Carbon Disclosure and Climate Risk in Sovereign Bonds
A new report by Global Footprint Network, Carbon Disclosure and Climate Risk in Sovereign Bonds, outlines a methodology for investors to disclose and manage carbon exposure in their sovereign bond holdings.
Until now carbon disclosure has focused mostly on listed equities and to a lesser extent corporate bonds. Yet sovereign bonds represent one of the largest asset classes and a significant percentage of diversified investment portfolios, especially among institutional investors.
Regulatory momentum is also growing for more carbon risk disclosure. On Dec. 14, the Financial Stability Board’s Task Force on Climate-related Financial Disclosure issued recommendations calling for greater carbon risk disclosure not only from companies in such industries as energy and transportation, but also from the financial sector, including asset managers and asset owners.
“The Task Force’s recommendations are expected to contribute significantly to the ability of investors to prepare for the transition to a low-carbon economy. However, transition risks also exist at the country level, and we hope our report helps to extend investors’ view to better understand how these risks are material to sovereign bonds,” says Susan Burns, Director of Global Footprint Network’s Finance for Change Initiative.
The recommendations in the paper were developed in collaboration with a working group of nine asset owners and managers brought together by Global Footprint Network and South Pole Group to address the lack of clarity on climate disclosure methodologies for sovereign bonds. The participating companies included Aegon Asset Management, Alliance Bernstein, BlackRock, BT Pension Scheme, DEGROOF Petercam, MN, Swisscanto Invest, Nippon Life Global Investors, and Vontobel.
Incorporating insights from these organizations, the report reviews a variety of approaches for assessing the carbon exposure in sovereign bond investments, recommends a carbon intensity approach, and provides case examples. Going beyond simple sovereign bond portfolios, the report recommends an approach for carbon disclosure of mixed asset class portfolios and an approach to company-wide reporting in multiple asset classes. The report also addresses additional dimensions including emissions in production, consumption and trade, and emissions from land use changes.
The report recommends a dashboard of indicators for the most comprehensive climate and carbon risk assessments, pointing to three key elements:
- Transition risk, including dependence on fossil fuel reserves and the carbon intensity (see graph below);
- A country’s policy response including its adherence to climate agreement pledges (Intended Nationally Determined Contributions, or INDCs); and
- Physical climate change risk, including a country’s exposure to extreme weather events, water scarcity, and food price shocks.
The report concludes that while carbon intensity is a useful exposure indicator, the ways that a low-carbon transition might impact a country’s creditworthiness, both positively and negatively, need further exploration. Future research needs to map more explicitly the transmission mechanisms between a country’s carbon dependence and its economic performance under various scenarios.