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Unlocking Emerging Markets

Mobilising sovereign debt for clean energy projects in emerging markets can have a big positive impact, but it’s not without its challenges. 

ESG factors, alongside other risks, have long played a part in determining an investor’s decision to channel capital into emerging markets (EMs). This has typically been done by investing in sovereign debt. 

“When investing in sovereign debt, the ‘G’ and the ‘S’ have been within our investment framework because, in the long term, we believe that if a government invests in its population and in reforms, those investments will eventually pay off in the shape of a more vibrant economy,” says Henrik Paldynski, Emerging Market Debt Portfolio Manager at Aktia Asset Management.  

Assessing an investment’s exposure to environmental factors is increasingly relevant, particularly in EMs. After all, the world’s energy and climate future hinges on decisions made across both emerging and developing economies, according to an International Energy Agency 2021 report.  

“Evaluating the ‘E’ has been more difficult to factor into our sovereign investing. We have mainly focused on climate change risks in our assessment of a specific country,” Paldynski says. 

Although EMs account for two-thirds of the world’s population, they represent just one-fifth of investment in clean energy. Furthermore, the IEA report noted that annual investments across all parts of the energy sector in EMs fell by around 20% over the previous five years, in part because of persistent challenges in mobilising finance for clean energy projects. 

ESG-labelled debt products promise borrowers greater access to a growing number of engaged investors, including EM issuers.   

Pole position 

Poland was the first sovereign to launch a green bond in December 2016. Since then, it has been followed by other EM peers. 

According to data provided by Refinitiv, EM sovereign green bond issuance accounts for around 18% of total sovereign volumes, at US$28 billion from 28 issues.  

In the rest of the ‘use of proceeds’ ESG bond universe, they have played a more prominent role, accounting for 100% of total sovereign social bond issuance, at US$19 billion from 12 issues, and 70% of total sovereign sustainability bond deals, at US$15 billion from 14 issues. 

The only EM sovereign to issue a sustainability-linked bond (SLB) so far has been Chile, which launched a US$2 billion SLB in February via BNP Paribas, Credit Agricole CIB and Société Générale.

“ESG-labelled bonds are very useful in attracting both investors and issuers,” says Carmen Nuzzo, Head of Fixed income at the UN-convened Principles for Responsible Investment (PRI).  

“EM countries have been very active in this space because there’s been high demand from investors for these types of products.” 

By issuing labelled bonds, borrowers are able to diversify their traditional investor base and, in some instances, achieve marginally tighter pricing than with conventional debt. 

The labelled bond route is compelling to EM borrowers “because they need to raise funds more than other countries to address their climate and social challenges,” says Nuzzo. 

Pure labels 

Issuing labelled bonds brings benefits to the borrower, but the process also comes with burdens.  

For the ‘use of proceeds’ format, green or social projects need to be identified, which is not always straightforward for smaller countries.  

“For the smaller debt management offices of some countries, they’ve already run out of projects they can tag as pure green,” notes Fiona Stewart, Lead Financial Sector Specialist at the World Bank. 

The sustainability bond format goes some way in mitigating the need to find all green or all social assets to be financed by ‘use of proceeds’ bonds, since they can fund a combination of identified activities. More recent SLBs, where funding costs are linked to an issuing entity’s performance against specific KPIs, have attracted growing interest.  

“You can’t put green assets or projects together quickly. It takes time,” says Nuzzo. “That’s why SLBs are interesting, because the bond’s proceeds are not linked to green projects or assets. It’s more about strategy.” 

Borrowing to fund public spending is an attractive proposition.  

“SLBs are an appropriate structure for the market in general as we want to see outcomes as well as outputs,” notes World Bank’s Stewart. “Green markets are nice, but what’s really changing the underlying performance? What’s really moving the needle? These performance type instruments are very interesting.” 

For Chile’s SLB, the country’s interest payments have been linked to two KPIs: an absolute decarbonisation target and achieving half of electric power generation through Non-Conventional Renewable Energy sources (NCRE) over the next six years, increasing to 60% by 2032.  

“Chile has an excellent and innovative debt office that likes to push the boundaries,” says Stewart. 

The country has aligned the SLB to its official nationally determined contribution (NDC) commitment, and is also the only sovereign borrower to tap all three ‘use of proceeds’ structures and the SLB format, issuing in euros and US dollars as well as the Chilean peso to maximise demand.  

Other Latin American sovereigns have also issued ‘use of proceeds’ bonds and some are reportedly contemplating the SLB structure. 

Nevertheless, there are still costs associated with choosing the labelled bond structure.  

“We acknowledge the cost of developing and maintaining sustainability bond frameworks as the biggest hurdle, however investor demand for these types of assets should be encouraging for issuers,” says Emilia Matei, ESG Analyst of Emerging Market Debt at Aviva Investors. 

Establishing a framework can also have longer term benefits beyond short-term cost saving. 

“ESG-labelled issuance by EM sovereign borrowers gives a clear indication of their commitment to addressing sustainability risks and indeed strengthens their commitment to these issues,” says Matei. 

Sustainable discipline 

While the labelled bond market continues in its development, other projects are underway to provide investors with increased levels of transparency.  

The Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) project has been established to create a tool giving investors a common understanding of sovereign exposure to climate risk. 

ASCOR will allow investors to assess governments’ climate-related commitments, their policy frameworks and the actions they are taking to ensure the benefits of a low-carbon transition are shared among their citizens. 

“Investors are concerned about the implications of climate change because of the cost of transition and because of the fiscal impact of climate change,” says Dr Rory Sullivan, CEO of Chronos Sustainability. “Yet there isn’t a standard assessment framework that all investors can use.”  

Without a standard framework, investors will utilise different data sets, drawing widely variable conclusions.  

“It means that investor influence on public policy has been limited because investors haven’t really been speaking with one voice in terms of how they assess sovereign risk,” Sullivan notes.  

The project could help identify countries with strong commitments and policies that need more capital backing their ambitions. 

“It becomes more than just about a price issue, but a recognition that there’s an institutional structure or set of dependable policies that need to exist,” says Sullivan.  

“It enables a more informed assessment of a sovereign’s approach to climate change – for example, when evaluating investments in SLBs.” 

Small steps 

The growth in SLB issuance has been impressive over the last two years, but the product is still in its infancy.  

Some investors question the level of intent in the choice of KPIs and are unconvinced by the step-up coupon structure.  

To further address some of the issues, the International Capital Markets Association (ICMA) recently published more illustrative examples of potential KPIs applicable to SLBs per sector. 

“The registry does not refer to issuer types, but any of the KPIs listed can be used by sovereigns/EM sovereigns if suitable,” says Simone Utermarck, Director of Sustainable Finance at ICMA.  

“For example, KPIs related to climate change, biodiversity, social factors or the ocean could all be relevant to EM sovereigns.” 

The step-up feature for SLBs, which rewards investors financially when borrowers miss targets, has its detractors. It is difficult for funds investing in climate change to justify an improved financial performance due to borrowers missing climate-related targets. 

Rewarding a borrower with a step-down coupon for hitting targets is also not straightforward.  

“The step-down is problematic for an investor,” says PRI’s Nuzzo. “It would be an advantage from an issuer perspective, but no investor will buy it unless the full coupon is guaranteed by another body. Such a structure could be even more attractive for sovereigns, from a cost of capital perspective, and protect investors that cannot go below a certain level of yield once they’ve subscribed to the issue.” 

As EM borrowers become increasingly reliant on bond markets to finance their UN Sustainable Development Goal ambitions, improvements to sustainable finance will require a collaborative effort from stakeholders.  

Aviva Investors’ Matei says: “Borrowers must provide an increased level of transparency and ambition on the ESG initiatives they plan to pursue with the proceeds from bond issuance, while investors should carefully assess the strength of these initiatives. Regulators should provide universal ESG standards to help investors and borrowers align their sustainability goals and reporting.”  

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