What’s happening? Verisk Maplecroft has launched Sovereign ESG Ratings – a tool which assesses 37 issues across nine ESG elements for 198 countries. Verisk’s ESG research found that human rights and labour rights are associated with lower sovereign borrowing costs and environmental issues are factors in debt pricing. (ESGToday)

Why does this matter? The sovereign bond asset class is valued at more than $60tn, and sovereign debt is typically considered a popular risk-free asset by many investment managers. In the UK for instance, the pension fund market has 63% of investments allocated to debt – 43% of this is in sovereign securities. Despite its size and importance, sovereign debt has, however, lagged other investment classes when it comes to ESG integration.

Are climate risks factored into sovereign bond yields? Verisk Maplecroft says that ESG issues have a material impact on sovereign bonds, and factors such as a country’s climate and energy transition risk can impact borrowing costs.

In October 2021, an Australian study said that climate-change risk is factored into sovereign bond yields via two avenues: directly through risk factors, and indirectly through macroeconomic variables such as GDP. The study found countries with lower emissions have a lower cost of sovereign debt, and that countries with higher renewable energy consumption also have lower borrowing costs.

ESG risks can impact a country’s economic performance in multiple ways – AllianzGI, for instance, provides the example where global warming increases the probability of natural disasters such as drought and heavy rainfall. As a result, supply chains and infrastructure within a country are more likely to be disrupted. Such shocks could significantly affect companies and risk the financial performance of sovereigns.

Multiple studies, including by AllianzGI and Hermes Investment, have found a negative correlation between credit default swap spreads and ESG scores. This implies that sovereigns with a higher ESG score have a lower default risk and those with low scores have a higher default risk.

Do sovereign credit ratings capture ESG risks? AllianzGI also conducted research that found credit ratings do not effectively capture the ESG score of countries, and leave out material ESG risks. The firm provides the example of Thailand, which has larger environmental risks than Peru, but still has the same BBB+ S&P credit rating. This research suggests that investors can benefit from integrating ESG factors when investing in sovereign bonds.

Other resources to help investors consider ESG in relation to sovereign debt – FTSE Russell has developed the FTSE Climate Risk-Adjusted Government Bond Index series to support investors incorporating climate considerations into government bond portfolios. The index scores countries across three core climate pillars – transition risk, physical risk and resilience risk. The scores are then used to re-weight a country’s exposure in the index, so that there is higher exposure to countries better prepared for climate risks and lower exposure to those nations more exposed to climate risks.

Furthermore, the Partnership for Carbon Accounting Financials has published draft guidance for consultation about measuring the financed emissions of investors’ sovereign bond holdings. Meanwhile, the Principles for Responsible Investment has launched human rights and climate risk guidance for sovereign debt investors.

Investors take action – Some investors have even decided to completely divest from a nation’s sovereign debt over issues related to climate change. For instance, in June 2021 Robeco Institutional Asset Management aimed to pressure the Australian government to reduce its reliance on coal and other natural resources by no longer accepting Australian government bonds into its funds. Since December 2019, Nordea Asset Management has also quarantined Brazilian government debt over deforestation concerns.

Lateral thought – As Russia nears default on its sovereign debt, it’s possible investors that previously conducted their due diligence with ESG risk factors taken into account have been able to reduce their exposure to any possible default and the subsequent portfolio impact this will have.