At CountryRisk.io, it is our view that a holistic understanding of sovereign risk, as with other asset classes, requires material environmental, social and governance (ESG) factors to be integrated into the risk analysis.

We are not the only ones to hold this belief, which helps explain why the assets managed by funds that incorporate ESG strategies grew 58% in Europe last year, according to Morningstar and saw a fourfold increase in the US — with flows into US sustainable funds reaching $20.6 billion.

But it seems that the US Department of Labor (DOL) does not agree. A new DOL proposal last month could severely hamper ESG integration among US-domiciled funds.

The proposal would amend the 1974 Employee Retirement Income Security Act, known as ERISA, to require employer-sponsored retirement plans which are considering ESG-focused investments to show that these investments are expected to perform at least as well as similar non-ESG investment options.

The proposal could prevent ERISA plan fiduciaries from investing in ESG vehicles that could potentially sacrifice investment returns or are seen to take on additional risk.

Future proofing returns with risk management

By seeing ESG as merely a vehicle for furthering social goals, Secretary of Labor Eugene Scalia has completely misunderstood and misinterpreted ESG integration. ESG is about prudent risk management; due diligence carried out to future-proof and protect returns from a myriad of material risks waiting on the horizon.

In Secretary Scalia’s own proposal, the DOL acknowledges explicitly that ESG factors can create business risks and opportunities, and evidence is incontrovertible that climate change will have a material impact on our economy and on asset prices. This makes the DOL’s attempt to limit ESG integration extremely short-sighted.

A recent study by Kempen Asset Management highlights just how important ESG is to risk management. In both equity and credit funds, the research found that ESG approaches can compete with conventional funds in the good times and can offer protection during cyclical downturns. Performance so far in the current market downturn backs this up.

This is aided by the fact that tentative empirical evidence from corporate and diversified bond funds with ESG approaches suggests they have performed in line with, or outperformed conventional approaches, mainly due to avoiding ESG laggards.

ESG is the new standard for sovereign risk

Certainly, the evidence in sovereign bonds is clear that ESG factors enablesound investment strategies, not get in the way of them, as Secretary Scalia claims.

The CountryRisk.io community of analysts is increasingly examining the current crisis through an ’S’ lens — looking at a country’s healthcare system, population health and overall resilience to deal with a crisis. By incorporating social factors in in sovereign risk analysis, countries’ ratings will improve or deteriorate compared to their standard sovereign rating and paint a more accurate picture.

We firmly believe that including ESG factors creates better granularity in country and sovereign risk assessments, ensuring that users of our platform stay ahead of the curve.

COVID-19 has plunged the global economy into the worst recession since World War II. The regulatory and legislative actions nations take now will have dramatic ramifications in the near- and long-term future for their sovereign credit risk. Amid so much uncertainty, a premium must be placed on ESG integration and risk management to eliminate blind spots.

The current DOL proposal risks trying to row the US backwards just when the waters are at their choppiest.