Mandate design considerations for sovereign debt net zero portfolios

Momentum for expanding net zero coverage to sovereign debt

Net zero alignment efforts have historically focused on asset classes such as listed equities and corporate bonds, however asset owners or investment managers are increasingly working to incorporate sovereigns into their net zero commitments. This trend is partly driven by the inclusion of sovereign bonds in the NZIF 2.0 framework and NZAOA’s workstreams.

It is also an acknowledgement that excluding sovereigns is increasingly seen as not an option, given the weight of sovereign bonds in fixed income allocations (whether as a distinct category or as part of an aggregate bond portfolio). This is especially true for asset owners or investment managers that adopt a universal owner approach with an ambition for driving global outcomes.

Excluding sovereigns also could mean that other asset classes would have to work harder to achieve emissions reductions at the overall level, given the omission of sovereigns.

Even though investment practices are not established yet in this area and there is no agreed portfolio construction framework, it is important for asset owners to start analysing what net zero targets could mean for their portfolios. Many have started mapping the investment universe using tools like the NZIF 2.0 framework and guidance from the Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) project, which assesses countries’ progress with regards to climate change.

Investment consultants have an important role to play in advising asset owners on the development of industry best practices and solutions that will support them meeting their climate goals.

Challenges to implementation

The group examined some of the reasons why implementing a net zero approach in the sovereign bond space was challenging. Some of these challenges were also compiled ahead of the workshop in discussions with our sovereign debt working group.

Client/mandate-specific considerations

Contrary to other asset classes, investors do not always hold government bonds for return generation and country-selection purposes. Investors also use them to provide liquidity, meet regulatory requirements, or for asset-liability matching. As a result, there is no one-size-fits-all approach to incorporating net zero targets for sovereign bonds for a given investor’s portfolio.

For example, a diversified global sovereign bond portfolio with an objective of return generation is a very different starting point from a single-country government bond portfolio, where the single country cannot be avoided or underweighted.

Client expectations also matter in the design of the portfolio. Is the goal purely to construct a portfolio that scores higher based on net zero metrics at any point in time, or is the climate target a much more long term goal which still allows alpha generation across the opportunity set? Participants mentioned that it is important to understand, for each portfolio, any trade-offs presented by a net zero approach. Does it introduce constraints on portfolio construction, leading to an inability to meet required risk/return and liability-matching mandates? Would asset owners be willing to give up alpha for net zero commitments? If so, how much? Are end beneficiaries aware of this trade-off?

A final key element is to ensure any unintended consequences in the mandate are well understood and flagged. For example, emerging market countries can become underweight due to their potentially lower scores on net zero alignment. Blindly following these scores could therefore exclude countries that are arguably most in need of capital to meet climate goals. Emerging markets may take longer to reach peak emissions whereas developed markets have the capacity to move faster. The group noted that the NZIF 2.0 and ASCOR frameworks considered this engrained bias, and each incorporated fair-share considerations and equity principles. This work is in line with the Common But Differentiated Responsibilities and Respective Capabilities principle from the United Nations Framework Convention on Climate Change, which acknowledges the different capabilities and differing responsibilities of individual countries in addressing climate change. The group agreed that, while acknowledging the status of emerging markets is helpful, more consideration must be given by both asset owners and investment managers to how to weight emerging economies in bond portfolios.

Challenges specific to sovereign bonds

While an equity or corporate bond portfolio offers a wide range of companies to invest in, the sovereign debt universe is a lot more constrained. In practice, this makes it more challenging to find substitutes for markets seen as less desirable. In addition, the universe of sovereign debt is very concentrated, with the largest markets dwarfing the rest of the universe. This makes it difficult to avoid or underweight these larger countries as replacements may not be available.

There are also differences in expectations on emissions reductions between investors in sovereign and corporate bonds. Decarbonisation at the country level is more complex to achieve, not only in terms of who owns the decision but also its implementation and timeline. One open question is how to deal with large holdings in countries where net zero is a politicised and polarising topic. To set net zero targets, investors can take into account their influence with debt issuers and the ability of an issuer to improve relative to the risks it poses to the portfolio.

Investor influence also differs in the sovereign space relative to corporates or equities, where engagement on climate is more advanced. Sovereign investors are exploring how to incorporate climate considerations into engagement even as best practices emerge to guide how investors engage, with whom, and on which KPIs.

A distinct challenge for sovereign investors is navigating the electoral cycle and political uncertainty. For example, elections in a given country could bring a sudden change in climate ambitions and commitments; investors need to think how this could impact their strategy.

• Does it change the country’s eligibility for portfolio inclusion?
• Before taking any action, what criteria should be considered (e.g. existing engagements, size of country)?
• What would be the cost of selling the holding?

Most investors are typically not ready to implement a drastic and costly portfolio rebalancing due to shifts in political commitments, at least not until more consensus is established in the market on best practices to apply net zero considerations.

A final challenge specific to the sovereign asset class is the lack of clarity around interest rate derivatives, such as government bond futures. These instruments are frequently part of the toolkit for sovereign bond investors, yet the industry lacks clarity on how net zero or more broadly sustainability targets would apply to the use of these instruments.

Industry-wide challenges

The lack of consistent, comparable and timely climate data has been an obstacle to assessing emissions for sovereign bonds. A lot of the disclosure from sovereigns lacks standardisation when it comes to climate, and forward-looking metrics are particularly inconsistent as these are more qualitative in nature. Participants in the workshop agreed that the industry needs reliable metrics for emissions intensity and to understand the implications of applying a net zero angle using these metrics to portfolios. An agreement on a robust carbon accounting method seems to be missing for the moment.

Another example of a gap in the ecosystem is the absence of adoption of net-zero or climate-aligned sovereign bond benchmarks across the industry. Participants noted that benchmark providers are eager to create new solutions but would require more industry consensus on the preferred approach and methodology. The reality is that asset owners are still attached to using market weighted indices as a reference benchmark, where the weight of each country is defined by the size of its bond issuance. The composition of these market weighted indices is far from reflecting the reality of a net zero world. The question is whether asset owners are ready to entirely re-think the composition and weight of their sovereign debt universe composition, with implications for performance. The industry would benefit from more consensus and collaborative work to agree on best practices.

Participants also discussed the elephant in the room: what if the components available are not suitable for this exercise, i.e. sovereigns have not sufficiently committed to net zero alignment. The role of sovereign bonds in meeting climate ambitions in portfolios needs more analysis to reassure investors that these instruments can fit into a net zero portfolio construction process. This is not a black or white exercise; the nuance, conviction, and implementation are still being examined by the industry.

Emerging solutions

Despite these challenges, the group noted analysis done to date and the emergence of solutions for investors.

Some investors shared their experience converting country data on climate and emissions into quantitative scores and negative or positive screens to test if they could be used for portfolio construction. Quantitative techniques included converting the data into forward-looking signals and using data to re-weight, score and apply optimisation rules. Analysis continues to determine whether these approaches create unintended consequences and whether portfolios can meet their intended purpose. The group noted the importance of being cautious when applying data-based / quantitative techniques to sovereigns, for example optimisation, given that a change in signal can arise from a new electoral result, a change in public policy or a new data point. The outcome would need to be navigated on a case-by-case basis rather than in a rules-based manner, taking into account the profile and objective of each portfolio. In extreme cases, excluding some issuers may be appropriate, though clients would need to have conviction. The approach would also need to be flexible and forward looking, the idea being to capture improving emission trends over time. A positive screening logic is also encouraged by the NZIF 2.0 framework.

When applying a portfolio construction approach with net zero targets, whether quantitative or qualitative, investors noted the importance of incorporating fair-share considerations to address the unintended consequences of underweighted emerging economies. This could be done by, for example, layering a World Bank income-group view (which takes into account each country’s Gross National Income) into the portfolio construction process and ensuring that the resulting portfolio will maintain an allocation to countries from lower income groups.

Participants in the workshop agreed that engagement with the underlying sovereigns should be an important component of the net zero investor toolkit. Climate-focused sovereign portfolios open the opportunity to engage on topics like Nationally Determined Contributions (NDCs), national climate action plans and targets introduced in the 2015 Paris Agreement. By tying dialogue with sovereigns to provision of debt capital, investors can start to hold sovereigns accountable to meet their targets. Interestingly, engaging with sovereigns offers the opportunity for system-wide engagement for investors, complementing corporate stewardship efforts with discussions with policy makers who can affect the climate policy environment in which corporates operate.

Another important element in the net zero sovereign debt investor toolkit is investing proactively into climate solutions, such as green bonds or sustainability linked bonds (SLBs). Green bonds exclusively finance projects that have environmental benefits. SLBs attach the financing conditions of debt to meeting certain sustainability targets, e.g. carbon emission reductions. These bonds are not only issued by sovereigns but also by other entities, such as sub-sovereign issuers and public agencies. Investors with net zero targets could prioritise investment in these labelled/themed bonds to increase the opportunity set for their portfolios. For example, green bonds from sub-sovereign issuers that score well on climate could be an interesting replacement for sovereign bonds from laggard countries. The investment universe is not as wide for green and other labelled debt, as not all countries have issued them, but it’s an interesting place to start. Work undertaken by the Partnership for Carbon Accounting Financials (PCAF) would create a standard for measuring emissions by sub-sovereign issuers, facilitating their potential inclusion in sovereign portfolios with net zero targets. Some participants shared that they would prefer looking at these climate solutions as opposed to excluding some issuers outright.

Workshop participants agreed the process of defining a portfolio construction process to meet climate targets was likely to be iterative, as best practices and standards are developing. A good place to start is applying a net zero lens to the “greenest” types of sovereign portfolios, which have an appetite for higher conviction views. This could help develop the tools and methodology to classify countries between fully aligned, aligning, and lagging. In addition, the process would likely not be binary, classifying countries as aligned or not, but rather a nuanced “shades of green” approach, measuring to what degree countries are on the right track.

One development investors are following closely is the ASCOR project tool, which is likely to play a role in crystallising a common framework of metrics to assess individual countries’ progress on climate change. At the time of the workshop, the tool provided information on past emissions and forward-looking metrics for 25 countries. This does not cover enough countries for global bond investors, however, by the end of 2024 the framework will expand to 70 countries. The availability of the expanded dataset will help investors make progress in designing an investment framework for net zero-aligned sovereign portfolios. Workshop participants noted that the tool is designed to provide a suite of different metrics for investors to use rather than a single score. Participants agreed ASCOR is very helpful and solves some practical challenges, but asset managers need to be aware that the tool is a useful foundation to build investors’ own analysis as opposed to a new market standard binary score.