Powerless creditors?

Powerless creditors?

#1 Government bonds

In terms of their ESG performance, governments are much harder to assess than companies. And the ways in which investors can exert influence on sovereign issuers are also more limited. But they do exist.

For a long time, government bonds from industrialised countries were regarded as safe havens. But the sovereign debt crisis in Europe showed that even industrialised economies with above-average sustainability scores can be volatile and thus carry a risk of significant expansions in spreads. Several studies have identified correlations between credit risks and deficiencies regarding environmental, social and governance (ESG) aspects – in industrialised countries as well as in emerging and developing economies. One such study, focusing on the impact of corruption on government bonds, was carried out by Dr Mauricio Vargas and Florian Sommer from Union Investment.

There are also many other ESG factors that can have an impact on economic growth and affect the performance of a country’s government bonds. Corruption makes countries function less effectively. Social tensions can also arise from environmental destruction or an inadequate healthcare system. Resulting outbreaks of unrest can have a tangible effect on investors. Assessing countries with regard to ESG aspects also enables investors to gain a more comprehensive understanding of the investment risks associated with individual countries.

„Ultimately, governments are different from issuers of other asset classes in that their most important stakeholders are not the investors but their citizens.“

Johannes Böhm, ESG Analyst in Portfolio Management at Union Investmen

How can investors obtain information? How can they effect change?

Investors in this market face two fundamental challenges. How can they obtain as accurate a picture as possible of the sustainability of a country? And how can they exert influence and encourage countries to improve their sustainability performance? “Ultimately, governments are different from issuers of other asset classes in that their most important stakeholders are not the investors but their citizens,” explains Johannes Böhm, ESG analyst in portfolio management at Union Investment. “This means that the government has to account for its actions only to its citizens, and not to investors. There are also fewer channels available through which influence can be exerted – no annual general meeting where shareholders can exercise their rights.” In addition, decisions on sustainability issues rarely fall within the remit of the state treasury department issuing the government bonds. Availability of data is the first problem: governments that make standardised and reliable ESG data available are an exception rather than the norm. Investors thus have to resort to studies conducted by non-governmental organisations. “Another factor is that this type of data is typically not comparable with the almost real-time nature of share prices. The insights available to investors come with a degree of time lag and imprecision that often necessitates further self-directed research,” Böhm points out. For this purpose, Union Investment uses its own sustainability platform SIRIS and analyses additional information, some of which is gathered by speaking directly to representatives of the relevant countries.

Collecting information is also a way of initiating an engagement process with countries. This is a relatively new discipline for Union Investment’s asset managers and at this stage, there is limited experience available to draw on. But Böhm also emphasises that when it comes to engagement with states, there is no such thing as a ‘standard case’. The country-specific findings and the channels used to communicate with governments are far too varied. Brazil, one of the five most significant emerging markets in the world, can be used as a case study. Since Jair Messias Bolsonaro became president of Brazil on 1 January 2019, there have been changes in many areas of policy. An in-depth analysis conducted by Union Investment examined the extent to which these changes have adversely impacted the country’s sustainability. The study was commissioned against the backdrop of the forest fires that ravaged Brazil and several other South American countries in the summer and autumn of 2019 and dominated the news headlines for many weeks.

A satellite image of South America shows the scale of the fires across Brazil and its neighbouring countries between 15 and 22 August 2019.

A nuanced examination of the forest fires

To this end, Union Investment contacted the Brazilian federal environmental agency (IBAMA), which proved very forthcoming in answering a whole host of questions. Our in-depth research revealed that these forest fires are an annually recurring phenomenon that takes place primarily during the dry season from July to December. A statistical assessment showed a slight increase in these fires in 2019 compared with the previous year. Relative to 2010, 2007 and the early 2000s, however, the 2019 fires were actually noticeably smaller. But in light of a relaxation in environmental policy standards under the current Brazilian government, the forest fire season of 2019 could nonetheless mark the start of a more prolonged upward trend in deforestation. The increase in forest fires in 2019 was partially attributable to illegal slash-and-burn practices, which have intensified significantly. According to IBAMA, the government is planning to adopt new strategies and a five-point plan to address this issue.

“We critically examined this and further information provided by IBAMA, and checked it against other available information,” says Böhm. However, some of the figures cited in the agency’s answers could not be conclusively verified. “All things considered, we have not found evidence that the Brazilian government is pursuing an ambitious, long-term forest protection strategy. In light of the half-hearted approach to environmental policy taken by the current Brazilian government, we are in fact concerned that the loss of rainforest could worsen in the coming years,” concludes Böhm. If the current trend towards a relaxation of environmental protection regulation in Brazil is not halted, there is also a significant risk that the country will fail to reach its climate action targets on reforestation and, as a result, fail to fulfil the nationally determined contributions (NDC) to carbon emission reduction targets. This would put Brazil in breach of its commitments under the Paris climate agreement.

In conversation with Dr Ekaterina Gratcheva, Lead Financial Officer, World Bank (FCI GP), Washington D. C.

Union Investment wants to know more

Ms Gratcheva, how common is it for investors in sovereign debt instruments to pursue engagement activities with issuers?

Interest in ESG topics is growing noticeably among investors, including in the sovereign debt sector – as the example of green bonds shows. But active engagement with sovereign issuers on ESG-related topics is still in its infancy. We are also observing that levels of ESG awareness and integration of ESG factors differ substantially between industrialised countries and emerging economies.

What aspects are particularly important in engagement activities with sovereign issuers?

Engagement with sovereign issuers is much more complex than engagement with companies. One challenge is that sovereign issuers – especially those from emerging economies – often lack a clear understanding of relevant ESG issues. And in most cases, there is no well-established method for assessing the impact of ESG factors on the default risk of government bonds. At the World Bank, we are working intensively on promoting the integration of ESG factors in investment and bond issuance processes globally and making the financial system more sustainable.

Will sovereign debt investment combined with engagement remain a specialist discipline?

Investors are currently a step ahead of bond issuers when it comes to ESG integration, but we have noticed that sovereign debt offices are becoming more aware of these topics and also more willing to take action. However, genuine ESG integration is very complex from a technical point of view. As a result, it is currently primarily applied by highly advanced and forward-looking investors. Against the back-drop of the COVID-19 crisis, the World Bank and its Finance Global Practice Team are working very hard to support country clients. But we also regard this crisis as an opportunity to gain a better understanding of market and investor behaviours and of the impact of sustainability-related measures on financial performance.


#World Bank, Finance, Competitiveness and Innovation Global Practice (FCI GP)

FCI GP is part of the World Bank’s long-term finance team, which focuses on providing policy advice on sustainable finance.


Engagement with governments is a balancing act

How does Union Investment as a fiduciary asset manager incorporate the findings of such ESG analyses in its investment process for government bonds? Ultimately, we can always exclude a country from our portfolio as a measure of last resort, but this also makes further engagement all but impossible. Exclusion or disinvestment is therefore not our first choice of action. The fact that we hold a large pool of assets in trust gives us a certain amount of influence. Some countries also actively try to attract investors in the run-up to a new primary market issue. This can be a way in and an opportunity for us address topics such as sustainability issues. In addition, we can use platforms like the UN PRI and further existing channels to pursue engagement activities together with other investors in order to expand our influence. This requires diplomatic skill and tact. Engagement with governments also involves a lot of independent critical research. For this purpose, it is important not to rely exclusively on information from the daily news coverage, which can only ever be a snap-shot. A comprehensive overview is needed to gain a full picture that can be used to assess the sustainability of a country and incorporate it in our investment process. Over the course of his-tory, there have been numerous instances of influential private financiers like the Fugger family and the Rothschilds trying to exert influence over European rulers – with varying degrees of success. Today, just like back then, engagement in the sovereign debt sector is proving to be an extremely complex undertaking – much more so than in the equity or corporate bond markets.

Johannes Böhm

Johannes Böhm

ESG Analyst in Portfolio Management

As at 03 July 2020.