Sovereigns soup up ESG push

SSA Special Report 2021
19 min read
Julian Lewis

Before the pandemic, elite names were mostly missing from the pioneering ranks of sovereign ESG debt issuers. A year later, the menu of committed issuers is far broader and innovations are emerging

France was the only G7 nation to have issued green bonds prior to the onset of the coronavirus crisis, putting it among a mixed group that ranged from Egypt, Fiji, Hong Kong and Nigeria to a number of smaller EU states.

Now, however, much of the G7 has endorsed green bonds, with Germany’s €7.5bn debut in September 2020 the pivotal moment. Italy too has issued its first deal in the format, while both Canada and the UK are readying their entries into the market.

Moreover, other leading sovereign names active in the international arena such as Austria, Spain and Sweden have debuted in green (or announced their intention to), joining early movers like Belgium, Ireland, the Netherlands and Poland.

Sovereign social, sustainable (green/social hybrid) and sustainable development bonds are picking up traction too. The likes of Chile, Luxembourg and Mexico have all found investor demand for these products.

These initiatives come with the super-sovereign European Union putting unprecedented volume into the social market, financing its €90bn SURE (Support to mitigate Unemployment Risks in an Emergency) programme through the product, ahead of committing a striking one-third of its €800bn NGEU (Next Generation EU) financing effort to green bonds.

The sovereign ESG market has “without a doubt” passed its tipping point, argues Kerr Finlayson, head of FBG syndicate, debt capital markets at NatWest Markets. “Green and sustainable have gone from the appendix of pitch books to the front page. Two years ago, the focus of national treasuries was that that these are a small part of capital markets. But they’re in every single discussion now,” he said.

Investor demand is key to this. “The trend in terms of development of all kinds of ESG fund management keeps growing at a fast pace. Not a single large asset manager in Europe, and increasingly in the US too, doesn’t offer clients ESG strategies – and this is translating into increasing appetite for use of proceeds bonds,” said Pierre Blandin, global head of SSA DCM at Credit Agricole CIB.

As so much of buyers’ portfolios is now dedicated to ESG instruments, he sees it likely that “investors will drag” more reluctant sovereigns into the market.

With the sovereign sector “in take-off territory” and the EU launching its giant NGEU programme, Sean Kidney, CEO at Climate Bonds Initiative, expects the next two years to deliver very significant volume. This is likely to include a number of the highest profile sovereigns emerging with debut green bonds in 2022.

The “wall of money” now chasing sovereign ESG debt is making new issues increasingly successful, he believes.

“The market has developed exponentially in the last two to three years. We’re seeing huge steps forward for sovereign green bonds,” said Asif Sherani, head of DCM syndicate EMEA at HSBC. “And this year feels like a year when we have really eclipsed the past.”

Both he and Kidney cited Italy’s recent €8.5bn debut, which attracted record orders of over €80bn. “It’s not often you see this magnitude of innovation – a first-time issuer breaking all-time records and with an accelerated marketing and timeline,” said Sherani. “This should be a watershed moment for governments to label much more, hopefully, as the green agenda increases.”

Moreover, issuance volumes are set to sky-rocket as the sovereign ESG market welcomes five or six significant new issuers, including the EU, in the near term. “It’s getting a bit difficult for large, visible sovereigns not to be in the market,” said Blandin.

He describes sovereign green bonds as “a great communication vector”, particularly when focus on the climate and biodiversity crises are at the top of political agendas.

Innovation in view

Moreover, innovations are starting to emerge. Sovereigns are considering products such as detachable green warrants, sustainability-linked bonds, green inflation-linkers and green commercial paper or treasury bills – though none of these has yet traded.

Denmark has been open about its sponsorship of the warrant concept. Uruguay has disclosed that it is exploring SLBs and at least one G7 sovereign has also examined the product’s potential. Austria had indicated that green CP is one of the options it is considering for its green funding – though the sovereign’s treasury will now say only that it is analysing potential eligible expenditures with the Ministry of Finance.

Sovereigns are also starting to look to mobilise individual investors’ capital for social and/or environmental purposes. Having been something of a laggard in green bonds, the UK is set to launch a ground-breaking green retail ‘savings bond’ – the first sovereign green retail offering – before hosting the COP26 climate change summit in November.

This follows Italy’s issued retail social bonds in 2020. The country raised nearly €12bn from individual investors through a pair of ‘BTP Futura’ issues that explicitly support its future recovery from the Covid-19 crisis. Besides a step-up coupon structure, the deals pay holders a premium of 1%–3% at maturity, depending on Italy’s GDP growth over their life. As this report went to press in April, the sovereign launched a third GDP-linked offering.

Green growth

Green is the main focus of sovereigns’ growing ESG push. After Germany issued its landmark in a striking ‘twin-bond’ format that proved beyond all doubt that investors were willing to buy green bonds at a premium – the so-called ‘greenium’ – to a conventional twin, peers quickly began to fall in line.

“Germany managed to reach a greenium on the 10-year at the time of issuance and the bond has continued to tighten,” against its conventional counterpart, said Blandin, noting that the same is now true for the sovereign’s subsequent five-year green Bund.

Launched by auction rather than the syndication used on the 2030, the shorter deal only achieved its premium after launch.

Green Bunds “drove the last nail into the coffin” of the cost argument against sovereign involvement in the product, argues Kidney.

“Germany was a real catalyst” for other issuers, believes Finlayson. Europe’s benchmark credit, its endorsement of ESG funding provided “a real ratification of this as ‘something we also need to be doing’”.

Canada, Italy and the UK all moved to introduce their own sovereign green bonds before the year was out. Italy pulled off a record-breaking €8.5bn debut in March, while the UK is set to launch green Gilts (at least £15bn across a minimum of two deals), as well as its retail innovation. Canada has said that it will issue during its 2021–22 fiscal year.

Now, only Japan and the US stand outside the ranks of G7 green bonds issuers, with one significant question on many lips being whether green US Treasuries are a likely consequence of the political change in Washington that has already seen the US return to the Paris climate agreement after the Trump administration withdrew from it.

According to some sources, the Obama administration considered the product previously.

The Treasury department has made no official statement on its intentions in this area under new Treasury Secretary Janet Yellen (and declined to respond to IFR’s enquiries). But most market players agree that any issue would have an enormous impact.

“Wow, imagine that!” enthused one DCM banker. “It’s definitely a feasible option.”

“It would be more than emblematic. It would be a massive game-changer if the largest, most liquid issuer in the world decided to offer green Treasuries as part of its financing,” said Blandin.

“Treasuries are a risk-free measure of global markets, so it would be momentous,” said Lee Cumbes, head of public sector debt EMEA at Barclays.

“The significance would be huge from a signalling perspective, especially for US issuers who have lagged a bit in green bonds,” agreed Sherani.

“The commitment of the majority of the G7 sends an extremely strong message,” said Blandin. “I can’t see a single sovereign borrower not at least spending time to analyse the market now to see if it makes sense for them.”

“They will all do [green bonds] in time. It’s only a question of how fast,” said CBI’s Kidney. “It’s exactly what a sovereign ought to be doing.”

“We always knew that sovereigns would be important to address the scale of the enormous challenge we face and for crystallising the private sector. Initially, green bonds didn’t naturally fit into how sovereigns arrange their accounts, but having seen some innovations, we are getting close to a tipping point in sovereign green bonds now,” said Cumbes.

Rare indeed now is the sovereign that is willing to defy calls from investors and civil society for them to demonstrate commitment to climate mitigation and adaptation by issuing green bonds. Indeed, the NGO Climate Bonds Initiative is calling for sovereign issuers to double to 40.

Norway wouldn't

One exception is Norway. According to its debt office, which is run from the central bank, “the government has no plans to issue green bonds or any securities labelled green”. A spokesman notes that the Ministry of Finance could decide otherwise, however.

Although Norway is an atypical issuer (so cash-rich it only issues government bonds to maintain a yield curve for the rest of the market), such a reversal is feasible.

Neighbouring Sweden, the home of some of the very first institutional green bond investors but a laggard in sovereign green, only entered the market last spring – a few days before Germany’s debut. Its debt office had previously resisted the product, but was given a political instruction by the ministry of finance to issue. A similar dynamic last autumn led to the UK’s decision to enter the market.

Most sovereigns, though, echo comments from Ireland’s National Treasury Management Agency that green bonds “are an innovative form of finance and it makes sense for Ireland to be at the forefront of developments in this space. The sovereign green bonds programme demonstrates Ireland’s commitment to finding attractive new ways to meet the state's funding requirement by diversifying our issuance and accessing a new base of investors to lend to Ireland”.

Variety picks up

Few market players expect innovations like SLBs to contribute much volume to the sovereign ESG space – especially not in the nearer term. But they mostly view the new groundswell towards new formats positively.

“That’s the beauty of a larger market. You get variety at the margins,” said Kidney, though he believes sovereign SLBs “will be a niche piece”.

While Barclays’ Cumbes anticipates an “array” of ESG debt products from sovereigns as they grow more active in climate and social financing through bonds, he expects the bulk of activity to be at the mainstream end of the spectrum.

“They all have their place, but vanilla use-of-proceeds bonds will be the majority,” he said. “A key characteristic for government bond buyers and government green bond buyers is liquidity, which tends to favour keeping critical mass in products with that selling point.”

Credit Agricole’s Blandin agrees that the bulk of sovereign ESG volume to be in use-of-proceeds formats but sees the SLB format as potentially attractive for issuers too. “It is easier to implement. You don’t need to distinguish green expenditure within the budget and track it. No framework or reporting are needed,” he said.

“It’s possible that some sovereigns will see it as a good way to put a footprint into the market without going the whole way.“

While “the two [UoP bonds and SLBs] could complement each other”, Blandin also cautions over political factors. Depending on the size and number of issues, would governments be ready to commit future administrations to follow the policy steps embedded in their SLBs or leave them facing significant costs for failing to meet the bonds’ KPIs?

SLBs might work best for emerging markets sovereigns, some bankers suggest. “With Western governments committing to net-zero, there isn’t the same need to reinforce that with KPI-linked structures,” argued one.

Lust for liquidity

Moreover, sovereign SLBs would not align with borrowers’ liquidity-first strategies. With liquidity a key consideration for government bond investors, HSBC's Sherani emphasises liquidity-enhancing innovations such as Germany’s twin approach. Twinning green bonds with otherwise identical conventional bonds “seems to be a winning strategy”, since it involves increasing the non-green bond’s outstandings too.

But approaches to liquidity vary. While Denmark’s warrants find some support, others are critical. One banker criticised the scheme as “unhelpful, not ideal” for its potential to accommodate bonds being “green one day and not the next” due to the freedom to detach the warrant and trade it separately.

“Theoretically, it may not be flawed, but perceptions count for a lot in the real world. You can over-engineer in this area,” he cautioned.

As a smaller sovereign borrower, Denmark “should just make their entire borrowing programme green”, said one market player. “They could pull it off.”

France and some other sovereigns have addressed liquidity by making the building of a green curve a secondary priority. Instead, they opted to place all of their green expenditures into a single bond – at least until the recent second OAT verte, which extended the French green curve by five years to 2044 four years after the landmark first.

At the other end of the maturity spectrum, the potential for sovereign green CP or Treasury bills is arousing debate.

“Investors of all different stripes want to contribute, and that includes the short end,” said Cumbes. “While green CP might not instinctively feel like it naturally fits with raising money to change long-term infrastructure, for example, it is important to provide products for investors and the financing can then be transformed.”

Blandin at Credit Agricole takes a different perspective. Going beyond the issue of maturity mismatch to investors’ needs, “there will be times when green bond funds are not 100% invested: allowing investors to park cash while still using a green instrument has validity”, he said.

Reaching out to retail

Sovereigns’ retail ESG moves are also attracting attention. The UK’s decision to issue via NS&I “ticks all the boxes” in mobilising individual investors’ capital, believes NatWest’s Finlayson. He describes the planned landmark deal – the first retail green bond from any sovereign – as “phenomenal”.

One banker is “fascinated to see the detail” of the deal. The sovereign has made what he terms a “smart move” to broaden its ESG offerings beyond the institutional market and build broad public support for financing climate mitigation and adaptation.

Could other sovereigns also launch retail ESG bonds, mobilising local capital for national climate change mitigation and/or social benefit? “The answer is yes,” said Sherani.

BTP Futura-type or sustainability-linked structures might be feasible on these deals, he suggests. This reflects the much lower priority that individual investors place on bonds’ liquidity.

Inflation structures are another untried possibility. Indeed, green linkers barely exist in any sector. But with a number of sovereigns already very committed linker issuers, Sherani sees scope for the product – especially as it would be “perfect for investors” due to combining capital and environmental preservation.

Amid the enthusiasm, Blandin at Credit Agricole notes that European retail banks have found it increasingly difficult to distribute bonds to retail buyers through their branches – except in Italy, where the sovereign has always been able to draw on retail support for its debt. The current ultra-low yield environment has only exacerbated the issue.

Accordingly, he views yields as pivotal for the success of future sovereign retail ESG offerings. While the green use of proceeds probably holds some allure for individual buyers, tax advantages (within the sovereign’s power) and yield enhancement through structuring (as seen on the BTP Futura deals) may be key for demand.

Withering away?

Are ESG-labelled sovereign bonds a permanent feature of the debt capital markets or a staging post along the way? Some DCM bankers anticipate a future era in which the bulk of sovereign financing is intrinsically ESG-friendly and no longer requires labelling. Perhaps only non-ESG financing (of armaments, for example) will carry labels eventually.

Ultimately, the labelled bond approach may fall away. “It is so mainstream that at some point it will become issuance by default. The frameworks are so enshrined that it’s inevitable,” said Finlayson.

Not all bankers expect a withering away, however. “Labels exist to organise private markets and help coalesce interests,” said one.

Instead, he sees the five-year outlook for the market as “building out green so that it’s normal – it has to be completely normal, an expected part of capital markets financing – and building out liquidity”.

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