Challenges in Applying Principal Adverse Impact Indicators to Sovereign Debt Portfolios

Purpose: This study explores potential effects and challenges of integrating Principal Adverse Impact (PAI) indicators in a sovereign bond portfolio through select exclusion policies. Design/Methodology/Approach: The authors created two model portfolios based on BlackRock’s IGOV and EMB ETFs. After recreating the data supplied to asset managers by MSCI, the authors apply two sample policies excluding the worst scoring sovereign bonds. This approach mimics the actual integration of PAI indicators into sustainable investments and, thus, lends itself to discussing the challenges of implementing PAI indicators in practice. Findings: Sovereign PAI indicators disadvantage emerging markets (EMs) and exhibit a regional bias towards European and North American countries. Excluding sovereign bonds belonging to the 10% of the worst-scoring countries does not significantly impact the developed market (DM) portfolio composition, while the same threshold heavily affects the portfolio composition for developing markets. The current indicators have an inherent income bias, with four out of seven numeric indicators substantially correlated with GNI per capita, systematically disadvantaging EMs. Implications: Applying PAI indicators for exclusion raises concerns about sustainable investment in sovereigns where a large transition is still ahead. Limitations: Limitations are associated with the approach adopted by the authors, primarily due to the novelty of the regulation, as well as the absence of relevant data. Future Research: Research is needed to explore the influence of PAI indicators on the composition of financial products, particularly their effects on sovereign bonds, as they remain underexplored in terms of environmental, social, and governance metrics.