Integrating net zero in sovereign bond portfolios

Countries will take different paths and not all will decarbonise at the same pace. Figure 1 explores the distribution of emissions in 2050 under various scenarios of equilibrium temperatures, starting with those that could achieve the Paris Agreement target temperature of 1.5 degrees above the preindustrial average.

As explained in the sixth Intergovernmental Panel on Climate Change (IPCC) report, achieving this implies some regions must reach net zero earlier if others reach it later (the first two 2050 scenarios in Figure 1). Some might need to go further and achieve net-negative emissions by 2050.

Differences in timings will depend on multiple factors, including countries’ potential to reduce emissions and deploy carbon-removal solutions, associated costs and the availability of a global mechanism to balance positive and negative emissions between countries.

Timings will also depend on whether equity principles are applied, whereby developed countries would be expected to reach net zero earlier than some developing countries.

The report found cost-optimal scenarios imply relatively early net-zero emissions in Latin America, around 2050 for OECD countries and relatively late in Asia and Africa. However, an allocation based on equity principles would change this, often resulting in earlier net-zero years for OECD countries.¹

Figure 1: Emissions by region in different 2050 scenarios, GtCO2-eq (including 5-95th percentile range)

Source: IPCC, April 2022.²

In addition to the long-term increase, recorded rises to date must also be considered. Global temperature increases have already exceeded one degree Celsius and there is a 66 per cent chance of having at least one year above 1.5˚C in the next five years.³ In fact, boosted by an El Niño event, July 2023 was the hottest month on record globally, with the first and third week breaking through the 1.5-degrees threshold.⁴

The extreme weather and other impacts that accompany such change will create challenges for every region, but the ability to prepare and adapt will also vary by country, with financial implications.

Figure 2: Largest emitters versus most vulnerable nations

Source: IPCC, John Lang, Energy & Climate Intelligence Unit, April 2022.⁵

Natural catastrophes will affect countries’ financial resilience but increased investments in mitigation and adaptation measures might require additional borrowing. That could create resistance, as sovereigns would weigh the potential impacts on a country’s credit rating and the government’s fiscal policies and commitments, as well as any political cost. 

“Prioritising short-term considerations over long-term climate and financial resilience could compromise the Paris goals and lead to higher costs in the long run,” says Apostolaki. “If we miss the Paris Agreement targets, greater climate warming and a disorderly transition will be expensive.”

For investors in sovereign assets, the ability to meet their net-zero commitments and facilitate a real economy transition will depend in large part on their portfolio’s regional exposure and decarbonisation expectations.

The first step is being able to assess the climate impact of assets held by measuring the portfolio’s carbon footprint.

“Sovereign carbon accounting is a relatively new area compared to corporate emissions, but progress has been made in the past two years,” says Apostolaki.

The Partnership for Carbon Accounting Financials (PCAF) included a methodology for sovereign debt in its latest iteration, published in December 2022. In short, the PCAF standard recommends using emissions/purchasing-power-parity-adjusted (PPP) GDP for carbon intensity scores and bond value/PPP-adjusted GDP for absolute emissions attribution in portfolios.⁶

In January 2023, the UN-backed Net Zero Asset Owner Alliance endorsed the PCAF methodology in its framework and now includes sovereign debt in the list of asset classes for which its members need to assess their carbon footprint.⁷

And, since 2021, the Institutional Investors Group on Climate Change (IIGCC) has included sovereign bonds as one of the asset classes for which its members must assess net-zero alignment and offers guidance in its framework.⁸

Assessing a portfolio’s climate risk

Measuring their sovereign portfolio’s carbon footprint also provides investors with a proxy for the embedded climate risk. This is because it gives an idea of the level of transition risk a country might accumulate, such as the potential impact of a carbon tax or litigation challenges.

“Climate transition risk will become more financially material over time, so will increasingly impact our portfolios and investment decisions,” says Thomas Dillon, head of ESG for sovereign investments at Aviva Investors.

Measuring the carbon footprint also lets investors derive the temperature rise implied by these emissions. 

“It provides a proxy for risks, since we already know that the higher the temperature rise, the higher the physical impact of climate change, both in terms of extreme events and overall impact. The quantitative analysis helps put figures against that impact from both physical and transition risks,” says Apostolaki.

Climate risk is most commonly expressed through a portfolio’s Climate Value-at-Risk (CVaR), a forward-looking and return-based quantitative model that estimates how climate change could affect company valuations and, by extrapolation, countries’ economies.⁹

Several ESG data providers now offer CvaR estimates, but also other ratings and insights that aim to capture climate risk, either as a standalone consideration or as part of a broader range of sustainability factors.

For example, INFORM Climate Change ranks countries based on their preparedness to adapt to climate risks. Higher vulnerability and lower readiness would require greater compensation.

Complementary to this, some data providers look at each country’s sustainability performance, including emissions, relative to its development, which provides useful insights for investment decisions across diverse markets.

“Using absolute and wealth-adjusted assessments of ESG risk helps avoid indiscriminately penalising poorer countries” says Dillon.

Quantitative and qualitative data

However, purely quantitative assessments have limitations. Crucially, while a quantitative climate score and risk rating can tell investors about the level of risk exposure in a country, they don’t say anything about how that risk is being managed or the policy environment to address it.

“We put a significant amount of weight on our qualitative overlays because ESG data, like all data, is primarily backward-looking,” says Dillon. “We use data as a starting point, placing more weight on timely, holistic qualitative views like the policy direction to improve future readiness.”

A qualitative approach gives portfolio managers an up-to-date snapshot and assessment of a country’s momentum towards the transition, positive or negative. Deep-dive sovereign assessments that include climate transition strengths, weaknesses and trajectory in addition to traditional economic and credit data allow for forward-looking analysis.

“That's where the value is because we're making a forward projection on what it means for a country’s credit rating and, importantly, the sovereign bond yield,” says Steve Ryder, senior portfolio manager, global rates, at Aviva Investors.

This is critical as a policy enacted today will typically take three to four years to feed through into an emissions intensity indicator – one or two years for the policy to have an impact on emissions, and another year or two for the data to be collected and reported.

“That is why we put effort into understanding policy, momentum and events happening now, and feed it into our investment decisions,” says Dillon. “There is work to do to bring emissions data up to date, contextualise it and link it to current events and trends.”

Translating the latest developments into possible emissions trajectories allows investors to compare them to the decarbonisation commitments governments have made in their nationally determined contributions (NDCs) as part of the Paris Agreement.¹⁰ This translation is therefore important to make, but comes with its own challenges.

“The NDCs are submitted in a variety of forms and levels of granularity, which makes the translation of targets into future emissions hard to quantify and compare. Expert judgement is also involved, adding complexity,” explains Agneta Bamania, climate investment strategist at Aviva Investors.

As an example, Bamania says while all countries submit an unconditional target to be implemented with domestic resources, some also submit a more stringent, conditional target, subject to receiving technological and financial support from the international community. Additionally, imprecise definitions and alternative interpretations of key commitments and assumptions can lead to varying projections for countries’ emissions pathways.

This type of analysis nethertheless helps investors understand if countries are delivering on their commitments and assess whether they are ambitious enough to support the transition to net zero. For example, Figure 3 shows the EU 27 countries’ expected emissions reductions based on their plans against a 1.5-degree-aligned pathway.

Similarly, understanding progress in increasing resilience and adaptation means investors can start identifying countries that might not be responding quickly enough.

This combination of qualitative and quantitative insights also provides useful context for asset owners and managers to engage with sovereigns on transition plans, the level and speed of change and investments needed, and to communicate expectations (see Levers to decarbonise sovereign portfolios).  

“It is important to understand each country’s approach to the various facets of climate change, including mitigation, adaptation, resilience and ability to take advantage of the opportunities a net-zero economy creates. It helps build a more robust portfolio directly, but also indirectly by supporting our stewardship activities,” says Apostolaki.

More holistic frameworks are becoming available that will help investors assess those facets and make use of diverse sets of information to understand a country’s contribution to the net-zero transition and preparedness for the risk of a warming planet.

For example, the Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) Project was established to give investors a common understanding of sovereign exposure to climate risk and provide insights into how governments plan to transition. It will publish the ASCOR Final Report and pilot country assessments in the fourth quarter of 2023.¹¹ A recent report by the United Nations Environment Programme Finance Initiative on climate risk also found an increasing number of tools can integrate physical and transition risk to support climate risk assessments.¹²

A robust approach to climate risk can help safeguard a portfolio but identifying and acting on climate opportunities will optimise its performance. How then can investors identify the opportunities for sovereign portfolios that might emerge?

“The transition, focus on emissions and analysis of that will become increasingly important, but my role covers two areas,” says Ryder. “One is tracking the winners and losers based on the impact of climate change, the other is around funding the transition. That will be critical because a large part of it will be funded by bond markets.”

With the end of large bond-buying programmes by central banks, issuers face the question of whether there will be enough demand. Markets that need to attract foreign capital, like the UK or Australia, could face more difficulties than those with larger domestic markets. Central bank bond-buying programmes eliminated a lot of credit risk, and their removal increases investors’ sensitivity to fundamental assessments of budget plans and debt sustainability.

Climate transition plans are an additional input in this mix, which will become increasingly important because of countries’ ongoing funding needs, heightened by the significant rise in interest rates that began in 2022.

“It will be essential to assess the fiscal side and issuance needed to transition, and the cost of capital for the transition will have more of an impact each year,” says Ryder.

The European Union (EU) appears to be something of an outlier in that its momentum towards a fiscal union, notably through the Recovery and Resilience Fund and issuance of collective EU debt, has made a significant difference to euro-zone countries’ growth outlook and cost of capital to fund transition plans. So, while each EU country’s emissions, net-zero plans and funding needs are important, investors assessing their bonds also need to understand collective initiatives at the euro-zone level.

“When you look at countries like Italy, France and Spain, which have high debt-to-GDP ratios and budget deficits, you could conclude it will be expensive for them to commit to climate transition policies. In fact, collective action at the EU level is bringing down the cost of capital for these countries and speeding up the transition,” says Ryder.

The need for more issuance creates a bigger difficulty for emerging-market debt (EMD) investors, who need to assess which way the scales are tipping: will transition and adaptation plans mitigate more risk than is created by additional issuance? And over what timeframe?

Emilia Matei, ESG analyst for EMD at Aviva Investors, explains that, while issuance is critical and should be assessed on a case-by-case basis, environmental factors are becoming increasingly important as countries set up climate strategies, update their NDCs and look for financial support from developed markets to fund transition plans.

“All of this would entail important foreign direct investment (FDI) and feeds into our macroeconomic assessments and ideas,” says Matei. “If one of our ideas is to buy a government bond, we will look at any FDI-related environmental objectives the country may have and assess how these would drive the performance of our trade idea.”

Meanwhile, labelled issuance, like green or sustainability-linked bonds, could help mitigate some of the rise in the cost of capital that might stem from increased borrowing because there is strong demand for such bonds. Labelled issuance can also actively mitigate wider issuer-level risks where it channels capital towards the factors most material to a country’s sustainability profile or sets targets related to these factors. That could improve the overall credit risk of the entity, including any contribution from climate risk, which will need to be robust to attract investors.

“We will buy labelled as well as traditional bonds. At the same time, we’re often more interested in the sustainability profile of the entity issuing the bonds than the particular security. We don’t just want to see green bonds, we want to see green companies, green governments and green economies,” says Dillon.

“By assessing risks and opportunities and employing a forward-looking approach, not only can we create solutions that are building resilience into our portfolio, but we can also determine the levers we can influence and refine our asks to help support an economy-wide transition,” says Apostolaki. “This feeds into our work across various levers and supports active stewardship.”  

Finance ministries and central banks have a vital role in accelerating the necessary economic transformation and mobilisation of investment for the transition, helping mitigate the threat to long-term growth and prosperity that makes climate a material consideration for investors. Engagement offers an opportunity for investors to gather information and push for change.

“These institutions hold the purse strings and set interest rates, so are important to engage with,” says Dillon. “They set the rules of the game for all market participants; if they are not on board, your sovereign holdings will not decarbonise quickly enough, but neither will your other assets.”

Every January, Aviva Investors sends out tailored letters to key sovereign stakeholders, including finance ministries and central banks, outlining our annual ESG engagement priorities. Throughout the year, the sovereign teams’ meetings with issuers are an opportunity to follow up, get responses and better understand sovereigns’ thinking and approach to ESG risks.

“As an example, Uruguay issued sustainability-linked bonds last year and one of its targets was on carbon emissions,” says Matei. “That was a positive example of engagement because the Ministry of Economy and Finance was knowledgeable about the bonds’ framework and targets. After several discussions, we purchased these bonds when they were issued.”¹³

However, sovereign engagement comes with challenges. One is limited access, particularly to major issuers who operate in highly liquid markets. These issuers make up a significant portion of investor portfolios and have outsized influence on the global climate transition.

As a result, collaboration among investors is another important lever. Initiatives such as the Principles for Responsible Investment coordinated Collaborative Sovereign Engagement on Climate Change, the ASCOR project, the Net Zero Asset Owners’ Alliance, the IIGCC and Net Zero Asset Managers initiative can and have started facilitating such collective action. ^{14,15,16,17,18}

Investors should also look to improve the financial system itself, for example by collaborating across jurisdictions to set global standards for robust mitigation and adaptation plans and financing that will support them. For example, the recently launched Bridgetown Initiative 2.0 presents six key actions to build a more sustainable financial architecture. These must involve governments, multilateral institutions and private actors, and asset owners can engage at all levels to support this transformation.¹⁹

Our macro stewardship team actively engages with governments, policymakers, NGOs, academics and other key stakeholders on such initiatives to try to correct the market failures that lead to global warming and the destruction of nature. At COP27 in Sharm-El-Sheik last year, for example, we presented our thinking around the urgent need and possible ways to transform the financial system.²⁰

Beyond engagement, asset owners can support countries’ mitigation and adaptation efforts by funding green innovation and assets, at the sovereign level where available, but also in other asset classes.

They can also work with regulators at home to identify ways to allow for more flexibility to tilt sovereign portfolios in a way that signals their preference for climate leaders and helps decarbonise their holdings.

For a better tomorrow

The climate transition is progressing at different speeds across the world and there are various interlocking elements for sovereign debt investors to consider as they gauge the resilience of their portfolios.

By following a structured and methodical approach, it is possible to not only gain a better understanding of the risks and opportunities in sovereign debt markets, but also to work with governments and other stakeholders to bring us all closer to a net-zero future.