Investors are increasingly engaging with governments, showing resilient demand for green bonds and debt-for-nature deals, but is it enough to accelerate policy change?
Governments are facing a volatile geopolitical situation against a backdrop of intensifying climate and nature impacts, with policy choices squeezed by competing spending demands, high public debt, and rising debt servicing costs. These pressures pose systemic risks, potentially handing investors greater scope for influence. But there are also opportunities to address debt, climate and nature challenges together with innovative financial solutions like ‘labelled’ bonds and debt-for-nature swaps.
With world leaders gathering in Brazil for COP30, financing the net zero, nature-positive transition will be high on the agenda. The urgent need for private capital means governments are open to dialogue with investors.
Climate engagement
Investors are increasingly engaging with sovereigns on climate risk and opportunity, with related nature and biodiversity issues also firmly on the agenda.
This is most well established in emerging markets, as Claire Meier, Investor Director of ASCOR, points out: “As an emerging market investor, you talk to your issuers on a much more regular basis. And so that really lends itself to engagement and dialogue.” Historically this focused on governance and transparency, but now “the thinking around material risk is evolving to include climate”.
Developed markets have lacked this close engagement due to the assumption that their bonds are safe assets. However, “this is very much evolving to include developed market investors as well”, says Meier.
The Collaborative Sovereign Engagement on Climate Change is an investor initiative organised by the UN Principles for Responsible Investment, comprising 41 global investors with US$13 trillion in assets. The initiative began by engaging the Australian government on climate, advocating for an investable and credible nationally determined contribution (NDC), and is now expanding to cover Canada and Japan.
To engage effectively with governments, investors need credible national climate data. ASCOR is a tool for assessing the climate readiness of countries, using a transparent, academically rigorous methodology developed by the TPI Global Climate Transition Centre (TPI Centre) at the London School of Economics and Political Science (LSE), based on investor requirements. Now in its third year, it covers 85 countries, accounting for the majority of the global sovereign bond market.
The tool is used by investors for sovereign engagement and portfolio allocation, and is also used by some governments to show their climate record to investors.
ASCOR’s Meier says the transparent methodology allows sovereigns and investors to have a “collaborative, fact-based conversation about where the sovereign is in their climate journey”.
Deforestation focus
Nature degradation and biodiversity loss are increasing concerns for investors as well. With COP30 located in Belem in the Brazilian Amazon, deforestation will be brought to the fore. The International Policy Dialogue on Deforestation (IPDD), another investor-led sovereign engagement initiative, covers Brazil and Indonesia and has expanded to include consumer markets.
Graham Stock, Senior Sovereign Strategist, Emerging Markets at RBC BlueBay, says the IPDD is “particularly active” in engaging with the Brazilian government on deforestation because of the risk it poses to debt repayment. Material country-level risks from deforestation include changes in rainfall patterns leading to drought or flooding, impacts on crops driving food inflation, and loss of access to export markets.
“These are long-term impacts but could potentially threaten the returns on sovereign assets,” says Stock, noting that governments issue long-term bonds of 30 or even 50 years. “We can’t say, ‘if you cut down ten more trees, this is how much our portfolio is going to lose’. But we can say, ‘if the deforestation reaches acute levels to the point where it changes macroeconomic trends, then clearly that would have an impact’.”
Stock adds that he has seen an upward trend over the last 10 years, with more clients taking an interest in climate- and nature-related engagement.
Debt for nature
More than half of low-income countries are either experiencing or at high risk of debt distress, according to the World Bank, many of which are also highly vulnerable to climate and nature risks.
This presents a vicious cycle where unsustainable debt limits the fiscal space for climate and nature spending, while climate impacts and nature deterioration cause economic harm that further increases fiscal risks. However, there is growing recognition that the debt, climate, and nature crises are interlinked and can be addressed together.
“We already see that playing out in debt-for-nature swaps, for example, in Ecuador, Barbados and Gabon” says Stock. “The focus in these cases was on marine conservation, but we see no reason why forest conservation could not also be a beneficiary,” he observes, adding that debt-for-climate deals are also possible.
“The underlying concept dates back to the late 1980s, but has gained strong interest with a range of commercial debt conversions in recent years,” says Jonas David, Research Director at the Anthropocene Fixed Income Institute (AFII).
Also known as debt-for-nature conversions, these swaps reduce a developing country’s foreign debt in exchange for commitments to domestic environmental action, paid for in local currency.
Around 140 debt-for-nature swaps have been agreed so far, with the 2023 Ecuador deal the largest to date, which reduced the country’s net debt burden by US$1 billion and committed US$450 million to conservation of the Galapagos Islands.
Green bonds grow
A further opportunity for investors to use debt funding to influence climate and nature-positive government policies is the ‘labelled’ bond market. The market for green, social, sustainability, and sustainability-linked bonds (or GSS+ bonds) reached a cumulative US$6.9 trillion in 2024, according to a Climate Bonds Initiative report, with an 11% year-on-year growth in issuance.
Magali Van Coppenolle, Global Head of Policy at the Climate Bonds Initiative (CBI), says the GSS+ market “looks more resilient than maybe we had expected given the changes in the political landscape”. She puts this down to the “economic edge” that many green activities have.
Slovenia issued its inaugural sovereign sustainability-linked bond (SLB) in June, with a coupon step-up/step-down depending on achievement of its emissions reduction targets. “This can be seen as a hedge for an investor,” says the AFII’s David. “It creates a very balanced incentive.”
BlueBay is positive about SLBs. But for Stock, the benefit is less about the coupon adjustment and more about the positive signals the issuance sends, in terms of the strength and longevity of policy commitment.
“They demonstrate good governance on the part of the issuer because to get the whole government to agree those long-term targets requires a high level of institutional sophistication and also commits future governments to respecting the same targets.”
The greenium effect
In September, Denmark issued a pioneering green bond of DKK 10 billion (US$1.54 billion), which is the first issuance to be aligned with the new European Green Bond Standard and EU Green Taxonomy.
According to David, Denmark issued the bond with a yield 1.5 basis points lower than its conventional alternative, offering a small benefit in terms of pricing, similar to the country’s previous green issuances.
“Denmark really stands out with a quite persistent positive greenium of two to three basis points over time,” he adds.
Evidence that issuers are rewarded for their environmental policy ambitions due to structural supply and demand imbalances in the green bond market is increasingly contested, due to the scarcity of like-for-like instruments.
Van Coppenolle says, “green bond issuers tend to get better book cover, sometimes some spread compression, and we can at times witness a ‘greenium’”, but CBI (which coined the term in 2017) is cautious about making broad claims due to comparison difficulties.
“If it exists, it’s definitely small, I’m not even sure that you can demonstrate that it exists,” says Stock at RBC BlueBay.
A market warning?
Greeniums notwithstanding, there is ample evidence that institutional investors are not prepared to give governments a free ride when linking debt raising to net zero and nature-positive transition policies.
Japan released its Green Transformation (GX) transition bond in 2024, with the first issuance certified under the CBI’s Climate Bonds Standards. No fossil gas was included, even though it plays a role in Japan’s wider GX strategy.
“Japan clearly positioned itself as a transition leader, and it was ambitious for them not to include any fossil gas,” says Van Coppenolle, stating that fossil gas is not a transition fuel despite often being portrayed as such.
The following issuances of Japan’s GX bonds were not certified, as CBI could not fully identify all of the use of proceeds. Investors’ response to the first issuance was generally positive, but the reportedly tepid interest from international investors for subsequent issuances can be seen as a signal to Japan to raise its environmental standards.
Pricing in risk
Credit rating agencies are increasingly incorporating climate risk. An academic study in 2023 on 117 countries found that climate factors were significant, especially for developing countries.
Government debt offices are also beginning to consider how climate risk impacts creditworthiness. A 2022 report by Australia’s Treasury, used to support Australia’s Long-Term Emission Reduction Plan, warned of increased borrowing costs if Australia failed to set a net zero target.
In a new book on the links between the deforestation and the fixed income markets, the AFII says it is “highly likely that credit ratings will begin to include deforestation risk” in their assessments of both corporate and sovereign bonds, in the wake of academic research into the correlations between credit risk and biodiversity loss.
Valentina Ramirez, Head of Climate Strategy Implementation at the Institutional Investors Group on Climate Change, says both physical and transitional risk are impacting sovereign spreads and ratings, citing Pakistan’s experience following devastating record-breaking floods in 2022: “After the Pakistan flood, the yield increased significantly,” Ramirez says, clarifying that it later stabilised at a lower rate.
But this does not mean that only the countries most vulnerable to climate change and biodiversity are impacted. “Most asset owners of pension funds are described as universal owners, meaning that they have globally and sectorally diversified portfolios,” says Ramirez. “So even if you’re not a sovereign bond investor buying say the Pakistani sovereign bond, you would be exposed to those risks anyway via value chains, even in your corporate portfolios.”
Van Coppenolle concurs: “Climate risk is a problem for every single country, every single investor. … Is it going to hit only the portfolios of investors who think about green? No, it’s going to hit everyone.”
Similarly, the AFII warns that failures by governments to address deforestation risks will have ramifications, increasing risks for investors by “destabilising supply chains, exacerbating climate change, and exposing both companies and countries to regulatory, reputational, and credit risks”.
The UK’s Climate Financial Risk Forum recently acted to accelerate the incorporation of nature risks into finance sector decision-making with the release of new guidance, which included case studies, systemic risk assessment principles, and actionable steps for integration.
As the capital markets start to price in these risks, while demand grows for innovative solutions to scale up climate and nature finance, the evolution of the sovereign debt market will inevitably pick up pace.
