How Green is Government Debt?

Consistent data on sovereign climate risks is crucial, says Victoria Barron, ASCOR Chair and Head of Sustainable Investment, BT Pension Scheme.

Governments know they must attract ESG investors to sovereign debt if they are to meet their net zero carbon emission targets by 2050.

Data from the Climate Bonds Initiative reveals sovereign global, social and sustainable (GSS) bond volumes increased by 103% in 2021 raising cumulative issuance to US$193 billion compared to US$95.2 billion at the end of 2020.

Green bonds provided most of the additional US$97.8 billion (74%), and Europe – where the climate agenda dominates policy discussion – was the largest source of sovereign GSS bonds, responsible for 75% of issuance.

This March, Chile was the first sovereign to issue a sustainability-linked bond which adheres to the Paris Agreement on climate change, including a commitment to limiting emissions to 95 metric tons of carbon dioxide by 2030 and ensuring renewable energy accounts for 60% of electricity production by 2032.

Yet all this momentum in green, social and sustainable bonds does little to help investors understand the ESG credentials of traditional sovereign debt, which accounts for a far larger portion of the market – and many asset owners’ portfolios.

In Q4 2021, EU Member State and UK bonds and bills issuance was €624 billion. This compares with €28 billion in green bonds and €0.6 billion in sustainable bonds.

Since asset owners – particularly mature defined benefit pension funds with an asset/liability matching strategy – struggle to ignore government debt, they need more support in scrutinising the climate-related risks represented by the bonds issued by sovereigns.

Key metrics

For the past year, the Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) Project has been investigating how to create a tool that gives investors “a common understanding of sovereign exposure to climate risk and of how governments plan to transition to a low-carbon economy”.

In a progress report released this June, ASCOR – an international collaboration of investor networks, asset owners and asset managers, representing over US$5 trillion AUM and chaired by BT Pension Scheme (BTPS) and the Church of England Pensions Board – claims to have “made significant progress in developing the overall framework”.

Victoria Barron, ASCOR Chair and Head of Sustainable Investment at the BT Pension Scheme, says: “Asset owners are setting net zero goals and sovereign debt is a really big part of their investment universe, but there is yet no way to assess the climate risks and opportunities of [government debt].”

The Transition Pathway Initiative team at the London School of Economics’ Grantham Research Institute on Climate Change and the Environment has conducted interviews with asset owners to establish what data and information they need to assess how well sovereigns manage their climate change risks and opportunities.

“Investors want a line of sight on the transition and physical risks in government policy, and detail on where countries are on getting to net zero,” says Barron.

She continues: “If you compare countries’ national determined contributions (NDCs), they are all very different and difficult to compare. They’re all using different types of data. So how on earth do investors cut through that and have a framework that gives them the answers to questions in these key areas.”

Barron says investors want more detail on national climate change policies and greater consistency in reporting.

“All countries must have a physical risk report and analysis as part of the Paris Agreement, but they all vary. We need more detail on different exposures across countries. For example, how are low-lying regions that have a lot of exposure to agriculture going to be impacted by climate change and what does that mean for GDP which then impacts the quality of a sovereign issuer’s rating,” she says.

In the run-up to COP26, the FAIRR Initiative investor network flagged the lack of detail about emissions reduction in the agricultural sector in the NDCs of 16 Group of 20 countries.

Factoring in fairness

The just transition – which focuses on ensuring jobs and communities are protected in a zero-carbon economy – was also raised as a key issue for sovereign debt investors.

Barron says including societal factors alongside environmental considerations highlights the complexities ASCOR faces in building an effective tool.

“There has been some really good work on just transition, but how do investors think about that? I’m not saying that we’ve got the answer, but we do need to think about the fact that sovereign debt has many different indicators for investors assessing this asset class. The health of the economy is based on people and jobs. We are trying to make this as relevant as possible.”

Further complications lie in the vast disparity of wealth between sovereigns. ASCOR says its tool “should account for the financial strength of sovereigns, as well as adaptive capacity and resilience”.

Barron says “ASCOR is “mindful of the north/south divide – in terms of the need for capital, and in terms of responsibilities for historic and for future emissions – and we want to ensure issues of justice and fairness are fairly reflected within the ASCOR tool”.

However, she concedes that it is unclear how each sovereign will engage with the project and says that while they will all be given equal time to respond, “it is really hard to know kind of what’s going to come out of the assessment before they’ve happened”.

Barron says ASCOR has attempted to avoid western bias by including the Mexico-based Sura Asset Management, on the steering committee.

She adds: “We have to also remember this is an investor tool and countries already receive different sovereign ratings from various ratings agencies. This isn’t an NGO project; it is an investor project to be used to make investment decisions.”

She adds: “We are trying to juggle a few different things including the matter of fairness, which is why we want to integrate just transition into the tool and make sure we have diversity of representatives.”

Data-gathering challenges

The next stage of the ASCOR project is to find the data to inform the metrics investors say they need (see boxout below).

“The researchers are looking to see what is actually available because while investors may want certain information such as regional emission pathways, these may not yet be developed. We may not end up with the perfect final product but that is because – like everyone in the ESG space – we are on a journey.”

Barron says the tool will ultimately guide investors in the right direction and give them greater power to engage with sovereign issuers.

However, she concedes that efficacy of engagement will vary across countries. Engagement between issuer and investor, after all, is not a well-established practice on the sovereign bond market.

“Some countries are very coordinated, others are not. In some cases, engagement will involve tandem conversations with the finance ministries, debt management offices and ministries of environment. That is just a reflection on how general debt issuance is right now. A lot of countries don’t have an investor relations person.”

ASCOR expects to have identified and tested potential indicators for the tool the by Q4 2022 which will be applied to a universe of 20 developed and developing countries.

Barron says: “We expect to publish the results of this initial assessment in by Q2 2023, along with a critical assessment of the usefulness of the indicators and suggestions on whether some should be refined or replaced. We will share the results and findings publicly and engage with key stakeholders and issuers to ensure the framework’s usability.”

Investor expectations for the ASCOR tool:

  1. Focus on sovereign net zero commitments and develop a 1.5°C- aligned emissions pathway, to allow countries to be compared on a consistent basis.
  2. Cover the full range of government actions, including economy-wide and sector-specific policies in areas such as carbon pricing, energy subsidies, transport, deforestation and land use planning.
  3. Consider the Just Transition impact of policies, assessing both the social benefits and costs of acting and the distributional effects.
  4. Assess the physical effects of climate change.
  5. Account for the financial strength of sovereigns, as well as adaptive capacity and resilience.
  6. Be based primarily on publicly available data.
  7. Assessments should be updated on a regular basis and should be publicly available.
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