Recently, the risks of investing in fossil fuels have moved centre stage, thanks to factors including the rise of campaigns for divestment from fossil fuel companies, and the work of Carbon Tracker, which highlights the risk of fossil fuel ‘stranded assets’. Mark Carney, the governor of the Bank of England, said in 2014 that the Bank would examine the risks to financial stability posed by “unburnable carbon”.
“This constitutes a very significant development, as it shows that the debate over the future of fossil fuels now encompasses not only climate change but also global financial stability,” says Mark Lewis, senior sustainability analyst at Kepler Cheuvreux.
Much of the scrutiny has been on companies, but there is an increased focus on what the global push to cut carbon emissions means for the $47trn sovereign bond market.
“Asset owners have a fair chunk of sovereign debt on their books,” says Julian Poulter, chief executive of the Asset Owners Disclosure Project (AODP). “When carbon is repriced, those countries whose economies are most exposed to carbon will run into trouble. For some countries, their sovereign debt is not as safe as people think. It’s going to make sense for investors to start to underweight the most exposed economies, although there is not a single investor we know about who is doing this.”
It is inevitable that countries such as Canada, Australia and Brazil will be downgraded because of their carbon exposure, Poulter adds.
Yet many highly exposed sovereign bond investors contacted for this article had given the issue little thought, and felt unable to comment.
“We have just started to integrate ESG issues in our sovereign bond investments in a more systematic way,” a spokesperson for Sweden’s AP1 told IPE. “Climate policy and carbon footprint are of course part of that analysis. However, the study is in a very early stage, so it is not possible for us to answer any questions at this time.”
Sovereign returns are highly driven by macro risks, says Laura Nishikawa, head of fixed-income ESG research at MSCI. “In the long term, there is no greater risk than climate change,” she reasons. “We are seeing a lot more requests for research on energy security risks and the economic and political risks of an over-reliance on fossil fuels, which are vividly illustrated by the recent fall in oil prices. There is growing interest in incorporating these issues into sovereign bond investment strategies.”
ESG factors have an indirect impact on a government’s ability to repay its debt or raise revenues, but are not considered by traditional sovereign ratings, according to RobecoSAM, the Zurich-based sustainability-focused investor, which has created a framework to rank countries on their sustainability. “Such factors reveal potential opportunities and threats faced by countries,” the firm says. “Used in combination with traditional financial analysis, the Country Sustainability Ranking can be a powerful tool to improve investment decisions.”
Climate change is an issue that potentially represents material investment risks and opportunities for sovereign bond investors, ultimately having an impact on a country’s future economic productivity, as well as its social and political stability, says My-Linh Ngo, senior ESG analyst at BlueBay Asset Management.
“It is also applicable to the assessment of governments, given the majority of state-owned enterprises are in carbon-intensive industries such as oil and gas,” she says. “As there will be inter and intra-country variations in climate change effects, and bonds will have different durations and so differing price and liquidity sensitivities, sovereign bond investors will need to anticipate who the net winners and losers will be and manage the risk accordingly.”
However, this will be challenging because it is even harder to come by high-quality data for many countries than it is for companies. Another challenge is that there is no unified approach to considering carbon emissions or climate change. “It’s complicated because there are so many moving parts in a sovereign risk assessment profile,” adds Sean Kidney, chief executive of the Climate Bonds Initiative, which works to increase the size of the green bond market. “But we are really trying to convince old-fashioned raters that they need to bring in some of these risk factors – some countries are highly exposed.”
Climate change issues are particularly pertinent in the run-up to the next UN climate change meeting in Paris, which is supposed to agree a commitment to cut emissions that is binding on all countries, says Jane Goodland, co-head of sustainable and responsible investment at investment consultants Towers Watson.
“If there is an agreement, it could move the dial quite a lot in relation to global emissions targets,” she says. “We think investors should be thinking about the sensitivity of certain bonds.”
Yet, in the absence of a global carbon price, the reality is that carbon is not as material to sovereign creditworthiness compared with corruption or political unrest, says Fiona Reynolds, managing director of the Principles for Responsible Investment (PRI). “That said, carbon is relatively easy to measure and is a good proxy for environmental management,” she adds. “Other related indicators would be energy mix, energy resilience, capacity to adapt to low-carbon regulation and water stress.”
However, she notes that analysts are more concerned with a country’s ability to mitigate or adapt to climate change rather than their carbon output, and that is unlikely to change until there is a global carbon price.
“We prefer to look at an economy’s energy efficiency because there is more data,” says Kaan Nazli, senior economist at investment manager Neuberger Berman. However, he adds that information on a country’s approach to climate change is important not only in relation to the environment but also in terms of governance. “It shows you have a more advanced national energy policy and that you are being a good global citizen.”
With interest in how countries are tackling climate change increasing, and the market for green bonds growing rapidly, a logical next step is for governments to start issuing sovereign green bonds. None have been issued at sovereign level yet, but there are several sub-sovereign green bonds, from bodies ranging from the city of Johannesburg to the US states of Connecticut, Florida and California.
“I fully expect to see sovereign green bonds in the near future,” says Kidney. “There is a growing chance that we will see a flurry in the lead-up to the COP meeting in Paris.”
While the most likely issuers are emerging markets, he says: “I would love to see the French do a green bond in the run-up to Paris, or the US Treasury. It would be a hugely symbolic measure that would encourage others.”