A project to develop an investor-led tool for assessing climate risk in government bonds will kick off next month, with eight asset managers joining initiators BT Pension Scheme, the Church of England Pensions Board and key investor organisations. Will pension funds begin to engage with governments? 

   

UK defined benefit schemes rely heavily and increasingly on government issued bonds, while at the same time becoming subject to more stringent regulations around climate risk assessment and disclosure. The aggregate proportion of DB assets invested in equities fell from 24.0% to 20.4% between 2019 and 2020 alone, while the proportion in bonds rose from 62.8% to 69.2% over the same period, according to the Pension Protection Fund, with much of this consisting of government issues.  

   

The Advisory Group for Assessing Sovereign Climate-related Opportunities and Risk aims “to provide investors with a common lens to understand sovereign exposure to climate risk and how governments plan to transition to a low-carbon economy”, according to the group’s founders, the BT Pension Scheme, Church of England Pensions Board, the UN-convened Net Zero Asset Owner Alliance, Ceres, the Institutional Investors Group on Climate Change, the Principles for Responsible Investment, and the Transition Pathway Initiative.  

  

Asset managers Aktia Bank, Amundi, Colchester Global Investors, Franklin Templeton, MFS Investment Management, Ninety One and Wells Fargo Asset Management have now joined the project’s advisory committee, while Latin America’s largest pension fund provider SURA Asset Management is joining the steering committee.  

 

   

“Essentially the project has come about at a time when a lot of net zero commitments are being made, there is a lot of noise in the market on how to assess different asset classes. One asset class that hasn’t really been discussed but is prevalent in most institutional portfolios is sovereign debt,” explained Victoria Barron, ASCOR chair and head of sustainable investment at BT Pension Scheme Management.  

   

Over 12 months, ASCOR is planning to come up with a tool that will allow the measurement and comparison of both current and future climate change governance and performance of sovereigns. It aims to create an independent and academic framework that is free and open source so investors can use it for research, integrate it into their decision making and have a way of speaking about the topic.  

   

The framework will then be used to produce an annual public assessment, ASCOR said, but it will refrain from ranking countries, said Barron. “We're not going to rank countries, it’s going to be an assessment framework. As investors we can’t have debt denial,” she said.   

  

The project will look at the climate change governance and future risks and opportunities for sovereign issuers, she said, similar to the Transition Pathway Initiative, which offers a framework for equity investors. While the details will be established over the next year, she said the ambition is to look at the amount of investment by a country, climate change adaptation and exposure to physical risks among others. 

  

Divestment and engagement are often considered the main tools in improving climate risk management, with some seeing them in opposition and others considering them part of a spectrum. But are these an option for DB schemes dependent on bond exposure and removed from governments around the world?   

  

“In some cases it won’t be possible to divest. UK DB schemes have to have exposure to gilts,” Barron said, but she believes the framework will open the door to conversation and enable dialogue – and thus engagement with debt offices and issuers around the world.  

   

Investors can approach governments and say “we are stakeholders, we are investors, we need to see improvement and change", she said, depending on the particular investment. “What we plan on doing is engage with issuers around the world from key geographies."

 

One example of engagement with a sovereign issuer was last year’s meeting between the Brazilian government and 10 financial institutions, led by Storebrand Asset Management, to discuss deforestation. Storebrand is coordinating a public policy dialogue with Brazilian embassies in several countries including the UK, joined by 34 investors representing over US$4.6tn. Brazil’s government agreed to a meeting in response to a letter that had been sent to these embassies less than a month earlier. The manager has started similar engagement with Indonesia. 

 

 

Assessing and engaging with sovereigns is not entirely new, but doing so on environmental issues is, said Carmen Nuzzo, head of fixed income at the UN PRI, who argued that bondholders should be more vocal. 

 

First and foremost, investors should gather better information to be able to see whether a country’s environmental commitments are realistic and how the issuer intends to finance them, she said. 

 

She admitted there are barriers to engagement, such as investors fearing that they could injure political sensitivities by analysing sovereigns for environmental risks; local authority pension funds might be particularly alive to this, with the government seeking to enforce its foreign policy views onto their investment decisions. In other instances, the issuer might be unwilling to meet, or be so important – perhaps being used as a benchmark – that tabling engagement is difficult.  

 

Still, “even if we acknowledge that these may be barriers, this should not be an excuse not to engage,” said Nuzzo, arguing that if an investor wants to behave responsibly, engagement should be part of the investment process. 

 

Collaboration can be one way to overcome some of the obstacles and allow investors to explain that their expectations are changing, she said, also allowing governments to set out their policies and address any investor misconceptions. “It’s a two-way conversation. If it’s done well it should lead to lower funding costs,” she believes, potentially making the government bond market more attractive. 

 

The other issue investors may encounter is that the duration of many bonds exceeds the average electoral cycle, but Nuzzo pointed out that the impact of this depends on whether the pension fund is a buy and hold investor. She suggested investors should try to engage with opposition parties as well the government to look for alignment in case there is a change of power. 

 

On the whole, engaging with sovereigns is more “multi-pronged” than with corporates, she added – making it more time and resource-intensive. 

 

 

Industry experts welcomed the ASCOR project, saying it addresses a gap in current climate risk assessment.   

  

“Until now, the investor focus on climate financial risk has mostly been on equity and corporate bonds. Investment managers have often put sovereign bonds in the 'too difficult’ box,” said Mike Clark, founder of climate consultancy Ario Advisory.    

  

This is no longer the case, he added: “We can introduce a country’s public policy position on climate into its risk rating. If investors don’t like, for example, Australia’s [nationally determined contributions] commitments [under the Paris Agreement] and the implicit financial risks, then they can express that view through their bond portfolio capital allocation. Standard credit rating agency assessments do not seem adequate for leading investors.”    

  

Clark said that given the enormous size of the global sovereign debt market, leading asset owners “have a systemic lever to pull as they manage bond investments wisely for their citizen savers, with investment managers needing to keep up”.   

  

Despite being an important part of many investors’ portfolios, sovereign debt has to date had less attention than many other asset classes when it comes to climate risk, agreed Claire Jones,who heads up responsible investment at consultancy LCP. “I therefore welcome the ASCOR project, with its emphasis on creating a practical and open access tool for investors,” she said.   

  

Like Barron, she admitted that climate risk is unlikely to be a consideration in pension funds’ decision to allocate to UK debt but expects that it will be considered when investing in other sovereign issuers. “Certain countries might be deemed too risky to invest,” she noted.    

  

Where an investor has concerns about a country’s level of climate risk, it should be seeking to engage with relevant institutions in that country, where possible together with other investors, she said: “Indeed, engagement with regulators and policymakers about climate risk is important for managing climate risk across all asset classes due to the systemic nature of climate risks and the importance of national climate policy in enabling companies to meet their own climate targets.”  

 

Amy Mankelow

Mike Clark

Claire Jones