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Investment strategies come in two flavours: active or passive. An investor can take a manual approach to managing their portfolio, trading frantically to ‘beat’ the market, or place all their capital in an index fund that promises a market return.

When it comes to fighting climate change, however, only an active approach will do. By committing to the Paris Agreement, nation states pledge to make a hands-on effort to limit global warming by transitioning their economies to a net zero carbon future.

For climate-conscious investors, then, creating Paris-aligned sovereign bond portfolios should be a cinch. Indeed, couldn’t a firm take a purely passive approach, by simply allocating to debt sold by a sovereign party to the agreement and taking the issuing government at its word that it will abide by its terms?

Of course it’s not that simple. In fact, achieving a Paris-friendly sovereign allocation may be near-impossible for most investors. And even if it could be done, there’s a question whether it should be done.

‘Dirty’ sovereign bonds: a tough habit to kick

The Institutional Investors Group on Climate Change (IIGCC) certainly thinks it’s possible — and desirable. Part of its new ‘Net Zero Investment Framework’, which commits supporters to decarbonise their portfolios, is focused on aligning sovereign holdings to the goals of the Paris Agreement.

In practice, this means investing in the debt of governments that are on track to reduce their country’s emissions to net zero by 2050, and divesting from those that have veered off course.

This implies a far more active approach then simply buying up the bonds of countries that are party to Paris. An investor has to look beyond the paper commitment to the tangible actions being taken to hold to it.

To this end, adherents to the IIGCC framework are obliged to monitor a country’s past and future territorial emissions, carbon production per capita, and their progress fulfilling their own transition strategy. The group also recommends firms use the Climate Change Performance Index, a benchmark that ranks the efforts of countries to operationalise the Paris Agreement, as one methodology for assessing an asset’s alignment.

Screening sovereign debt using these tools, however, leaves investors with precious few investment options.

First of all, it turns out that only a handful of countries are truly on track to a net zero future. One recent study revealed that of 184 countries to have made carbon pledges, just 36 are sufficient to achieve the Paris Agreement's most ambitious goal of keeping global heating below 1.5°C. Four of the world’s five largest carbon emitters — the US, China, India and the Russian Federation — are falling short of this target.

That leaves institutional investors a limited pool of issuers to choose from, one that shrinks even further once credit rating and liquidity constraints are factored in. For example, while the European Union is on track to fulfill its Paris Agreement commitments, just five of the EU 27 are AAA-rated and eight are rated BBB or lower, meaning a fair chunk of Paris-aligned sovereign debt may fall afoul of investment mandates that limit exposures to assets of impeccable creditworthiness. Some of these top climate performers also have only small amounts of sovereign debt outstanding — meaning there wouldn’t be enough assets to go around if a bunch of investors all wanted to tilt their portfolios towards them at once.

The inverse is true, too: vast quantities of highly-rated, liquid sovereign bonds are issued by climate laggards. Outstanding US Treasury bonds, rated AA+, amounted to some $20 trillion in July. Yet the US was the worst-performing country in the 2020 Climate Change Performance Index. Australia, Canada and Japan are also among the top sovereign issuers in terms of volume and creditworthiness, but are also near the bottom of the index table. Put simply, it’s hard for sovereign investors to avoid the debt of climate-unfriendly countries.

This isn’t only true when it comes to their core allocations, either. Institutions that engage in derivatives, securities financing and repo also cannot get away from the fact that a fair chunk of the collateral they receive and post will, by necessity, be highly-rated sovereign bonds issued by these same climate-harming nations.

Liability-driven investors (LDIs), such as pension funds and insurers, are also constrained by the need to match up incoming and outgoing cash flows. This requires them to invest in assets of the same currency and duration as their policyholder obligations, and own-country sovereign debt ticks both boxes. The IIGCC exempts domestic issuance for liability matching from the scope of its net zero framework because of this inescapable fact.

The fairness trap

Crude efforts to ‘green’ sovereign portfolios will also rub up against the imperative to foster a ‘just transition’. Many developing countries have yet to, or are in the very early stages of, decarbonising their economies, meaning their sovereign debt does not count as Paris-aligned. But paradoxically, if their bonds were excluded from institutional portfolios en masse, it would make it harder for them to afford to transition, as the diminished demand would hike their borrowing costs. This would be an unjust outcome.

Recognising this, the IIGCC says signatories to the Net Zero Framework should “maintain an appropriate proportion of exposure between Developed Market and Emerging Market [sovereigns] … taking account of the differentiated pathways towards net zero that can be expected from countries at different levels of economic development.”

As guidance goes, it’s pretty woolly. After all, what counts as a credible pathway? Could a sovereign issuer say it plans to rely on carbon capture technology sometime in the future to lower its net emissions while doing nothing in the here and now to reduce its carbon footprint? Perhaps. Should developing and developed countries be graded on separate curves, to account for their unequal starting points in the journey to net zero? If so, should a ‘dirty’ developing country bond take priority over a ‘green’ developed country instrument all else being equal?

Much is left to the discretion of the investor.

This begs the question: what real power can institutional investors wield over governments? The IIGCC members represent $16 trillion in assets, yes, but these encompass thousands upon thousands of issuers. Their collective investment in any one sovereign entity may be marginal.

More to the point, to what extent do sovereign issuers listen to investors? Global banks, often formally designated as “primary dealers”, function as intermediaries between government debt offices and end-investors. They, not investment funds, are the entities that sit at the critical intersection between public and private actors. It is their inventory risk and funding costs that matter.

Of course, this inventory risk is elevated if a bunch of clients say they’re not interested in the debt of the country for which a bank acts as a primary dealer. Therefore, a clique of huge investors, working in concert, could indirectly have an effect on a sovereign’s issuance through its roster of primary dealers.

Still, it’s asking a lot of buy-side institutions to co-ordinate lobbying efforts in a bid to pressure an array of top banks — which they rely on for a whole host of services other than sovereign debt inventory — to haggle with government debt offices on their behalf. Furthermore, in a democratic society, the populace writ large should not abdicate responsibility for shaping government policy to a select band of money managers. That’s the job of voters, civil interest groups, and politicians.

But nor should top investment funds completely forswear an ‘active’ strategy towards sovereigns. It’s inaccurate to depict pension funds, insurers, and global asset managers as mere observers in the race to net zero. After all, financial institutions have the ability to shape and amplify government policy like few other economic agents.

Take the global financial crisis. Certainly, years of effort by successive US administrations to promote homeownership helped create the conditions for a housing bubble — as did the accommodative monetary policy of the Federal Reserve known to history as the ‘Greenspan Put’. But it was the banks that engaged in the complex financial engineering that allowed subprime mortgages to be originated, packaged, and sold on in such mind-boggling quantities, and the yield-hungry investment funds that provided the demand.

The hybrid model

Perhaps institutional investors should take a little of the ‘active’ and a little of the ‘passive’ approaches to aligning their portfolios.

Why not condition relationships with primary dealers on their willingness and capability to provide data on the carbon-intensity and absolute carbon emissions associated with each new sovereign issuance they want to resell? Doing so places the responsibility on the banks, which may be better equipped to run such analysis in the first place. The European implementation of the Partnership for Carbon Accounting Financials, for example, has a methodology firms can use to measure the carbon footprint of sovereign bonds.

Beyond this, investors should consider transitioning away from binary mandates that give a ‘yes/no’ answer to the question: should we buy this asset? Those mandates focused purely on creditworthiness are inherently flawed from a climate risk perspective, anyway. Specifically, sovereign vulnerabilities to physical and transition risks may be underappreciated in bond credit ratings (though some rating agencies are taking steps to incorporate climate change into these assessments).

Perhaps the climate-friendly investment mandates of the future will be less ‘yes/no’ and more ‘if/else’, which would, for instance, allow a firm to invest in a A-rated bond over a AAA-rated one if the former was more Paris-aligned than the latter, or a ‘dirty’ developing country bond over a ‘dirty’ developed country issuance with the same duration risk.

Maybe ‘flexible’ should be added between the ‘active’ and ‘passive’ dichotomy to best describe a sensible — and fair — approach to decarbonising sovereign portfolios.

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