The sovereign pay-off

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.”

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 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.

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.”