Investors are looking at their sovereign holdings through a sustainability lens, but we’re some way from consensus on ESG integration.
A substantial rise in sovereign green, social and sustainability (GSS) bond issuance could hit the markets in the next few years, filling an urgent need among investors hoping to achieve net zero investment targets.
Decarbonising portfolios has become a priority for asset owners, and not just for the members of the Net Zero Asset Owner Alliance, which collectively agreed recently to cut portfolio emissions by up to a quarter in the next five years.
Sovereign green bonds represent a “tangible ESG solution” to ‘greenify’ the portfolios of long-term investors who usually hold a large portion of this asset class, explains Bram Bos, Lead Portfolio Manager Green Bond at NN IP.
According to non-profit organisation Climate Bonds Initiative (CBI), at least 14 sovereigns have indicated an intention to issue GSS bonds. Out of the 10 largest issuers, France and Germany have already issued GSS bonds, while the UK, Italy and Spain have plans to do so within this year, according to a 2021 CBI report.
“Sovereign green issuance by the remaining eight nations [of the ten largest issuers] would give enormous impetus and momentum to the mainstreaming of green markets,” says Sean Kidney, chief executive of the CBI.
In the year of the outbreak of the pandemic alone, total agency and sovereign issuance more than tripled to US$304.5 billion compared to US$71.9 billion in 2019, according to Refinitiv data.
In 2020, green bond issuance reached US$222.6 billion, an all-time annual record, whereas the sustainability and social bond categories surpassed the US$100 billion mark, funding Covid-19 relief and recovery efforts.
Investors in these bonds play a role in supporting sustainable development, as GSS bonds provide disclosure and transparency through reporting on their use-of-proceeds.
They are seeking greater understanding on these and issuers’ sustainability targets and performance when investing in sovereign bonds, according to a 2020 report by the World Bank titled ‘Engaging with Investors on ESG Issues’.
Wilfried Bolt, Senior Investment Manager Fixed Income at PGGM, tells ESG Investor: “Green, social and sustainability bonds let an issuer, including sovereigns, communicate its effort on these important matters in an accountable way to financial market participants.
“Sovereigns therefore [do] both: gather insights internally on their trajectory towards e.g. Paris commitments and also put themselves in the spotlight.”
Developing green bond standards
To aid investors’ decisions, second party opinion providers have been verifying green bonds, but the absence of a mandatory green bond standard has left room for flexibility.
Kidney says that it is to be expected that “to date, sovereign green programmes have been highly scrutinised”.
Despite the attention, NN IP’s Bos adds that greenwashing risk will never be zero. He explains the risk always remains that “issuers could still issue a green bond in line with international standards, to distract stakeholders from other controversial activities on other parts of the balance sheet”.
The EU is developing an EU Green Bond Standard (GBS) which has mandatory aspects and is linked to the EU’s taxonomy to define the greenness of financed projects.
This could level up the playing field, but how it will apply to the EU’s recovery fund is not clear.
The Recovery and Resilience Facility is at the heart of the EU’s recovery effort. It seeks to help member states address the impact of the Covid-19 pandemic while also ensuring that their economies undertake the green and digital transitions.
A 2020 paper from the Bertelsmann Stiftung and the Jacques Delors Centre says that “if the European Commission were to raise up to €225 billion to finance 30% of the Recovery Instrument’s expenditure and loans through green bonds, it would give the associated market a massive push”.
However, it warns that “the key determinant of the greenness of recovery instrument spending will not be the bond covenant or any form of external verification mechanism”, adding that “the methodology currently proposed in the various legal texts is too weak to provide a good green bond standard”.
CBI’s Kidney, who serves as a member of the EU’s Technical Expert Group on Sustainable Finance, however believes that “the EU GBS will provide a solid foundation to the green portion of the recovery programme as well as private sector investment.
“There is always some risk of greenwashing when hundreds of billions of dollars are being invested, but if both the EU Taxonomy and EU GBS are being followed, we don’t see a high risk at this stage.”
Due to its mandatory aspects, the EU’s standard would be another milestone reached in a rapidly evolving GSS bond market.
Innovative structures to counteract liquidity issues arising from green bonds are developing too, with recent examples coming from nations like Germany and Denmark.
Despite the existence of voluntary principles such as those by the International Capital Market Association, the state of flux in the market will continue to demand scrutiny and engagement from investors.
Evolving integration of sovereign ESG factors
Beyond labelled GSS bonds, fixed income investors increasingly apply an ESG lens to a wide range of sovereign investments, which allows a long-term outlook on countries’ sustainable development pathways.
Whereas traditionally investors have focused on governance-related risks, they are increasingly considering environmental and social risks when making investment decisions, surveys in the World Bank report have shown. For now, however, their analyses are more art than science.
“There is no shared understanding of key ESG issues at the sovereign level that can have material impact on the valuation of fixed income instruments”, the report said.
“Undeniably, however, the depth and breadth of such approaches are growing exponentially; the available financial instruments and data are increasing; and investors’ interest in assessing material ESG issues in sovereign credit is becoming irreversibly mainstream.”
Rajeev De Mello, former chief investment officer of Bank of Singapore and managing director of Singapore-based fintech firm Deep Learning Investments, believes that integrating ESG factors in the credit process is important, but cautions to interpret their correlation with sovereign ratings with care.
He points especially to the difficulty of evaluating the impact of ESG factors on largely immobile sovereign ratings.
“Think of Germany and think of the US, [their ratings] hardly change. We [can only] see the correlation when they change,” he says.
But while some ratings are more resistant to change, market pricing will reflect a significant deterioration in environmental or social factors of a country a lot faster, he adds.
Another 2020 World Bank report on the topic says that “ESG methodologies tend to favour wealthier countries, because ESG scores are highly correlated with national wealth and those with more developed capital markets.
“However, increasingly, investors are integrating ESG criteria into investment decisions by considering not only the levels of ESG performance, but also the progress that the country is making on various ESG dimensions,” it continues.
This means that the usage of ESG factors can be twofold.
Felipe Gordillo, Senior Analyst at BNP Paribas Asset Management, explains that the impact of ESG factors can be understood in terms of their contribution to the long-term sustainability and growth of a nation or in regard to their short-term impact on the pricing of bonds.
“You can expect that those countries with a high level of human capital today would be able to ensure sustainable economic value in the future. But would that determine any dynamic in the short term about yields [or] pricing [of bonds]? Maybe, the answer is no,” he says.
A Moody’s commentary, published in January this year, found that the effect of ESG factors on ratings is as high as 87%, but it also noted that they have commonly “a negative overall impact on sovereign credit quality”.
“This reflects mostly negative exposure to environmental and particularly social risk, often combined with weak governance strength, and limited financial capacity to mitigate these challenges for many sovereigns,” said the ratings agency, commenting also on the generally positive influence of governance factors on the ratings of advanced economies.
ESG factors and pricing of GSS sovereign bonds
“In the majority of the cases, the market doesn’t care [about long-term factors when pricing bonds],” Gordillo tells ESG Investor.
Meanwhile, reviewing the Covid-19 crisis, he also observes that unexpected events can create a correlation of long-term ESG factors with the short-term pricing of sovereign bonds.
As an example, he posits the number of hospital beds, which is usually an indication of the strength of a nation’s health system infrastructure.
This particular metric became suddenly a financially material ESG indicator after the outbreak of the pandemic, because a large number of hospital beds represented the ability of a nation to keep its economy open.
You need to understand market events and that unexpectedly a long-term ESG factor can become financially material in the short term, Gordillo explains.
But then again, if you have larger volumes of the market taking into consideration these factors you can assume that there will be an effect in terms of pricing, he suggests further.