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Analysis: Sovereign bonds – the final frontier for ESG?

Country credit starting to come onto the ESG radar

Is looking at sovereign credit according to environmental, social and governance (ESG) factors the final piece of the jigsaw for responsible investors?

Traditionally, socially responsible investors have tended to look through the prism of equity investment – where they can engage with companies and vote and divest their shares as they deem appropriate.

Sovereign credit – i.e. investment in the bonds issued by countries – has not hitherto been a significant factor in responsible investors’ armoury. How do you as a bond investor ‘engage’ with a country?

But it seems that is starting to change, if a series of initiatives are anything to go by. For the first time it could mean that countries themselves will begin to be held up to scrutiny for their ESG performance in the same way as companies.

The UN Principles for Responsible Investment currently has a fixed income work stream underway, which is due to report early next year.

The project aims to create clarity about how complex ESG issues affect fixed income investments as well as achieving greater “market recognition” of the impact of these factors on both sovereign and corporate bonds.

And MSCI recently launched a new offering covering fixed income, including ratings, scores, profiles and reports. The firm is also partnering with Barclays to create a series of ESG fixed income indices.

Then there’s the E-RISC initiative from the UN Environment Programme Finance Initiative and the Global Footprint Network (GFN), which is at the first phase of developing a methodology and metrics for integrating environmental risk into sovereign credit analysis.
There’s a conference in Paris next month on sustainable bonds called “My Name is Bond… ESG Bond”, which will look at the emergence of the SRI bond market and investors’ expectations and issuers’ innovations.

Also bubbling under is a project at Long Finance, theresearch group, looking at Index Linked Carbon Bonds.

The raft of initiatives is timely as it seems the ‘cult of equity’ is in retreat. Some in the industry suggest there is a huge pent up demand from pension funds, especially in Europe, for this type of analysis.

Martin Halle of GFN reckons the materiality of environmental risks facing countries could be significant enough to affect their ability to service their debt.

Pascal Coret, Head of Fixed Income at French state investor Caisse des Depots, is a supporter of the E-RISC project. “Sovereign risk is changing, environmental risk can be major stuff for investors,” he said at its London launch.

He made the point that data on countries’ ESG performance is not as available as for companies: “We have to know what countries are at risk.”

It would be “unwise, sub-optimal, and dare I say, unprofessional” not to integrate ESG into a sovereign credit rating, he concludes.

Coret’s views were echoed by SNS Erik-Jan van Bergen, chief investment officer at Netherlands-based funds firm SNS Asset Management. He likens environmental risk to the debt crisis – where we are “borrowing from the future”.

Michael Wilkins, Global Head of Carbon Markets at Standard & Poor’s, points out that S&P’s existing sovereign ratings do already take some account of environment risks. Given that it has recently started to look at ESG risks for companies, Wilkins hinted S&P would look more closely at how similar factors could be integrated for its sovereign ratings.

But the real test, as ever, will be when these issues start appearing en masse in requests for proposals (RFPs) from asset owners to asset managers.

One thing is certain, however. Political leaders – and finance ministries – will have have to take notice if and when ESG matters result in higher borrowing costs or restricted access to capital.