The Paris Agreement, a pledge signed by 174 countries at the 2015 United Nations Climate Change Conference, has had something of a transformative effect on the way people invest. As the planet’s temperature has risen, so too has investor interest in portfolios that align with the goal of achieving net-zero global carbon emissions by 2050. As the energy transition continues to play out, it's more critical than ever that investors have the climate integration tools at their disposal for all asset classes.

However, the drive towards net-zero investing has, so far, left out sovereign bonds. For example, a recent report from the Net Zero Asset Managers Initiative found that out of 325 signatories, only 24 had included sovereign debt in their sustainability portfolios, which was far fewer than for all other major asset classes [1]. This is despite the global sovereign bond market accounting for US$64 trillion [2]. Many institutional investors are also required to hold sovereign bonds for asset liability matching purposes and matching adjustment reasons.

What’s hindering the inclusion of government bonds in net-zero investing?

Integrating government or sovereign bonds into net-zero investment strategies has historically been tricky. Firstly, owing to a limited number of issuers, reducing or removing poorly-performing sovereigns from portfolios could lead to concentration risk. Secondly, there is a major measurement problem. Compared with companies, countries are highly complex entities that are involved in different activities - some of which may be environmentally friendly, while others may be less so.

The measurement issue could in theory be helped by the Paris Agreement, which mandates that participating countries must set nationally determined contributions (NDCs). These NDCs outline what a country will be doing to combat climate change. All countries must maintain their goals and update their progress every five years. There’s a catch, though in addition to being country-specific, NDCs are flexible, meaning policymakers can legitimately adjust their goals based on their (often evolving) needs or constraints. This tends to make the country-level assessment of environmental sustainability rather challenging and resource intensive.

The rise of labelled bonds

A relatively new route for sovereign bonds to enter sustainability portfolios has been found in the form of ‘labelled bonds’. These are bonds issued by governments with the purpose of financing specific sustainability projects, including green projects. As shown below, the issuance of these bonds has exploded over the last decade, with European countries like Germany, France and Italy leading the way. Needless to say, it’s far easier to determine the sustainability of sovereign bonds that are earmarked for specific green or social projects. 

Assessing sustainability at the country level

But labelled bonds aside, regular sovereign bonds rarely feature in sustainability-focused investment strategies. This is despite governments, through policy and regulatory levers, having great scope to advance more sustainable outcomes. Indeed, the impact of such national-level changes can potentially be far greater in terms of real-world positive outcomes than the efforts of any single company.

With this in mind, we have been participating in the initiatives of the Institutional Investors’ Group on Climate Change (IIGCC). We have developed a proprietary toolkit for assessing the green credentials of sovereign bonds, with a view to more easily facilitating their inclusion into decarbonisation-focused portfolios.

Establishing sovereign issuer credibility

We are now using our experience of net-zero portfolio alignment and credibility for sovereign bonds. Our proprietary ‘credibility’ framework aims to identify which countries have the most robust climate policies. As such, this not only aids portfolio insights but can also enrich our engagement with sovereign issuers. This allows us to discuss their climate policies and actions in detail.

Our credibility framework for sovereign bonds, which is based on the three key pillars of decarbonisation, policy action and political backdrop, aims for a comprehensive perspective on the overall reliability and plausibility of national climate policies. The major focus here is on qualitative factors, and with a view to establishing the overall future direction of travel. Each country is scored based on these three factors, resulting in a single composite score that enables more direct country comparisons.

Our bespoke, top-down climate scenario framework is another tool that we use to complement the bottom-up assessment of individual countries. This allows us to simulate emission trajectories under different potential scenarios, including our central scenario. We have found that while national policies are significant, technological innovation and specific country characteristics can also be important factors.

Reporting consistency

The implementation of a credibility framework helps to enhance overall analytical rigour, as well as increasing reporting consistency across asset classes. Investors using such an approach should be better placed to monitor, communicate and report on portfolio progress against climate considerations.

The way forward

The glaring absence of sovereign bonds in most decarbonisation portfolios may reflect the various issues that can complicate the assessment of sovereign issuers from a sustainability perspective. But increasingly, we are seeing new approaches in the industry that are getting past these issues and enabling more informed assessment. This evolution could be especially pivotal because, unlike individual companies, countries have the legislative and policy-making powers that can have a wider-ranging, real-world impact.

Indeed, if the barriers to portfolio inclusion keep lessening, then we think the huge global asset class of sovereign bonds may have the potential to become the missing piece for sustainable investing.