Asset owners face steep challenges trying to differentiate between the climate performance and governance of sovereign issuers. A new initiative aims to identify the common ground.
A key feature of green bonds is their ringfencing of proceeds to finance projects with specific environmental objectives. However, few investors feel comfortable ignoring the issuer’s credentials completely, environmental or otherwise. This partly explains the growing appetite for sustainability-linked bonds, which set targets for the issuing company’s overall environmental or social performance.
When it comes to sovereign bonds, it is even harder to separate the instrument from the issuer. A growing number of governments are issuing green and social bonds, with a view to investing in low-carbon energy or transport infrastructures, or to support health, education or housing expenditure as economies recover from the Covid-19 pandemic.
The second party opinions provided by independent experts on these bonds not only comment on their alignment with frameworks such as the ICMA’s Green or Social Bond Principles, but also their coherence with the issuer’s strategic sustainability priorities. In short, the government’s wider performance and policies are still a material factor for investors.
Further, green bonds make up only a tiny fraction of any sovereign issuer’s outstanding debt portfolio. ESG factors play a large and increasing part in the ratings, performance and credit risk of traditional government bonds too. In response, ratings agencies and data providers have developed a new and evolving generation of scores and ratings services to help investors evaluate the impact of ESG risks and opportunities on sovereign issues.
Despite this, asset owners lack a coherent assessment framework to help them understand sovereign issuers’ overall environmental risks and performance, especially when it comes to the urgent issue of mitigating and adapting to climate change.
Understanding the state of play
To this end, a new initiative was launched in June, called the Assessing Sovereign Climate-related Opportunities and Risk (ASCOR) framework, to help investors measure, monitor and compare sovereign issuers’ current and future climate change governance and performance.
The project was jointly launched by the BT Pension Scheme, the Church of England Pensions Board, the UN-convened Net-Zero Asset Owner Alliance, Ceres, Institutional Investors Group on Climate Change, Principles for Responsible Investment, the Transition Pathway Initiative (TPI) and Chronos Sustainability, a UK-based responsible investment and corporate sustainability strategy and policy development firm, which will co-ordinate the project.
Research will be conducted by the London School of Economics’ Grantham Research Institute on Climate Change and the Environment (GRI). The project has recently secured funding support from seven asset managers, with a range of geographic footprints, including both developed and emerging markets, and perspectives.
“Attracting financial support from firms with diverse areas of expertise will help to ensure our outputs will be relevant to a wide range of asset managers and owners,” says Adam Matthews, Vice-Chair of the ASCOR Project and Chief Responsible Investment Officer at the Church of England Pensions Board.
The multiplicity of tools, data sources and philosophies on assessment does not lend itself to a common understanding on climate policy among asset owners, says Matthews, who draws a comparison between ASCOR and existing climate-focused collaborative projects developed by institutional investors.
“Asset owners are looking for a consistency in assessing countries’ approach to climate change, both in terms of mitigation and adaptation. It’s not our primary intention to develop a whole new toolkit, but to provide a commonly agreed framework, similar to how TPI and Climate Action 100+ have helped investors to compare companies,” he says.
This means an initial focus on identifying the most important criteria to investors, i.e. does the entity in question have policies, targets or reporting processes relating to a particular climate risk, rather than evaluating the efficacy of such. This leaves evaluation to the interpretation of the individual investor, but it offers the assessed entities a checklist of common concerns across major institutional investors and bond purchasers.
“Investors will still need to conduct further analysis and engagement, and consider other aspects [of the issuer’s profile]. But ASCOR will provide a comprehensive assessment framework for understanding the state of play for a sovereign issuer’s approach on climate change,” says Matthews.
Comparing apples and oranges
When trying to understand the climate risks of sovereign issuers, a prerequisite is to assess them using common criteria. This also applies to corporate bond issuers, but the range of differences between sovereign issuers can be extreme, in terms of their ability to manage the climate risks to which they are exposed, both in terms of climate change mitigation and adaptation.
This is influenced by multiple underlying factors such as size, economic development and political system. How, for example, does one make a meaningful comparison between say Liechtenstein, Indonesia and the United States on climate policy and governance in order to make reliable investment decisions?
At an early stage, ASCOR aims to develop consensus about investors’ expectations of government policy on climate change, such as policies, targets, enforcement mechanisms. This will be a key step toward a framework through which investors can understand both the areas of alignment and difference.
“Every country’s policy mix depends on national circumstances. Regardless of whether a country has a command-and-control or market-led economy, the aim is to focus on the desired outcomes for investors and the effectiveness of policy in achieving them,” says Matthews.
A real challenge will be ensuring less developed countries are treated fairly. Impact Cubed, an investment analytics and solutions provider, has partnered with investment teams from ten asset managers to build a sovereign bond impact model aimed at countering a “wealth bias” toward mature sovereign bond issuers in many ESG country rankings.
Using 20 years of data, the model compares the rate of progress achieved by sovereign issuers against expected levels for 29 factors across the 17 SDGs, identifying strong improvements, even from low levels. Lithuania was shown to be a leader (above average on level and faster progress pathway) in the highest number of factors, while many mature economies stalled or lagged in a wide range of factors, notably the US.
At this stage, ASCOR’s plan at the current stage is not to release traditional rankings. Despite the efforts of Impact Cubed and others, project participants feel this would unfairly disadvantage countries with poor regulatory infrastructure, or which are less well developed economically or are highly exposed to physical climate. Further, such a ranking would not likely enhance the investor’s understanding of what each country is doing, in terms of adaption and mitigation, and what can be expected of them.
Based on corporate reactions to existing ratings models, a low ASCOR ranking would not be the ideal starting point for establishing deeper engagement between investors and sovereign issuers, notes Dr Rory Sullivan, Chief Technical Advisor, ASCOR Project and CEO, Chronos Sustainability.
“We don’t want to reinforce existing biases. How we present the information is integral to making this credible and helpful to investors as they engage with governments to improve their approach to climate change,” he adds.
Engagement with sovereigns
Reducing climate risks and greenhouse gas emissions in one’s portfolio is not merely a matter of evaluating, divesting and rebalancing. ESG investing is often most effective through engagement, not just by shareholders but increasingly by bondholders too.
In areas such as corruption and modern slavery, large investors’ views have helped to shape and accelerate legislation. ASCOR participants hope the framework will serve to shape investors’ collective priorities and expectations from sovereigns in terms of climate risk management, to the benefit of both parties.
“Regional investor networks already engage with policymakers on specific climate-related policy measures as important stakeholders. But it’s less clear at this stage how investors should engage with governments on the broader direction of climate policy,” says Matthews.
“The outcome of ASCOR will enable the kind of coordinated investor engagement undertaken by Climate Action 100+.”
Climate Action 100+ pairs asset owners and managers with heavy-emitting corporates to develop detailed plans to decarbonise their operations, processes and policies. If governments understand the criteria being used by a large number of institutional investors to assess their performance on climate-related issues, they are more likely to bear these in mind from a policy perspective.
“There is broad consensus among institutional investors in terms of expectations in areas such as fiscal discipline and transparency, for example. That does not yet exist in climate change policy. But agreement on the direction of travel that investors expect from governments will help to lay the basis for engagement,” adds Matthews.
As a method of assessing issuers of bonds rather than bonds themselves, there is scope for ASCOR’s methodology to be used beyond the sovereign markets, e.g. perhaps helping to assess state-owned enterprises, says Matthews.
“The ASCOR assessment framework may also be useful when investors look at a corporate issuer’s exposure to country risk. For example, an investor may want to factor in the fact that 25% of a mining firm’s operations are in countries without a clear policy framework on a particular area. Further, communication of common investor expectations on aspects of climate mitigation or transition could encourage greater private-public collaboration on common solutions,” he explains.
Inputs and outputs
Initially, ASCOR’s outputs will be based on publicly available information. This may include countries’ nationally determined contributions (NDCs), as well as other well-established data sources, such as the World Bank’s Worldwide Governance Indicators and Climate Change Knowledge Portal, the data supplied by governments to the UN Framework Convention on Climate Change, and the GRI’s climate laws database.
“Our aim is to build on credible, authoritative and publicly accessible sources that are regularly updated, well-understood and validated. We want to build on data sets that are already widely used, methods that are widely recognised and outcomes already seen as valuable by investors. These are important inputs into our selection process,” says Sullivan, who nevertheless acknowledges that alternative data sources could be valuable in due course, such as satellite data on land clearance.
Rather than assessing and scoring NDCs directly, ASCOR is more likely to establish a framework for evaluating NDCs alongside other indicators of climate risk policy. If a country’s NDC does not provide sufficient detail, for example, the ASCOR framework will suggest that the asset owner take this into account.
Explaining the possible roles of NDCs in ASCOR’s sovereign assessments, Sullivan draws parallels with TPI’s assessments of management quality and company performance in specific sectors. The first is based on whether a company has certain policies and structures in place, the latter is an assessment based on company data, processed and analysed and compared via benchmarks. “Similarly, ASCOR could assess whether a country’s NDC covers six particular categories of information, but separately it could also assess the overall adequacy of the NDC,” he explains.
As ASCOR is focused on issuers not issues, it will not be focusing specifically on the attributes of specific green bonds, says Matthews. However, the proportion of an individual sovereign’s outstanding debt represented by green bonds could be a criterion for evaluating the credibility of the issuer, or their commitment to reducing carbon emissions, as could the use of particular KPIs or evaluation frameworks by their green bonds.
“Issuance of green or other sustainability bonds is certainly a candidate to be one of the indicators for consideration when assessing the climate credentials of a particular sovereign. Further, an asset owner might decide only to invest in a sovereign green bond if it is issued against a recognised standard and the country is also assessed positively on a particular number of indicators in the framework, for example,” he adds.