Sovereigns set sail for ESG
Although the biggest issuers of all — the US, Japan and China — remain outside the market for now, sovereign ESG debt has gained real momentum in the past 18 months, as a growing number of developed and emerging market issuers have endorsed green, social and sustainable bonds as part of their financing options. As a result, investors are seizing new opportunities to engage on national pandemic recovery and net zero strategies and targets.
The arrivals of Germany and Italy this year, to be followed by the UK in September, Canada before the end of its 2021/22 financial year and the super-sovereign European Union (EU) most likely before the end of 2021 too, underscore the rapid take-up of green bonds in particular among major sovereign names.
The EU, which is poised to become the world’s top green bonds issuer by dedicating 30% of its €800bn-€900bn ‘Next Generation EU’ funding programme to the product, has also been key to growth in social bonds. Solely financed with labelled social bonds, its €90bn SURE (Support to mitigate Unemployment Risks in an Emergency) programme has boosted volume in the newer use-of-proceeds instrument significantly.
Moreover, EM names have added valuable diversification to the ESG market through their green, social and sustainable offerings. While Latin American issuers such as Chile, Mexico and Uruguay have been especially prominent in this trend, Asian and EMEA credits like Egypt, Indonesia, Nigeria and Thailand have featured too.
Further growth appears certain as the recent host of debut sovereign issuers build out their ESG curves and further new names (Spain, for one) arrive too. More broadly, the fact that around 20% of pandemic recovery spending globally — around $410bn in total — has been green in nature and an even higher proportion qualifies as social expenditure is likely to drive volumes up.
The development of a sovereign sustainability-linked bond (SLB) market could spur additional flows, though this product poses multiple challenges for sovereign issuers and to date only Uruguay has voiced the intention of offering it (see accompanying SLB chapter for further discussion).
“We think there are several reasons why this market will continue to grow,” notes Ana Colazo, head of sustainable finance for the UK & Nordics at V.E, part of Moody’s ESG Solutions. She cites countries’ Nationally Determined Contributions (NDCs) under the Paris Agreement, as well as national strategic initiatives against climate change and action to address social inequalities, as key drivers.
“The trends are favourable,” agrees Rahul Ghosh, managing director for ESG outreach and research at Moody’s ESG Solutions, who points to sovereign ESG bond volume of over $40bn since the start of the year — “already well on course to eclipse last year’s full-year total”.
At the same time, sovereign ESG debt is broadening. “We are starting to see more development in this market,” Colazo says. “We are starting to see governments issuing consistently — some frameworks, like Mexico’s for example, are mapping their whole federal budgets to the SDGs. They are looking at a broader strategy for labelled issuance to become more recurrent in their sovereign debt financing plans.”
Ghosh emphasises, though, that “bond issuance is not the end-goal here”. Rather, ESG debt is only “part of an extensive toolkit that governments have at their disposal to encourage greater flows into sustainable projects, alongside tax incentives, specific policies on disclosure, or net zero country targets of which we have seen a proliferation of the last 12 months.”
He cites the UK as an example. The sovereign announced its first labelled bonds (both institutional and retail green offerings) as part of “a broader suite of actions”.
This includes changing the Bank of England’s mandate to explicitly factor in climate risk and the establishment of a technical expert group to develop the UK sustainability taxonomy.
Upping EM momentum
Despite growing sovereign traction in developed economies and sporadic activity from emerging markets too, as noted, one key challenge is bringing more EM sovereigns into the ESG debt market. None of the BRICS countries (Brazil, Russia, India, China, South Africa) has yet issued a sovereign ESG bond, for example.
“Another important area will be how to encourage labelled issuance from emerging markets sovereigns with weaker credit profiles that are most in need of sustainable financing,” says Ghosh. “With a few exceptions, this market has been dominated by investment-grade governments, and we know that many emerging markets have larger sustainable development challenges that they need to finance.”
Moody’s ESG Solutions sees a combination of official sector support to help EM sovereigns with the workload behind issuing, plus market innovation and investor demand for ‘transition’ sovereign paper, providing a solution.
The task can be substantial, Colazo acknowledges. “Issuing a labelled sovereign bond involves bringing together representatives and information from different government departments.”
Most sovereigns that have issued set up a dedicated sustainable finance working group to co-ordinate the work. This breaks down the national budget, moves different budget lines into eligible categories, and determines which are large enough to justify inclusion in the framework. Other substantial tasks include understanding how KPIs monitored by multiple ministries and international departments could be consolidated to provide transparent and clear reporting.
Despite initiatives like the EU’s SURE programme, combined green/social sustainable bonds from Luxembourg and others and very significant social issuance from agencies such as France’s Cades (Caisse d’Amortissement de la Dette Sociale), very few sovereigns have yet issued pure social bonds. Chile is an ultra-rare exception.
Even so, Moody’s ESG Solutions sees “robust potential” here, as Ghosh puts it. “If we just think about the nature and mandate of government expenditure, we see fertile ground for growth and diversity in social bonds from sovereign issuers — particularly in post-pandemic recovery spending.”
Colazo expects social spending on the green recovery to feature most heavily, along with social issues highlighted by the pandemic. These include income inequality and access to health care.
Impact reporting is a significant challenge for sovereign social bonds, however. “We have a pretty defined and widely accepted set of indicators for measuring carbon emissions,” says Ghosh. “With social bonds, depending on the projects being financed, impact assessments can be more qualitative in nature, more challenging to aggregate at the portfolio level or compare from transaction to transaction.”
Even so, he does not expect this to hold growth back.
At the same time, Moody’s ESG Solutions sees scope for sovereigns to show leadership in environmental reporting. Ghosh notes that the use of proceeds for sovereigns’ labelled bonds is already significant in areas such as clean transportation, waste and water management, and adaptation. He anticipates that they may direct more financing towards flood mitigation, drought management, disaster reconstruction and sustainable land use.
Engagement on national pandemic recovery and net zero strategies/targets is a key benefit for investors in sovereign ESG debt.
“Institutional investors are really looking to engage with governments on ESG and on their climate and environmental plans in a way that wasn’t really possible in the debt markets even a few years ago,” says Ghosh. “But it is today, not least because of the development of green bonds and the opportunity that transparency and reporting on funds have provided for bondholder engagement.”
Transparency is a further benefit, Colazo notes. “For use-of-proceeds bonds it is important to keep in mind the level of transparency that they provide to investors on how the funds are being used, and on the impact of those funds. They are a tool that provides a high level of transparency to investors on the results of their investment.”
This offers sovereigns the potential to tap into a broader and more diverse investor base. That is particularly relevant for EM names.
“Institutional investors’ focus on ESG risks and opportunities in the government space is increasing, and there is a desire to engage on sustainability issuers either individually or collectively. For now, green bonds provide a certain level of information and commitments to allow investors to engage effectively,” Ghosh adds.
Regardless of whether debt is labelled, investors are going to continue wanting to engage with governments around their ESG credentials and objectives. So might the need for labels on ESG debt wither away over time?
Perhaps, but Moody’s ESG Solutions is doubtful for now. It sees labelled debt staying a useful instrument for investor engagement for some time to come.
“Labelled bonds will remain a pretty attractive tool for sovereigns to tap into this huge expansion of ESG investing that we are seeing,” Ghosh concludes. “There is still value in the signalling that these bonds provide for a government on its intentions, particularly given the Paris agenda over the next 10 years.”