The interplay between sovereign bond issuance and the climate transition has emerged as a focal point for both policymakers and investors.
Sovereign issuers clearly wield significant influence over economic growth and GDP. The policies they implement and investments they make also have a profound impact on the speed and scale of the energy transition. This means climate-focused investors cannot afford to ignore the sovereign bonds in their portfolios.
This is particularly true of bonds issued by sovereigns with state-owned enterprises (SOEs) and national oil companies (NOCs). For example, the world’s single largest corporate Scope 3 emitter (~5% of global emissions) is 98% government-owned. Sovereign debt is often the sole means to engage such entities on decarbonisation.
Transition planning and probabilities
The journey towards net-zero emissions is fraught with uncertainties, and there’s no consensus on what the “best” net-zero journey should look like. Corporates tend to favour their own chances of achieving net-zero based on their plans, while pooh-poohing the chances of others. A recent Bloomberg survey illustrated this vividly, revealing that only 33% of large-cap CEOs believe their peers will meet their net-zero targets, while 57% are confident of their own success.
This is like the classic “I am better than the average driver” survey. Someone – in fact quite a lot of someones – has to be wrong, but no-one thinks it is them.
For investors, these uncertainties necessitate a rigorous assessment not only of corporate transition plans but also of their execution probabilities. This probabilistic perspective is equally critical when evaluating sovereign transitions.
Deterministic vs. stochastic influences
Sovereigns have set out climate targets and plans to achieve them. Well-crafted transition plans set a clear, deterministic path to their goals, allowing for a projection of forward probabilities. However, myriad random factors – political shifts, technological advancements, or unexpected market dynamics – introduce stochastic elements that can significantly sway outcomes.
To paraphrase Mike Tyson, “Everyone has a transition plan until they get punched in the face.”
This blend of deterministic and stochastic elements in transition plans can lead to moral hazards. Governments may attribute plan failures to randomness or claim stochastic improvements as deterministic achievements.
Forces shaping transition probabilities
Let’s exemplify some of these stochastic factors.
First, technology. The evolution of technology may accelerate decarbonisation beyond initial forecasts. Consider the case of the Moorburg hard-coal power plant, originally touted as a ‘transition’ investment, which was turned on in 2015 and shut down a mere six years later because the world moved on from hard-coal faster than anticipated.
Second, elections. These can usher in sudden policy changes that have profound impacts on long-term decarbonisation probabilities. The example of the new(ish) Swedish government’s decision to lower petrol and diesel taxes is instructive here. The policy is increasing internal combustion engine (ICE) car sales, which in turn should pump up the country’s greenhouse gas emissions, and thereby undermine its climate goals.
Incorporating probabilities in sovereign bond pricing
From an investment standpoint, incorporating transition probabilities into bond pricing can drive more forceful climate action. The concept of a Sustainability-Linked Bond (SLB) embeds these probabilities directly into their pricing structure.
Take the following example. A sovereign bond promises to pay $1 (in net present value terms) in additional coupons if its issuer’s Paris Agreement targets are not met. An investor believes there is a 50% probability that targets will be met. Therefore, they should be willing to pay up to 50c extra for the bond today.
If the probability of the targets being missed increases – perhaps because the issuing government has just lowered taxes on petrol – then the investor should be willing to pay a little more, since the likelihood of that additional $1 payout happening has gone up, too.
The Twin Sustainability-Linked Government Bond
The link between transition probabilities and SLB pricing makes the case for the following idea: the Twin Sustainability-Linked Government Bond.
The Twin Bond pair would be made up of two bonds with almost identical features. They would have the same maturity, coupon, and so on – but one would have a step-up feature linked to a climate target, and one would not.
This structure would allow market forces to reveal implied transition probabilities. If the sustainability-linked twin trades at a similar price to the non-sustainability-linked twin, this would imply that the probability of the target being hit is high. The investor has a low expectation of receiving that extra $1.
If the sustainability-linked bond trades at a higher price than the twin, this would mean the market doubts the sovereign will hit its target. Or, equivalently, the investor has an expectation to get the extra $1.
In other words, by observing the price differential between the pair of bonds, we could directly infer the probability that the sovereign will achieve their intended climate goals.
Such a bond structure could dynamically reflect investor confidence in a sovereign’s commitment to climate targets, offering a transparent, market-based mechanism to assess and incentivise governmental actions.
It would also insulate sovereign climate plans from the volatility of electoral cycles – the status of the SLB component would depend on market assumptions on a country’s climate transition progress, rather than the whims of politicians.
Finally, large investors such as pension funds will have significant portfolios of government bonds. Being able to measure, aggregate, and engage on how likely such portfolio holdings are aligning with climate targets would be significant stride forward.
In conclusion
Integrating probabilistic analysis into sovereign bond pricing offers a potent tool for advancing the climate transition. We can harness these probabilities to create financial structures to drive ambitious climate action and promote transparency and accountability in transition planning, and without losing focus on fiduciary duty.
What are we waiting for?
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Watch Ulf's ICMA speech here:
