After Poland issued the first sovereign green bond in 2016, we saw more countries coming to market – France, Fiji, and finally, Nigeria. A close analysis reveals how scale, synergies and sovereigns’ exclusive access to specific sectors can create some unique sustainability benefits. On the flipside, the broad scope of national policies can lessen transparency and proceeds may not be distributed equitably; governmental change is an even more serious impact default risk, as are the governance weaknesses we see in some emerging markets. Transparent impact reporting, cross-party support for national climate agendas and robust regulatory frameworks emerge as critical factors for long-term sustainable returns.
How are sovereign bonds different?
The mandate behind all sovereign green bonds so far has been to support national environmental objectives, ranging from INDCs[1] to targets agreed under the Biodiversity Convention[2]. As a result, the frameworks cover numerous sectors, some of which are underrepresented in the impact bond space: marine conservation or sustainable agriculture are some examples. Their broad scope distinguishes them from issuances by other government-backed entities such as national development banks – those also contribute to national targets but typically operate within a narrower remit meaning that they usually have access to fewer sectors.
Few other issuers can utilise synergies and scale to create positive externalities the way sovereigns can. For instance, France’s ecocities[3] initiative for sustainable and intelligent city design integrates multiple areas: Low-carbon transport, urban planning and renewable energy are harmonised to maximise positive impact. Some municipality green bonds, such as the City of Oslo’s[4], finance similar concepts; but then a sovereign issuer is uniquely positioned to roll this out nationwide, including to cities that may otherwise lack the necessary funding. Supranationals do have a comparable leverage but they still need to consult sovereigns over project designs.
In addition, sovereigns can enable a scale, e.g. in agriculture or conservation, that would be difficult for many corporate issuers to match. For instance, the French government’s overall conservation programme[5] for 2017 had a budget of €2.9bn[6] to help preserve ecosystems both on mainland France and its overseas territories, some of which are known to be biodiversity hotspots. In comparison, the conservation impact of corporations, even publicly-owned ones such as SNCF Reseau[7] (the French rail network company), tends to be a lot more marginal because their preservation work is more of an add-on. It is also worth mentioning Nigeria’s inaugural issue finances afforestation initiatives across 26 states[8]; its overall green bond framework[9], however, additionally promotes climate smart agriculture, sustainable fishery and aquaculture.
Arguably, some sustainability gains are unlikely to be realised by anyone other than a sovereign. The Fijian issue[10] finances disaster risk reduction measures to make the archipelago less vulnerable to extreme climate events – urban infrastructure is made more resilient against storms, and coastal villages are relocated to protect them from rising sea levels. Environmental R&D is another case in point: France dedicated €2.4bn of its 2017 budget and €900m of its green bond to research on e.g. early-warning systems for extreme weather, a project that has been emulated by Fiji as well.
Contrast this with what primarily drives R&D in the private sector, namely to patent and commercialise any breakthrough findings. This makes innovations that have public value but lack a commercial angle unlikely to crystallise without state involvement. Unsurprisingly, green bond funding towards corporate R&D remains an exception: in 2015, Schneider Electric[11] came to market with a private placement to support R&D, but with an undisclosed portfolio, precisely because the information was commercially sensitive.
The German state Nordrhein-Westfalen (NRW) has issued thematic bonds[12] that partly fund research in renewables, motivated by public interest. In that respect, NRW is comparable to a sovereign but it is equally true that not many other regions are as well-funded innovation hubs[13] and therefore in a position to emulate this. The state is in fact a prime business location for different engineering industries and additionally benefits from having quite competitive educational institutions.
On the demand side, sovereigns’ unique reach over private households has the potential to bring about lasting, positive changes in consumer behaviour. One example are tax credits for energy-efficient home upgrades[14] funded by the French bond, which differ from the US property-assessed clean energy (PACE[15]) programmes in design whilst serving the same purpose: PACE bonds are securitised with green loans from private companies to home owners for retrofits; repayments are collected through beneficiaries’ tax bills by the relevant US authorities. A scheme that showcases how PPPs can feature in impact bonds.
What are the drawbacks that could reduce impact?
With the exception of Nigeria, the sovereign issues we have seen so far tend to reference national programmes rather than granular portfolios although some countries disclosed a few sample projects. Because national policies are so broad in scope this reduces transparency even more than is the case with other types of issuers. The French green bond, for instance, will use some proceeds to “support rail and waterways operators”, which could involve anything from general maintenance to energy-saving technology. It will also fund intangible assets such as human capital and organisations to support its low-carbon transition. Without disputing the need for this, it is probably best treated as an expenditure where impact cannot be quantified.
Another pitfall is assuming proceeds are allocated equitably only because a sovereign is supposed to look after its entire territory and population. There is a risk that politically important groups/regions may benefit disproportionately from investment thus increasing inequality. For example, vested interests could be as much behind funding asymmetries in infrastructure as demographics or industrialisation. In the case of France, some strategic plans of the Ministry of the Environment suggest that the needs of the different regions[16] are at least being factored in.
Political dynamics, however, probably pose the largest risk for a sustainability default. A robust framework cannot mitigate weak governance and corruption risks, a tangible concern with the Nigerian bond. Similarly, Fiji’s weak law enforcement[17] could mean that illegal fishing and logging could undermine its conservation programmes. The investor community faces the dilemma of wanting to help the countries that need it the most but being constrained by uncertain outcomes.
A change of government could jeopardise long-dated issues in particular, unless there is enough cross-party support for the national climate agenda to make policy reversals less likely. Theoretically, programmes that tie up little capital such as tax credits are more at risk than capital-intensive ones such as infrastructure. The Polish government curbing subsidies[18] for green energy-producing households, a scheme introduced by the preceding administration, is a case in point. The move was unrelated to its green bond but nevertheless raised concerns about greenwashing. The government has in fact been criticised for undermining its renewables sector in favour of its coal industry[18].
The recent political turmoil we have seen globally highlights political risk more than ever. The US has announced that it will pull out of the COP21[19] agreement; the UK has pledged to keep up its environmental agenda post-Brexit but some still fear that environmental standards might suffer considering Britain’s long-running breaches[20] of several EU environmental policies. We live in unpredictable times as events formerly thought of as far-fetched are becoming the political norm.
Conclusion
Sovereign bonds deserve investors’ attention for the unique sustainability gains they can bring – other issuers can achieve scale or synergies but rarely both, they also lack a sovereign’s leverage over the private sector or the incentive to innovate without a commercial gain. At the same time, it is not a given that these benefits will materialise or that they are discernible when they do, considering how broad and complex some national initiatives are.
This moves the issuer’s reporting standards into the spotlight and highlights how essential granularity is in accounting for impact. Screening the political landscape for governance issues, polarisation and counterproductive regulations appears even more critical for mitigating default risk. Although, until recently, this may have seemed more relevant for a developing country, in the current political climate not even the most advanced economy should be spared this scrutiny.