A new discussion paper explores sovereign bond net zero alignment for investors

Our latest discussion paper outlines new support for investors looking to integrate sovereign bonds into net zero investment strategies, outlining its challenges and its importance.

Full guidance will follow as part of the Net Zero Investment Framework (NZIF) 2.0 release scheduled for later this year.

In the paper, we map available data for assessing sovereign net zero alignment and analyse country decarbonisation pathways to inform sovereign net zero alignment. In doing so, we aim to help investors consider this challenging but crucial asset class.

➡ Read the paper.

We also cover ‘fair share’ elements to incorporate the common but differentiated responsibility and respective capability (CBDR+RC) principles embedded in the Paris Agreement and introduce preliminary ideas to define climate solutions for sovereign bonds.

A crucial link

Sovereign bonds are a prominent asset class within institutional investor portfolios, estimated to make up 50% of the global outstanding bond market in 2020 according to the ICMA. They also provide a crucial link between investors and policymakers. Decisions and administrative actions at the national, state, and municipal level play a pivotal role in facilitating, or delaying, the ability of countries and companies to reach their net zero emissions goals.

Integrating this asset class into net zero investment strategies is therefore essential to fulfilling individual commitments to net zero alignment, yet investors have encountered significant challenges when trying to do so.

Numerous factors affect their ability to exercise asset selection to meet their individual net zero commitments. From liability and cash management restrictions to the limited number of issuers and the concentrated nature of the market, which means that reducing or removing sovereigns from the portfolio may force others to be overweighted, thereby increasing material risks.

Flaws also remain in the global policy framework, with many existing nationally defined contributions lacking the necessary ambition or implementation planning to meet the goals of the Paris Agreement. Often, these exist within a non-binding framework.

Additionally, a combination of concerns remains around investor engagement with sovereigns, such as limited engagement opportunities; non-credible exit; the intricate nature of sovereign entities’; fairness considerations; and a lack of metrics to assess success.

Nonetheless, collaborative discussions on net zero alignment offer mutual benefits for institutional investors and sovereign entities alike.

Mutual benefit

Institutional investors are increasingly interested in unlocking policy levers to tackle systemic climate risk and expand investment opportunities - often holding diversified and long-term portfolios representative of global capital markets. Sovereign entities can equally benefit from these interactions, using them to improve their policy environments and foster private investment.

The paper concludes by encouraging investors to take some preliminary steps that may contribute to overcoming some of these challenges over time:

1. Track and measure financed emissions for sovereign bond holdings
2. Create methodologies to assess net zero alignment at country level
3. Set net zero alignment objectives and targets for this asset class
4. Map and seek engagement opportunities that enhance the use of their ‘voice’, and
5. When investment mandates allow, increase funds to climate solutions and transition finance, especially in Emerging Markets and Developing Economies (EMDEs).

We are in the early stages of developing this new and emerging guidance and welcome input and experience from investors facing to these challenges. Work will continue on recommendations for target setting and implementation guidance, as well as on climate solutions support for sovereign bonds guidance. We will also explore opportunities to enhance the sovereign engagement toolkit.

Initially, we aim to capture members’ views and experience in engaging with NDCs, aiming to define key features that investors would like to see to unlock further investments.

Our emerging markets and just transition workstreams will seek to incorporate these nuances across our wider NZIF guidance and other IIGCC tools. These will develop and strengthen the integration of differentiated country decarbonisation pathways and identify further avenues to address barriers to climate finance mobilisation in emerging markets and developing countries.

While substantial limitations persist in the short term, ultimately, our work in the sovereign bonds space seeks to facilitate collaborative dialogues between investors, governments and other stakeholders in the investment value chain to contribute to gradually overcome some of the challenges going forward.

If you’d like to take part in our working groups and help shape the outputs of our resources, why not get in touch today to learn more about becoming a part of IIGCC?