans.

Sector and firm risk

Political Monitor examines the implications of country and in-country risk for respective sectors and firms.

The process then assesses whether there are any sector or firm specific risks. This includes a review of community attitudes and global and domestic industry trends relevant to respective sectors / firms.

The firm level analysis determines whether the political risk outlook places a firm at a distinct competitive advantage or disadvantage to its industry peers. This isolates the nature of the risk and allows for responses to be tailored accordingly.

A risk rating with key influencing factors is then produced providing an understanding of relative risk profiles.

Political Monitor risk scores, ESG and ISO risk management standards

Political Monitor risk scores track and weight economic, social and governance variables including unemployment, inflation, poverty, corruption, government transparency, food security, consumer exposure to price volatility and population demographics.

The scores and supporting methodology are consistent with a number of the principles detailed in the International Standards Organisation Risk Management – Principles and Guidelines standard (AS/NZS ISO 31000:2009), including:

  • Principle (d): Risk management explicitly addresses uncertainty – the scores are designed to track variables that provide early warning signs of political and social uncertainty and for a number of scores / indices this is the explicit objective
  • Principle (e): Risk management is systematic, structured and timely – the scores are backed by a clear methodology and are dynamic in nature (meaning they are regularly refreshed). In some instances Political Monitor scores are refreshed daily
  • Principle (f): Risk management is based on the best available information – the scores rely upon datasets not traditionally used in economic and credit risk assessment and therefore provide an additional level of information that is directly related to the market environment
  • Principle (j): Risk management is dynamic, iterative and responsive to change – the scores are dynamic (meaning they are regularly refreshed) with some scores updated daily. The underlying methodology is also revised regularly to ensure appropriate factors are taken into account and weighted accordingly.

What are the Political Monitor outcomes?

In December 2013 Political Monitor rated Thailand a LOW political risk for the quarter ahead. This rating was unique within the market.

The Political Monitor risk rating for Thailand reflected our analysis of underlying political and social trends that pointed to high levels of stability despite the political turmoil. These included low levels of youth unemployment, dramatic improvements in poverty rates and relatively high levels of food security.

At the time of writing (March 14, 2014) the Thai benchmark index had increased more than 10% YTD and the Thai Bhat had traded in a consistent band, appreciating around 1.3% against the USD YTD.

Since its inception the Australian Political Risk Index has shown a clear correlation with the ASX200. As political and policy uncertainty rises the market trends downwards and vice versa.

The index tracks a number of variables that reveal both the manner in which political events influence markets and the nature of that influence. The index is dynamic providing a daily reading of political and policy uncertainty in Australia and allowing for daily comparison against key indices. Consistent with best practice risk management principles the index regularly undergoes review to deepen its insight and maintain robustness.

Accessing the data and insight

There is no ‘one size fits all’ model for assessing social and political risks. Every investor and each company has different challenges and processes and the Political Monitor services are tailored to meet specific needs. However, there are a number of ways in which firms are currently accessing and using this data:

  • Risk audits – twice yearly review of the social and political risks confronting firms in respective regions or sectors. These audits are usually conducted for a firm’s risk management committee as part of their broader commitment to ensuring management and investors are apprised of emerging and ongoing risks. The audits provide an opportunity for firms to gain a unique perspective on risk that goes beyond economic analysis and helps firms meet their reporting obligations. Audits include both quantitative and qualitative analysis
  • Consulting & advisory – a dedicated and focused review of the social and political risks confronting a firm or investor. The advisory service considers the implications of country and in-country risk and then drills down to identify sector and / or firm specific risks that are likely to influence the operating environment over the coming months. These bespoke advisory services include both quantitative and qualitative analysis
  • Political Monitor subscription – our subscription service provides daily access to our risk scores, indices and analysis providing executives with comprehensive but concise analysis of the political risk outlook at a country and sector level.

To learn more about using political risk data to meet your risk management and corporate governance obligations please contact either:

Damian Karmelich (Partner - Sydney)

p. 0407 772 548

e. karmelichd@politicalmonitor.com.au

Steve Cusworth (Partner - Melbourne)

p. 0417 178 697

e. cusworths@politicalmonitor.com.au

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