The 2025 deadline for submitting new nationally determined contributions opens the door for sovereign debtholders to push for credible net zero transition plans.
Governments signed up to the Paris Agreement are currently preparing the next set of plans to reduce their carbon emissions, known as nationally determined contributions (NDCs), which are due by 2025. At this year’s COP29 in Azerbaijan, the governments of developed countries will be required to establish a new climate finance goal.
These impending commitments are an important opportunity for institutional investors to meaningfully engage with sovereigns on the funding and policy priorities of their net zero transition programmes, according to Sean Kidney, CEO, Climate Bonds Initiative (CBI), speaking at ESG Investor’s Stewardship Summit 2024.
“There’s a lot of scope for investor engagement this year compared to the past few years,” he said, pointing to several sovereign roadshows underway including Japan and Australia. “We’re pushing strongly for NDCs to become transition opportunity plans.”
In addition, he predicted that next year there will be broader engagement around sovereigns’ plans. To support increased dialogue, the CBI is launching a sovereign engagement for thematic bonds initiative with investors from Japan, Europe, China and the US.
Governments’ existing NDCs were declared inadequate at COP28 in Dubai last December, under the Paris Agreement’s Global Stocktake process, with the summit’s final text committing them to going further and faster in adoption of renewable energy sources.
Sovereign issuers seeking to tie fundraising to ambitious net zero transition goals have been met with intense scrutiny. Investors made clear to Japan their scepticism about some of the projects to be funded by transition bonds issued in February, as part of the country’s Green Transformation programme.
Lack of ambition and credibility
However, there was some debate among panellists as to the role sustainability-linked bonds (SLBs) will play in delivering the financing required for sovereigns’ transition efforts. Kidney called into question whether having a “complicated” coupon arrangement would deliver the estimated US$50 trillion needed over the next two decades. He also pointed to the CBI’s inaugural report on SLBs that estimated around 50% of the still-nascent market was made up of low-quality deals that “lack ambition, credibility and adequate disclosure” around key performance indicators (KPIs).
Justine Leigh-Bell, Executive Director, Anthropocene Fixed Income Institute, a non-profit organisation aimed at influencing investment decisions in the fixed income markets, argued that SLBs will play an important role, alongside green bonds and other instruments.
“We finally have an instrument that is built for transition financing and has accountability built into it,” she said. “The KPI side is where investors have huge opportunity for engagement, helping to establish clear targets and pricing KPIs based on ambition levels. There’s potential for much more effective negotiation on pushing for that ambition reprice.”
Laith Cahill, Senior Specialist on Net Zero Stewardship, Institutional Investors Group on Climate Change (IIGCC), which launched a bondholder stewardship working group in December 2022, said the accountability mechanisms within SLBs offered important opportunities to investors for engagement with both sovereigns and corporates.
“When we examined what bondholder stewardship might look like, we focused mainly on engagement pre-issuance. But SLBs give investors a hook by which to engage post-issuance. That is important in terms of understanding how companies are progressing against their targets, but also where they might miss their targets and why. In that way, investors are able to glean additional information about the path to net zero,” said Cahill.
Noting the nascent status of bondholder stewardship compared with shareholder activity Cahill argued that collaborative engagement with sovereigns and corporates will help to accelerate the net zero transition and reduce risks. Leigh-Bell added that asset owners now have more negotiation power, particularly around ambition levels and contractual arrangements, that wasn’t available before with issuers.
But she also pointed out the need for greater transparency within the fixed income supply chain to ensure that bondholders have more influence going forward. “There is currently around 20%-30% coverage of bond holdings, which makes it difficult to scale up bondholder engagement. If we have greater visibility, the collective engagement that can happen among asset owners is quite powerful,” she said. “For example, it carries a lot of weight when the top pension funds co-sign letters to the Brazilian government highlighting deforestation risks.”
Collective action
Macro stewardship, which is founded on the idea that market participants have a responsibility to help preserve society and the planet beyond their portfolios, could be a key ingredient to increased bondholder influence, Cahill emphasised.
“It’s all about engaging with policies, policymakers and regulators, and creating an environment for bondholder stewardship. More precisely, it’s about enhancing climate risk disclosures, both for labelled debt and non-labelled debt,” he said.
“Issuers need to build on their transition plans, so bondholders are able to engage in meaningful dialogue on climate targets. That will inform investment decisions, protect long-term value and ultimately support the transition.”
CBI’s Kidney agreed that investor engagement activity needed to go well beyond its traditional scope if it was to drive transformational change among issuers in order to address systemic risks.
“Bond picking, like stock picking, is not the way to solve this problem,” he said. “The only way is collective action. We might argue about the nature of collective action or the underlying principle, but all the various groups have opportunities to work together on changing the game. Fundamentally, what we need to focus on is changing the game, not the components of the game.”
