“Cutting Out the Noise” on Sovereign Bonds

New initiative aims to help asset owners to assess sovereigns’ climate change governance and performance.

As sustainable bond issuance continues to grow, a new project aims to bring clarity and simplicity to sovereign bonds – the “poor relation” of responsible investment. The recentlylaunched Assessing Sovereign Climate-related Opportunities and Risk (ASCOR) framework will enable investors to measure, monitor and compare sovereign issuers’ current and future climate change governance and performance fairly and appropriately.

A project team will start work in June to build ASCOR, which will be released as an open source, free of charge report by the end of 2021. It is intended that the reports will be issued annually. The team comprises representatives from BT Pension Scheme (BTPS), Church of England Pensions Board, the UN-convened Net-Zero Asset Owner Alliance (AOA), Ceres, Institutional Investors Group on Climate Change (IIGCC), Principles for Responsible Investment (PRI) and the Transition Pathway Initiative. Chronos Sustainability, a UK-based responsible investment and corporate sustainability strategy and policy development firm, will co-ordinate the project.

“ASCOR is trying to create an innovative approach to sovereign investment for companies and big investors,” says Victoria Barron, Head of Sustainable Investing, BTPS and Chair of ASCOR. “Asset owners, including BTPS, rely heavily on sovereign debt and we aim to cut out the noise and give clarity about how to tackle this asset class.”

While target-setting frameworks such as the IIGCC’s Net Zero Investment Framework and the NZAOA’s Target Setting Protocol have emerged, asset owners have called for a standardised approach to assessing sovereign carbon performance. The ASCOR organisations agree there is a “critical need” for an investor-led tool that can provide a common lens to understand sovereign exposure to climate risk and government plans to transition to a low-carbon economy.

The ASCOR assessments will provide insights that support investors’ research and decision-making, giving them a sound and cohesive climate-based basis on which to analyse sovereign debt investments and engage with government officials and policymakers.

Tackling complexity

Rory Sullivan, CEO of Chronos Sustainability, says the complexity of the sovereign bond market is at the heart of the project. “Countries are much more complex than corporates and there is a lot of data out there,” he says. “Sovereigns are very important to investors but have been the poor relation of responsible investment, with very little work done by investors on assessing the climate risks.”

Barron agrees, pointing out that the reason for hitherto slow progress on sovereign bonds has been the multi-faceted nature of the asset class. “Equities are simpler, because they rely on a single entity – a company – to provide ESG data and to measure themselves. But most companies are not on the scale of a country such as India or China. This scale makes it difficult for investors to grapple with ESG information.”

Moreover, countries measure carbon emissions in different ways and there are many data points and different sources that investors need to draw on to piece information together.

Those involved are keen to stress that ASCOR is an assessment framework, not a ratings framework. Because countries are at different phases of economic development, comparing countries based on an element such as the Nationally Determined Contributions (NDCs) would not give a realistic picture of risk. The idea is to produce an assessment of where an individual country is on its transition journey that can be used as a basis for further discussion with the sovereign.

While ratings agencies factor climate risks such as rising sea levels, droughts, floods and wildfires into sovereign ratings, ASCOR will attempt to bring greater transparency to these risks for investors.

ASCOR will draw on a number of well-recognised data sources such as World Bank indicators and national government greenhouse gas inventories. “The focus will be on which data sources tell us something that is useful or interesting about a country and that governments can control and are acting on,” says Sullivan. “Publicly available raw data will be very valuable for this exercise.”

An increasing number of sovereigns have attempted to raise funds to support their climate-change policies through the issuance of green and transition bonds. Europe surpassed a cumulative US$500 billion of green issuance at the end of April, according to Climate Bonds Market Intelligence. Italy recently became the tenth sovereign issuer in Europe with a record-breaking €8.5 billion green bond issuance. Belgium, France, Germany, Hungary, Ireland, Lithuania, Netherlands, Poland and Sweden comprise the other nine sovereigns to tap the market. The UK is expected to issue a ‘green gilt’ this summer.

With overall sovereign issuance levels expected to surge due to unprecedented levels of government spending in response to the pandemic, investors may regularly need to factor climate performance into ever more complex analyses.

Assessment of the burgeoning sovereign green bond market will be considered, says Barron, but as a nascent market it might be too early to include them in the initial assessment process.

Sullivan describes ASCOR as a “route map” for countries to understand what systems they need to prioritise to respond to climate change. “It is not just a comparison tool, but it is also a self-reflection and diagnostic tool for governments themselves.”

Enhanced government engagement

Ultimately, the framework will be a tool to help investors to engage more with governments, says Barron. “The awareness that the assessment will bring will enable investors to speak to governments about policy and help to support countries to address the changes they need to make. This isn’t solely about risk; it is also about opportunity.”

Sullivan says the way in which investors engage with governments is “very underdeveloped. One of the problems we have had in this space is that no one knows what anyone else wants in terms of data. There are inconsistent messages from investors. ASCOR will put engagement on a consistent footing, making it clear to sovereign bond issuers what is important to investors.”

Speaking at a briefing earlier this month, Liam Spillane, Head of Emerging Market Debt at Aviva Investors, said there were differences in how investors engage with sovereigns versus corporate bond issuers. “We have to understand that the legal obligations are different for sovereign issuers and that engaging with sovereigns involves a range of stakeholders.”

Experienced emerging market investors have long engaged with sovereigns on ESG, he added, but most were focused on the governance aspect of ESG and some social concerns that relate to governance. “Only recently has interest in the environment picked up and we are in the early stages of sovereign engagement relative to corporates.”

Sovereign engagement has been an underutilised practice and should be scaled up to improve future financial sustainability and promote responsible investing more broadly, says Claudia Gollmeier, Senior Investment Officer at privately-owned asset manager Colchester Global Investors and Chair of the PRI’s Sovereign Working Group.

“As funders of sovereign debt, bondholders can play an  important role in driving change and shaping ESG outcomes through their investment decisions,” she says. While some investors have engaged with sovereign issuers and non-issuer stakeholders for a long time to better assess investment risk via country research trips, conversations around environmental, social and governance issues should happen more strategically, adds Gollmeier. This will help investors to enhance risk assessments but also help sovereign issuers to understand that their debt will increasingly be valued based on ESG criteria.

The PRI recently issued a guide, ‘ESG Engagement for Sovereign Debt Investors’, in which it observed that conversations between bondholders and government representatives specifically around ESG topics were limited, as is tracking of how countries perform on sustainability pledges. The report states: “This can change. Investors can use the meetings they already have with sovereign officials to point out which ESG information they deem important for their analysis, to encourage ESG data transparency and disclosure and to convey expectations.”

This echoes Sullivan’s point about inconsistent messages from investors. The PRI says engagement should not be considered a ‘one-way street’; if it is done effectively it can reduce sovereign risk and funding costs. “Furthermore, enhanced and clear policies can improve a country’s business environment, which in turn reduces country investment risk, supports economic growth and should ensure more sustainable debt paths,” the report states.

Among the key conclusions of PRI’s report is that as responsible investment expectations evolve beyond pure risk-return considerations to shaping sustainable outcomes, so too will capital allocation and engagement practices. Furthermore, through their contribution to countries’ funding needs, sovereign bondholders can help accelerate progress towards sustainability goals, and cease being an “under-utilised resource”.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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