Talking Heads – Scoring sovereign issuers of green bonds

This is an audio transcript of the Talking Heads podcast episode: Scoring sovereign issuers of green bonds

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing ESG assessments of sovereign bonds. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Malika Takhtayeva, ESG analyst, and Ilan Tamsot, Portfolio Manager. Welcome to the both of you and thanks for joining me.

MT: Thank you, Daniel. Happy to be here.

IT: Thanks, Daniel. Glad to be here.

DM:  Malika, we’re all pretty familiar with ESG assessments when we think about investing in securities related to corporates, so, an equity or a bond for a company. We can look at what the company does: Do they have objectives to meet certain sustainability criteria? And then we can determine whether it’s, so to speak, a good or less good company. However, today we’re talking about sovereign bonds and countries, and we appreciate [it is] more complicated to assess a country from an ESG angle. So, Mallika, how do you assess sovereign bond issuers using ESG criteria? What are some of the challenges you face?

MT:

BNP Paribas Asset Management’s approach to country ESG scoring – for environmental, social and governance – is designed to support better informed investment decisions and engagement with sovereign bond issuers. The comprehensive scoring methodology combines quantitative and qualitative inputs and draws on data from trusted providers. It is applied across the almost 110 countries – developed and emerging – that make up our sovereign investment universe.

The score provides a comparison among countries with different levels of economic development, commitment to addressing climate change and exposure to physical climate risks. It’s informed by investment team insights and dialogue with regulators and policymakers. The assessment combines 14 environmental, 12 social and seven governance themes to provide a comprehensive contextual view of a country’s ESG performance.

DM: How do you go about ensuring a fair comparison between countries?

MT: To enable a fair comparison among countries, performance for each ESG indicator is calculated relative to the expected level. Given the country’s degree of economic development, the expected level for each indicator is determined as the average per-income group with income classifications as defined by the World Bank.

Calculating a country’s ESG performance on a specific indicator requires identifying an expected level given the country’s gross domestic product. Increasing access to electricity delivers more impact in low-income countries and so is weighted more highly than for countries in higher-income groups.

We also assess a country’s ambition for tackling climate change, which is very important and based on information on the policies adopted to address climate change and their future exposure to physical climate risk. The Beyond Ratings Climate Liabilities Assessment Integrated Methodology provides an assessment of the commitment of each country to the goals of the Paris Agreement to generate a score for the country’s climate ambition.

DM: How do you incorporate input from the investment teams into the process?

MT: As with our company scoring model, we incorporate the investment team’s in-depth knowledge and account for dialogue and engagement with debt management officials and policymakers. Quantitative assessment allows for an efficient evaluation and comparison of countries’ ESG characteristics. However, the information captured through a fixed set of indicators is necessarily imperfect when investment teams believe the quantitative assessment does not fully capture a country’s current situation and expected evolution.

DM: Ilan, as a portfolio manager, how do you address those challenges when you go about investing?

IT: From the asset management perspective, one of the main challenges is to deal with the gap in maturity that is inherent in the way European governments are issuing green bonds. In other words, most European governments are issuing green bonds, mainly with a long maturity, leaving the number of green bonds at the short end of the curve limited. Thankfully, during these last few years, the sovereign ESG market has grown in quality and in heterogeneity. More sovereign asset [issuers]  are actively issuing ESG bonds. Those include supranational agencies and regions that have good liquidity, a high credit rating and more importantly, are issuing across all maturities.

Also, the number of countries that are now part of the green bond club keeps increasing. Countries like Germany have innovated the way of issuing green bonds. Instead of issuing green paper with only long maturities, Germany created a green bond curve that covered all the main maturity tenures. We can also mention Austria that issued a green bill with the maturity of less than a year. And finally, the amount issued by sovereign entities with an ESG label keeps increasing, thereby improving the liquidity.

DM: How do the recent developments in the ESG sovereign bond market impact your activity?

IT: [With] more countries issuing green [bonds, there is] better liquidity; a new way of issuing green, etc. gives us several ways to deal with and fill this gap of maturity. A country that doesn’t have any green government bond in the short part of its curve could now easily be replaced by a green supranational or an ESG labelled agency [bond] with the same maturity and level of risk.

And to conclude, what we can say for sure is that this improving trend is here to stay. The growing interest coming from investors for ESG is something that issuers are well aware of. We should also not forget that there is an ongoing push coming from the ECB to implement ESG in their monetary policy. All of that to say that those developments should keep the sovereign market in a good place for the coming years and keep contributing to address these challenges.

DM: Malika, could you give us an update on what the ESG sovereign bond market is like today?

MT: We expect more resilience and diversification. Issuance was resilient in 2023, growing by 2% year-on-year, which was really in line with our expectations. So, while the market is unlikely to rebound to the 2021 record, which was USD 1.1 trillion [in] issuance, we still expect it to hold up well despite challenges such as higher for longer interest rates and moderating economic growth. For example, Moody’s projects issuance could reach USD 950 billion in 2024, slightly higher than what they expected for 2023. S&P forecasts issuance could rise to above the USD 1 trillion mark.

Although supranational entities, financial institutions and agencies, as Ilan mentioned, initially led the way, sovereigns now account for a growing proportion of new bonds. Bonds issued directly by government departments have risen from about 7% of the total market value at the end of 2017 to over 20% at the end of March 2023, according to MSCI data. In 2023, a record 35 sovereigns globally issued sustainable bonds totalling USD 169 billion, exceeding the previous high watermark of 26 issuers in 2022.

DM: And what about emerging market sovereign issuers? Are they issuing green, social and sustainable bonds?

MT: Over recent years, EM sovereigns have contributed more to global sovereign bond issues, accounting for 25% in 2023 and underscoring the significant climate finance gap for developing economies. These national, also regional and local governments face not only high exposure to physical climate risk and carbon transmission risk, but they also often lack the fiscal and institutional capacity to tackle this on top of facing higher costs of capital. Such challenges require continued innovation in their financing approach to address these needs.

We believe sustainable finance will be a growing source of funding as emerging market sovereigns present national energy transition plans and their climate adaptation goals. As well as developed market sovereigns, [they] will be supported by regulation and standards in these bond markets, which are really improving.

For example, from late 2024, the European Union Green Bond Standard is set to transform, in our opinion, issuance across the bloc. From a reporting and transparency perspective, investors can showcase the green credentials of their portfolios, while sovereigns can progress towards their net zero commitment and goals, particularly as two key net zero milestones in 2030 and 2050 approach.

DM: Mallika, Ilan, thank you very much for joining me.

MT: Thank you very much, Daniel.

IT: Thanks, Daniel.