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ESG Focus: The Sovereign Bond Dilemma

ESG Focus | Jul 29 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: The Sovereign Bond Dilemma

As financialisation of the globe gathers pace, sovereign nations are being pressed to issue GSS bonds and they may have to take the bad with the good.

– Sovereigns hesitant to dip toes in ESG bond pool
– Financial colonialism or shared risk?
– Nuts and bolts of GSS bonds
– Developments in the green sovereign bond market

By Sarah Mills

The colonisation of climate finance has already begun.” – Joshua Long, Cogitatio.

Sovereign bonds constitute a fraction of the global green, social and sustainability (GSS) bond market but this may change as the green transition gathers pace.

Sovereign GSS issuance stood at roughly US$100bn by the end of 2020, the vast majority of which was green – only about 9% of the total GSS bond market for the year.

Governments (mainly wealthy) entered the sovereign green bond market four years ago with more of a whimper than a bang.

But observers note a sharp uptick in sovereign green bond activity in 2021, which they expect will accelerate in 2022 as the transition begins in earnest.

The Climate Bond Initiative (CBI) forecasts a doubling of the number of sovereign green bonds in 2021/22 from more than 40 issuers this year.

But 40 is hardly an impressive number, and sovereign interest remains tepid. 

Much of last year’s issuance stemmed from wealthy nations seeking to “build back better” post-covid. 

Strong investor appetite for the limited issuance also reflected on the more attractive risk-profiles of wealthy countries.

Sovereign interest in issuing social and sustainability bonds has been even weaker, suggesting a clear reluctance to join the ESG bandwagon.

The hesitance of sovereigns, particularly small nations, to jump into the bond market is understandable.

Previous experience has informed them of the exploitive and undermining nature of western largesse, which we will elaborate upon briefly, before continuing with trends in the GSS sovereign bond market.

It also takes time to establish GSS bond frameworks and to embed ESG skill-sets within government treasuries; and most of the global GSS finance to date has been directed to decarbonising the energy sector.

This article sets the geopolitical scene for the total GSS sovereign bond market, before focusing on green sovereign bonds.

We cover social sovereign bonds and sustainability sovereign bonds in a separate story, and finish up with an article on sovereign crisis bonds, for which covid-response bonds set the precedent.

Financial colonisation already pervading climate finance

Financial colonisation, or financial imperialism, as it is also known, has a history spanning back to at least World War 1, but it escalated sharply in tandem with intensifying global financialisation over the past four decades.

A summary from Francis & Taylor online sums up the situation for sovereign nations:

“ … financialisation is one of three epochal trends of capital accumulation in the 20th century, together with the slowing of the rate of growth and the rise of monopolistic multinational corporations …,”

“Financialisation represents a transformation of mature capitalism resting on the altered conduct of non-financial enterprises, banks and households.

“The transformation has taken place during the last four decades within an environment determined by neo-liberal ideology and shaped through deregulation of labour and financial markets. 

“Financialisation also has a subordinate dimension in developing countries reflecting the hierarchical nature of the world market and world money.”

Sovereign suspicion of climate finance is therefore understandable. 

As Joshua Long in Cogitatio points out:

“It is becoming clear that the emergence of green and sustainable bond markets as funding mechanisms – orchestrated by institutions like the World Bank – embody what Bigger and Webber (2020) refer to as ‘Green Structural Adjustment’.

“… aspects of the emerging climate finance system potentially represent a new mode of colonial control through debt bondage adapted for the neoliberal area.”

Debt as tribute

As part of the financialisation process, small countries (and workers) are systematically disadvantaged compared to banks and more powerful nations with regard to economic information and power.

Given capital always mobilises to suit its owners' interests, this creates a theatre for sovereign conflict.

Big capital naturally seeks to establish territorial empires by mobilising the political and military help of its own, and sovereign, states.

Most sovereigns well understand that financialisation, through debt, creates a system of tribute to more powerful nations – to the United States in particular, thanks to the dominance of the greenback.

Enter ESG finance

ESG represents an extension and intensification of the financialisation of the past few decades.

Financialisation is a means of absorbing surplus that can no longer generate profits from productive enterprise: when profitability is low in areas of production, capital then shifts to finance. Banks are a classic example of this.

The world is awash with surplus capital, so ESG finance offers a new channel to absorb these surpluses. 

On a more novel note, ESG finance is being dedicated to creating new “environmental” and “social” industries, which could yield productivity benefits; and new asset classes.

But given ESG finance is earmarked for specific purposes, it further exerts the agenda of wealthier nations over poorer ones.

Sovereigns are unlikely to be in a rush to throw away their control over the general purposes funds gained through vanilla debt offerings in favour of ESG funding, given ESG finance reduces politicians’ flexibility to curry political favour and protect sovereign interests.

This time it might be different – an old refrain?

But many are wondering if perhaps this time, things will be different, thanks to technology, astounding global capital surpluses and environmental imperatives. 

While financialisation has a predatory aspect, the mobilisation of surplus capital drives growth; and well-deployed debt can be a powerful tool.

ESG funding theoretically benefits all given the interconnected nature of humans and the planet.

Most governments recognise the need to protect the environment, and are largely aligned on a range of environmental measures; including Paris Agreement climate targets. 

GSS bonds just tie sovereign debt obligations more tightly to this global agenda.

Countries that don’t receive climate funding may struggle to compete, particularly as the transition accelerates and fossil fuel prices rise over time, forcing most to the market regardless, and under possibly more onerous terms. 

ESG finance should also help poorer nations build economies on new technology, while improving living standards. 

Still, poorer countries in the southern hemisphere, which also happen to have the greatest environmental assets, would prefer to receive subsidies and payments from the north, which has already destroyed the bulk of its environmental heritage in the past few centuries, while emitting the majority of carbon.

But subsidies pose their own challenges

Western governments, in turn, are rightly (and perhaps hypocritically) concerned that given political corruption in low-income countries, subsidies may not be the most effective tool for protecting the environment, nor investors’ funds.

Also, the rise of stakeholder capitalism and blended finance concepts appear to represent an effort to reverse the shareholder capitalism ethos (typically linked with exploitive financialisation) that has dominated in the past century.

This has simultaneously had the slightly counterproductive effect of leaving investors questioning whether they are to be the next subject (after workers and sovereigns) of “financial expropriation”.

Given the lack of oversight, accountability and efficiency of the sovereign bond market, both sovereigns and investors have good reason to be cautious. 

But that is expected to change as more monetisable projects become available in developing countries and disclosure improves.

ESG finance should also help ensure that environmental and social challenges are prioritised over a dictator’s Swiss bank account.

Do sovereign bonds stack up as an investment?

In terms of returns, The Journal of Fixed Incomes (JFI) says ESG is a material issue for sovereign bond investors, even after accounting for macroeconomic and credit variables.

“This is particularly the case for emerging markets where we document evidence of an additional ESG risk premium relative to developed markets … ,” says JFI.

“We find no evidence over our historical time frame that an ESG-focused investment strategy results in any investment disadvantage.

“In addition, our results suggest support for potential advantages of an active approach to ESG portfolio management.

JFI finds that ESG scores are large drivers of sovereign credit spreads; and that countries registering high social and governance scores tend to have tighter spreads.

“The relationship between ESG scores and credit spreads is particularly strong for emerging countries, where we find evidence of an additional ESG risk premium relative to developed markets,” says JFI.

“We find no evidence that investors are penalised for ESG-aware investment strategies in the form of lower returns, but our analysis does support the case for in-depth ESG analysis in the context of an active approach to portfolio management.

This suggests a problem for passive investors and very much reflects on the import large institutional investors are placing on engagement in developing economies.

One of the major challenges to investors and governments is the lack of transparency in sovereign bonds, which we discuss in more detail in our story on covid-reponse bonds.

Eurodad calls for concrete measures to improve transparency to protect developing countries, including:

– "The establishment of a public registry system for loan and debt data, including full disclosure on sovereign bonds.
– "Improved regulations for disclosures of bond contracts and holdings by underwriters and investors, such as investment banks and hedge funds.
– "The adoption of a statutory approach for private creditor participation in debt relief under a multilateral sovereign debt workout mechanism."

This suggest that for many investors and financiers, the lack of transparency is weighed in their favour.

History favours the rise of the sovereign bond market

Financialisation is a natural product of capitalism, and the only way to halt it, according to academics, is through the instatement of a command and control system, either through revolution or decree (the latter being more difficult to ascertain as decrees from big capital are rarely signaled as such).

This suggests that the initial reluctance of sovereigns is unlikely to stop the tide.

Given the success in promoting financialisation over the past four decades – and given a decree may already have been issued in favour of environmental priorities – the die appears to be cast.

After all, debt, like heroine, can be hard to resist; there are pushers on every corner; and political corruption is legend.

Sovereign debt and crisis capitalism are already well-entrenched models in our society and, to an extent, climate finance would simply represent a continuation of the status quo, albeit with greater consequences for sovereignty and freedom as hi-tech disclosure nets sweep the world.

Nuts and bolts of sovereign GSS bonds 

As with normal green, social and sustainability (GSS) bonds, sovereign GSS bonds are generally earmarked for individual environmental and social projects and, like vanilla bonds, pay a set coupon.

Sovereign nations will also be able to issue sustainability-linked bonds (SLBs), which link coupons to KPIs and step-up margins and penalties.

Given corruption, SLBs, while representing a potential boon for investors, could be problematic for governments. 

But if sovereigns are baulking at the relatively benign GSS bonds, it is hard to imagine why they would jump at SLBs, particularly given the “my word is my bond” ethos that prevails in the GSS market (referring to the lack of contractual default obligations on GSS bonds).

But corruption and ignorance are common partners in politics.

All sovereign GSS bonds suffer from the same lack of transparency, disclosure, accountability and compliance noted in previous introductory ESG bond articles.

To top it off, sovereign issuers are generally not held to the same standards of scrutiny as corporations; and there are many back-door international negotiations and trade-offs in the mix.

Green sovereign bonds lead the charge

To date, the most popular GSS sovereign bond has been the green bond, reflecting broader global trends, although covid-19 did spur some interest in the social and sustainability bond markets.

Green bond assets and projects are also easier for issuers to identify and ring-fence than social bonds, given it is usually secured against technology, energy, infrastructure or real estate portfolios – although governments have some advantage over corporate issuers in this regard

Sovereign nations are establishing green bond frameworks and taxonomies to tap the market.

In 2021, Germany issued an inaugural green bond, and Italy marked its debut with an E8.5bn issue – Europe’s biggest green bond to date.

Meanwhile, European Commission (EC) President Ursula von der Leyen has confirmed that the European Union plans to issue E225bn in green bonds over the next few years.

ESG pundits welcome sovereign issuance and the resulting injection of liquidity and credibility to the green bond market, expecting it will further incentivise corporations into the market – with private capital forecast to be the major beneficiaries.

It is anticipated that upwards of US$8trn a year will be channeled into decarbonisation efforts via a blended finance model requiring both private and government investment.

The EC has just tabled its “Fit-for-55” package, which will support the EU’s ambition of slashing emissions by 55% by 2030, and this is also expected to spur green issuance globally, particularly after the carbon border adjustment mechanism (CBAM) is introduced.

The Climate Bonds Initiative is also forecasting strong growth in the US given Biden’s commitment to the green transition. 

The US has rejoined the Paris agreement and committed US$5trn to the effort.

In China, President Xi Jinping has announced China will be carbon neutral before 2060. The country is already one of the world’s largest green issuers.

Chile has increased its stock of outstanding green bonds to more than US$6bn. Turkey has been issuing since 2016.

Trends in the sovereign green bond market

Sovereign green bonds mimic private green bond issuance, although individual nations are tinkering with various formats that suit their circumstances.

Green sovereign bonds should ideally comply with the International Capital Market Association’s (ICMA) Green Bond Principles, listed in earlier articles in this series.

The standard caveat of do no harm to the other environmental objectives also applies.

Green sovereign bonds raise funds for specific projects – usually infrastructure related (often prime assets) – and pay a coupon and repayment of principle at the end of the term. 

As an example of what future sovereign bond markets look like, the EU Green Bond Standard and the Swedish Bond Framework provide good examples.

The latter is more solidified and deploys use-of-proceeds bonds towards renewable energy, pollution prevention and control, environmentally sustainable management of living natural resources and land use; terrestrial and aquatic biodiversity; conservation; clean transportation; sustainable water and wastewater management; and green buildings.

It excludes expenditures related to nuclear power; fossil-fuel energy; new investments in large-scale hydropower; or purely management grants.

Certification offers options to improve liquidity

Sovereign nations carrying low debt have noted that green bond issuance reduces liquidity in their vanilla treasury-bond markets and are experimenting with new models.

Denmark in particular is considering issuing traditional vanilla bonds with green certificates, and has finally gained support from many of its pension funds in this respect.

Nations in similar positions are observing with interest.

Supporters argue that such a model could be adopted more widely and smooth the eventual transition of a vanilla bond market to an integrated sustainability market. 

Coming up

Our next articles examine trends in the social and sustainability sovereign bond markets, and take a look at the fledgling concept of crisis bonds.

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