The sovereign pay-off

Scoring and pricing sovereign borrowers on the basis of environmental, social and governance performance could have a greater impact on global sustainability than anything else capital markets can hope to achieve. But sovereign debt is the least developed major global asset class when it comes to integrating sustainability factors.

Laurence Davison Head of Content KANGANEWS

Sustainable finance took root in the equity market and has crept across most asset classes. While few would claim it is fully mature in any area, its adoption and evolution have been rapid and consequential – in most sectors. Major corporate entities, for instance, now have their sustainability and treasury teams closely aligned and working with common cause to satisfy the needs of, among others, equity and debt investors.

There have been plenty of headlines relating to sustainability in the sovereign debt space, too – but much less impact on, or more importantly from, markets on sovereign behaviour. Sovereign environmental, social and governance (ESG) investment briefly hit the headlines in Australia in November 2019 when Sweden’s central bank, Riksbank, announced its divestment of certain Australian and Canadian provincial bonds because of its assessment of their outsized climate impact. On the other hand, when the Trump administration announced plans to pull the US out of the Paris Agreement, in 2017, the bond market did not noticeably demur.

Where equity and debt investors are making increasing demands of private-sector entities on ESG performance and commitment to net zero emissions, capital markets’ response to sovereign sustainability policy has so far been inconsistent at best.

This is despite a potential breadth of impact – positive and negative – of national ESG policy that goes well beyond the sovereign issuer itself. “At the highest level, we all should recognise that governments are the most powerful actors in solving the existential issues that face us as humankind,” says Ryan Myerberg, partner, portfolio manager and co-head of global taxable fixed income at Brown Advisory in London. “Companies can do a lot but, when it comes to wholesale change and delivering on the issues we face, it has to come from countries.”

Positive change at sovereign level also has a natural, technical impact across economies. If capital markets begin to price ESG risk appropriately, a government that reduces its own risk will naturally pass on its cost of funds benefit to any borrowers that price off the sovereign curve. Even equity priced on a discounted cash flow basis will enjoy a valuation uplift, on the same basis.

Tamar Hamlyn, Sydney-based principal and portfolio manager, interest rate strategies and macroeconomics at Ardea Investment Management, reveals: “We have always felt we can get the best reduction in corporate ESG risk not by talking to the universe of corporate issuers here in Australia but by talking to the much smaller handful of state governments and the federal government. If we can encourage them to set appropriate policy frameworks, this will not only change the risk of the governments themselves but that of all of the markets and economies they supervise and that they operate in.”

“We have to ask what is ethically appropriate for an investor to act on in a sovereign portfolio – whether it be divestment or engagement. If investors remove financing from a country on the basis of climate policy, it could make that country more vulnerable and less capable of adapting.”

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On the other side of the coin, the potential negative consequences for governments that refuse to deliver credible climate policy are starting to influence strategic thinking.

In 2021, Australia’s Department of Industry, Science, Energy and Resources conducted economic modelling to inform the development of a federal long-term emissions reduction plan and associated net zero by 2050 target. As part of this research, Treasury estimated a capital risk premium of 100-150 basis points if Australia did not adopt such a policy and of as much as 300 basis points if it was the only developed country not to do so.

Again, however, the threat was a future hypothetical rather than a reflection of bond pricing. A funding premium that would at 2022 debt levels amount to a cost to the Australian taxpayer of A$9-27 billion (US$5.9-17.6 billion) a year across the federal government’s debt portfolio – with consequent knock-on impact on the cost of capital for local public and private sector entities – was not of sufficient concern to the previous government to persuade it to adopt a credible net zero policy.

In the end, it was the electorate rather than concern about how funding markets might respond in future that changed Australian climate policy. So far, the more responsive political tone on climate policy has yet to deliver a noticeable positive impact on cost of funds, however.

There is some evidence that there is already a correlation between sovereigns’ ESG performance and their cost of funds, though. In 2019, Federated Hermes and Beyond Ratings published research showing a clear relationship between good outcomes in the latter’s sovereign ESG scores and relatively lower sovereign credit default swap (CDS) spreads. The strongest relationship appeared to be between credit risk and governance, however, with environmental scores not as closely correlated.

Overall, the state of play in sovereign ESG investment appears in late 2022 to be one of growing interest but limited consensus or momentum. Zoe Whitton, managing director at Pollination Group in Sydney, describes the situation as reminiscent of the early stages of sustainable finance in the equity market, in the sense that there is ongoing dialogue but few ready answers.

She tells KangaNews Sustainable Finance: “In those days – to put it simply – investors would ask companies to do something about sustainability, companies would ask what it is they wanted and investors would tell them to figure it out. In other words, participants across the capital chain were expressing interest without having a strong view of what solution they sought.”

The US dilemma: ESG hits a wall of sovereign market realities

Any investor with a genuine desire for their allocations to reward good and punish bad environmental policy would have had to think long and hard about buying US Treasuries during the country’s previous administration. The problem is that it is hard to be a global government bond investor without exposure to the US sovereign.

“The hypothetical question with which ESG [environmental, social and governance] investment in sovereign debt is challenged is: are you prepared to not own US Treasuries if you think the US does not pass a certain scoring threshold or equivalent? Inevitably, the answer has been ‘no’. But unless a commitment to withhold capital is credible, investors cannot really expect market discipline to drive a change in behaviour,” says Tamar Hamlyn, principal and portfolio manager, interest rate strategies and macroeconomics at Ardea Investment Management.

This is not a purely theoretical point. Six months after his inauguration as US president in 2017, Donald Trump set the clock running on the US’s withdrawal from the Paris Agreement. Given a credible track to Paris goals is perhaps the single most commonly used baseline for environmental scoring, a country abandoning even lip service to the end goal would under normal circumstances surely have set off flashing red alarms for ESG screens.


The main reason ESG integration in the sovereign debt sector has been slow to emerge appears to reflect a fairly straightforward reality. Whitton continues: “The investors we work with have been moving through the asset classes as they think about net zero commitments and also their climate risk and opportunity due diligence requirements. They are getting to Treasuries last. There are a few reasons why they are getting there last, but probably the most pertinent is simply that it is very complicated.”

The complexity takes many forms but if there is a single, central issue it is that the sovereign asset class cannot reasonably be addressed in the same way as private sector investments. In some ways this is largely a technical issue: some practices developed in the equity market can be rolled into credit in a relatively straightforward manner because investment analysts are dealing with the same entities, boards, management and investor relations operations in both asset classes.

The same cannot be said for sovereigns. Neither does the idea of investor advocacy for improved ESG performance via access to boards and management apply in anything like the same way.

Myerberg explains: “Advocacy can take different forms, but it is fairly clear on the equity side and, more or less, in corporate credit. To engage with sovereigns is tricky, because at the end of the day national governments should be most accountable to their citizens rather than investors. We are aware of this but we believe there are still opportunities.”

If this was the extent of the challenges, the rollout of ESG investment practice to the sovereign space would likely just be a matter of time. But the issues are even wider. Delving further into the differences between government and corporate entities as investment destinations, perhaps the critical challenge is how wide governments’ sphere of influence spreads and how hard it is to separate – and, potentially, punish – a sovereign’s underperformance in a single aspect of ESG given how connected the three are within nations.

Hamlyn says Australia provides a useful example of how thinking holistically about ESG can make it hard to separate individual elements. “We can’t on one hand say we dislike the fact that Australia obtains some of its revenues from resource extraction and then on the other hand say we want to retain aged care, healthcare services and the NDIS [National Disability Insurance Scheme],” he argues. “Our approach is to start from a position of implicit trust that governments are generating net positive benefits for society.”

Adding to the difficulties is the nature of government bond markets and the purpose of sovereign debt investment. Much of any global sovereign debt investment process, other than funds specialising in emerging markets, is technical management of factors like duration and currency risk. This requires access to the world’s most liquid markets – not all of which can be assumed to clear the bar on ESG performance (see box).

Market infrastructure is also patchy for investors seeking to develop an ESG methodology in their sovereign allocations. Whitton, for instance, says there is a lack of frameworks to help understand how to respond – or even who should be responsible for responding – to sovereign ESG risk.

Some of this is a practical consideration. Carl Shepherd, London-based portfolio manager, fixed income at Newton Investment Management, tells KangaNews Sustainable Finance there is a shortage of reliable sovereign ESG indices available to investors.

For instance, one sovereign ESG index methodology was based on negative news reports emanating from a country but the news reports used were about corporate behaviour. This allowed Belarus, not generally regarded as a stellar ESG performer, to achieve double weighting in the index largely because of its lack of internationally significant corporate entities.

Shepherd comments: “It is easier to pick holes in methodology than it is to come up with a solution that meets everybody’s needs, and I understand that an index has to be completely dispassionate. But we have found that what is out there at the moment often comes up with quite unusual results.”

These market infrastructure issues have a wider cause, in the form of a further complexity inherent to the breadth of sovereigns’ influence. The equity and credit markets are still struggling to develop and agree on consistent approaches to scope-three emissions, and this topic is even more wide-ranging and fraught in the sovereign space. 

The key consideration here is how to weight countries’ climate impact – which would presumably take in their overall economic profile including exports – versus their own climate risk, in other words the likely impact on domestic economies from climate change. This is a type of double materiality that is extraordinarily difficult to measure, let alone price.

“We face a challenge that requires a collective action solution, but where free rider problems exist,” suggests Mitch Reznick, head of sustainable fixed income at Federated Hermes in London. “Take Australia: it is principally a services economy but also has a large exposure to mining and agriculture. The forest fires the country has been experiencing are obviously related to climate change – but who is responsible for them? Is it Australia, or is it the world as a whole?”

In the face of these complexities, Myerberg suggests many investors have effectively decided they are simply going to ring fence sovereigns from an ESG perspective – setting them aside rather than assessing them, because doing so is too hard – or limit themselves to some form of best in class, worst in class assessment that might exclude the very worst ESG performers.

“But this is a little too easy, because most of the bottom tranche of sovereigns will not be investable anyway. It is hardly a big claim for an asset manager to say it won’t invest in Iraq, Papua New Guinea or Timor-Leste,” Myerberg comments.

“Overlaying the performance of sovereigns on ESG to bond spreads or sovereign CDS, it is becoming very clear that ESG factors are economic. We expect countries that continue to improve ESG factors over time will deliver better performance than the countries that are not delivering on ESG.”

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Increasingly, however, investors are grasping the nettle. In fact, Whitton argues it is inevitable that they will do so based purely on how many asset managers have made commitments to manage climate risk and set climate targets, through their own networks and growing regulatory responsibilities. These commitments account for roughly half of all global assets under management.

Investors have typically now had time to work out how to apply ESG approaches to their listed equity and infrastructure portfolios, are still working on their strategy in credit and private debt – and are now starting to think about sovereigns. Myerberg joined Brown Advisory in early 2021 and one of his first goals was to build an ESG research framework to study sovereigns as comprehensively as the firm does corporate credit. His team spent nearly a year building this framework before launching its first fund in January 2022.

“Brown Advisory has been doing ESG investing for well over a decade now – it was an early adopter and has a lot of credibility,” Myerberg comments. “But 70 per cent of our investable universe in unconstrained fixed-income investing is sovereign bonds, and very little work had been done in this space.”

The good news is that there is plenty of data available to sovereign debt investors. In the corporate space, the proliferation of public and private companies means there is no harmonised data covering the whole universe, Myerberg says. But numerous multilateral NGOs – including World Bank, International Energy Agency, International Labour Organization and Freedom House – produce harmonised data for every sovereign on the planet. “In fact, one can compare them very, very easily by taking these data and putting them into a quantitative model, which is what we have done,” Myerberg reveals.

A common differentiator between sovereign ESG approaches stems from whether an investor has a risk-based or a values-based approach. The former focuses primarily on a country’s ESG risk, which can be very different from its performance. Many developed-world nations have sufficient financial flexibility to be relatively resilient to the impact of climate change, at least in the medium term, even if their own policies are lacking. By contrast, a values-based approach seeks to align investment with good climate policy independent of the nation’s own ESG risk.

It is often said that ESG risk is financial risk, and there are examples of this in the sovereign sector. Pakistan’s response to the domestic needs caused by recent floods will likely need some form of debt relief. This is a human tragedy first and foremost, but it also represents a clear illustration of investment risk stemming from environmental outcomes.

On the other hand, financial strength can often insulate against this type of risk regardless of ESG policy. Reznick comments: “There are financial risks attached to environmental risks for a country like Australia. But it is a triple-A sovereign in a significantly stronger financial position, and therefore has much more ability to withstand the risks than countries that don’t have the same financial strength.”

Reznick continues: “I view ESG investing as primarily being about risks and opportunities, and how these non-fundamental factors translate into credit risk. When we talk about things like US environmental policy, we are moving into a values-based approach. This is different from ESG investing – but the two tend to get lumped together.”

There is also the market effect. If critical mass builds in the weight of investment funds that are prepared to move with their values in the sovereign market, the idea that good sovereign sustainability policy will be reflected in positive capital market outcomes could become self-fulfilling and self-sustaining.

“Our approach is more values-based. But my research shows there is a relationship between ESG scores, credit ratings and ultimate sovereign spreads,” Shepherd reveals. “If nothing else, governments that are trying to do the right thing get treated better by lenders – and this has a performance implication. There is also a kind of stability attached to better governance, because there should be fewer shocks or left-field events.”

Myerberg agrees. “Overlaying the performance of sovereigns on ESG to bond spreads or sovereign CDS – which is a pretty good indicator of risk and performance – it is becoming very clear that ESG factors are economic,” he comments. “We expect countries that continue to improve ESG factors over time will deliver better performance than the countries that are not delivering on ESG.”

“The principles that justify investor engagement in the corporate sector are if anything even more true in the sovereign market. We are financial stakeholders that have a right to engage because the performance of our securities is linked to the performance of the borrower itself.”

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The most natural way for investors to deploy the insights provided by their ESG analysis may be in emerging markets – specifically by allocating to or overweighting sovereigns with consistently positive performance trajectories. Several investors mention Indonesia as an example of a country likely to benefit from this sort of capital inflow.

The Indonesian economy has historically relied on primary commodities like palm oil and coal, in a very traditional, resourceintensive manner. But it is now working hard to transition to a different basis – including committing to social programmes to help educate its citizens to become more competitive in a global world. This requires investment, but the country should find this easier to come by as more investors factor ESG performance into their decision-making.

“The opportunity, as impactful investors, has to be lending to countries that are really committed to making the transition from resource-intensive to non-resource intensive,” Myerberg comments. “We are looking for countries that are making strong commitments, as Indonesia did at COP26 – in this case to phase out coal and actually to accelerate the phasing out of coal.”

In some cases, the investment opportunity comes in the form of labelled product including sovereign green, social and sustainability bonds. In fact, given the focus on holistic sovereign performance and outcomes, investors are perhaps surprisingly positive about the value of these securities as an investment option today and as a driver of positive future impact (see box).

Labelled securities also give issuers, particularly from the developing world, an opportunity to engage directly with investors. Uruguay, for instance, conducted investor roundtables before publishing its framework for sustainability-linked bond (SLB) issuance, which it did in September this year. Uruguay may now become the world’s second sovereign SLB issuer, after Chile brought a US$2 billion deal to market in March.


Engagement and advocacy more commonly go in the opposite direction, however, in the form of investors asking sovereign borrowers to adapt or upgrade ESG strategies. This introduces a whole new set of complexities for investors, in the sense that the ethical basis for advocacy is much less clear cut than it is in the corporate space. The question of whether lenders should have any right to influence over governments – especially democratically elected ones – is acknowledged by asset managers but does not appear to be keeping them awake at night.

Reznick argues: “The principles that justify investor engagement in the corporate sector are if anything even more true in the sovereign market. We are financial stakeholders that have a right to engage because the performance of our securities is linked to the performance of the borrower itself. Second, the issuer of the securities depends on capital markets being there – which imparts a level of power and therefore influence.”

Hamlyn also believes investors have a legitimate seat at the table. While he says Ardea respects the fact that democratic governments reflect the preferences of their electorates, and this is a consideration when it lobbies governments for change and improved standards, he also argues that the investor brings a perspective that adds to the democratic process rather than diluting or distorting it.

“The way we have navigated sovereign engagement is to recognise that our time horizon is much, much longer than any electoral cycle,” Hamlyn notes. “We are buying bonds with maturities of 10, 20 or 30 years, so we can have a different horizon or perspective from a voter who is only looking as far as the next election.”

“If nothing else, governments that are trying to do the right thing get treated better by lenders – and this has a performance implication. There is also a kind of stability attached to better governance, because there should be fewer shocks or left-field events.”


Whitton suspects these expectations will be mirrored by other investors as they adopt ESG practices in sovereign debt investment. She tells KangaNews Sustainable Finance: “Investors have become used to being at the party as a really important stakeholder, and there will be a strong instinct to take the engagement model from the corporate space to governments.”

Investors have a degree of confidence that their preferences will come to have some influence on policy settings in the developed world. But they are also largely resigned to this being a marginal factor. There is little expectation of bond vigilantes of the type that eviscerated the UK government’s ill-considered fiscal plan in late September emerging with the same strength in the environmental realm.

“There is a lot of talk about the bond vigilantes being back with the response to the UK government’s fiscal update, and this is actually an interesting comparison,” Myerberg suggests. “The market is telling the UK its plan is not reasonable by moving toward a new, higher clearing level at which it is prepared to fund it over time. The same dynamic is less clear on the environmental side, because we are not trying to penalise countries that are more prone to environmental risks because of their location.”

This hints at the area in which advocacy starts to become a live ethical concern: emerging markets. Investors – even, at times, individual providers of capital – can potentially bring much greater pressure to bear via the narrower channel of emerging market debt, where liquidity is more constrained and transactions have more room for negotiation. The question is whether and to what extent investors should lay ESG demands on countries with equally pressing priorities.

The issue bubbled to the surface in April this year when Nordea Asset Management proposed tying a restructuring of Sri Lankan sovereign debt to enhanced climate policy commitments. The investor – which held only a small proportion of Sri Lanka’s national debt but asked other buy-side firms to join its demand – pitched the idea as allowing the struggling nation to become the first in the world to align all its bonds with the Paris Agreement.

The backlash was swift. It was based on the view that Nordea’s demands were a type of financial colonialism, making demands of a developing nation that the same investor would not or could not make of developed-world sovereign borrowers.

“We have to ask what is ethically appropriate for an investor to act on in a sovereign portfolio – whether it be divestment or engagement,” Whitton comments. “If investors remove financing from a country on the basis of climate policy, it could make that country more vulnerable and less capable of adapting.”

Whitton suggests investors planning to engage with sovereigns on climate risk – and ESG in general – should separate them into two groups. The first is sovereigns that are sufficiently robust that their affairs would not be significantly affected by major investors divesting. The second is economies that are more vulnerable to capital markets.

There may be a difference between responding to a sovereign’s failure to keep to its commitments and making new demands. Reznick comments: “It is possible for providers of capital – especially when the disintermediation of that capital is spread among a very narrow base – to take, frankly, a coercive approach. There are clearly challenges involved, but I don’t think it is fundamentally unreasonable for providers of capital to demand borrowers keep to commitments made, especially if the outcome is overall positive for the environment and society.”

Labels have a value, if they reflect values

The number of sovereigns actively issuing green, social and sustainability bonds continues to grow. Investors are pleased with this trend, though they caution that such issuance has to reflect a genuine underlying commitment to sustainability principles on a borrower’s part.

Labelled green, social and sustainability (GSS) issuance is still a tiny component of the overall governmentsector bond market. Climate Bonds Initiative (CBI) reports total sovereign GSS issuance of just less than US$100 billion equivalent in 2021, about one-thirtieth of OECD estimates of marketable debt issuance by its members.

On the other hand, the number of sovereign GSS issuers continues to grow. CBI data reveal that there had been around 40 such issuers by the end of 2021, with issuancevolume concentrated in Europe but plenty of activity coming from emerging markets, too.

Labelled bonds give investors that are just starting their journey with environmental, social and governance (ESG) integration in the sovereign sector a straightforward way of expressing their preferences.

“We are talking about a setting in which we have a group of investors that will increasingly be observing risks and climate related commitments, but do not have an action set to align with the risk assessment. In this context, I think sovereign labelled finance will continue to be popular,” argues Zoe Whitton, managing director at Pollination Group.


There is a widespread expectation that ESG practices will proliferate in the sovereign bond market just as they have in other asset classes. What is not yet clear is exactly what the impact will be – specifically, whether the weight of capital following ESG guidelines will be sufficient to shift pricing and liquidity and, in turn, policy.

A situation such as the one Australia was in before its most recent change of government, in May this year, may have been unsustainable in the long run, though. Hamlyn says bond investors may not be able to reshape a whole sector but they are relatively good at pulling outliers into line, as is demonstrated by successive waves of bond vigilantes.

“If one country decided to go it alone on ESG it should expect quite significant differentiation in price to be applied,” Hamlyn says. “But the likelihood of this occurring is quite low, simply because governments are generally not foolish in this respect. They can see market feedback and hear investor comments. The developments we have seen recently in the UK have been a fantastic example of how this process works.”

Whitton agrees that the idea of the bond market pulling the global government complex in a positive direction is less plausible. “I still don’t know how investors will manage emissions footprint in the sovereign market, because it is hard for them to march up to a government’s door and demand a change in behaviour that could fly in the face of the preferences of its citizens,” she says.

She expects investors will start to do more work on climate risk and emissions footprints in the sovereign sector, and that they will have more opportunities to observe the relationship between sovereign financial outcomes and climate change.

“There will be more droughts in Europe, and bushfires and floods in Australia,” Whitton comments. “Investors that are primarily active in government bonds increasingly understand the interaction between environmental risk, climate change and sovereign capital outcomes.”