Government bonds and environmental investing

If the universe of environmental investments were the planetary systems within Star Wars, then sovereign bonds would surely be found in the outer rim territories. That’s because investors generally regard efforts to apply a climate lens to government debt as a hazardous voyage into the unknown.

The common refrain is that selecting - or excluding – specific sovereign bonds on the basis of a country’s environmental record compromises portfolio returns and does little to bring about changes in national climate policy.

Yet such a stance doesn’t survive contact with reality. Viewed from every conceivable angle, net zero will fail without public money and state intervention. The world needs trillions of dollars of government investment in climate mitigation and adaptation technology. And it also requires carefully crafted environmental laws and regulations.

All of which means that, as lenders to governments worldwide and holders of some USD128 trillion in sovereign debt, bond investors are in a unique position to influence both the financial and legislative sides of the climate ledger.

This explains why Pictet Asset Management has dedicated considerable resources in the past few years to develop an investment portfolio that places sovereign bonds at the heart of the net zero transition. Drawing on both quantitative and qualitative analysis, Pictet AM’s Climate Government Bond strategy seeks to identify – and allocate capital to - countries making the greatest strides in reducing carbon emissions.

The strategy pursues twin objectives. It aims to build a fixed income portfolio that at least matches the returns and volatility of the FTSE World Government Bond Index but with a far smaller carbon footprint.

The choice of carbon emissions as the singular investment reference point is a deliberate one. Carbon emissions have by far the most potent impact on global warming. They account for about 70 per cent of all greenhouse gas emissions and can linger in the atmosphere for hundreds of years.

Carbon dioxide is also the greenhouse gas upon which the vast majority of national net zero plans are based. Indeed, all of the 194 signatories of the Paris Climate Accord have specific emission reduction targets against which their net zero progress can be judged.

It also helps that emissions can be accurately measured and monitored. Thanks to technological advances and tighter environment regulations, carbon emissions data are now plentiful, reliable and frequently updated.

But having access to a wealth of accurate and timely data can be both a blessing and curse. Depending on how the data is parsed, it can give wildly different indications for portfolio construction. If, for example, bond investors chose to allocate capital simply on the basis of a country’s total carbon emissions, they would exclude bonds issued by China and the US.

If, however, the terms of reference were emissions per capita, then Chinese sovereign debt would score much more favourably – better, even, than either US Treasuries or Australian government bonds.

Using emissions data in such a crude way throws up another problem – it doesn’t offer a portal into the future. To avoid such pitfalls, we have devised a data framework that we believe gives a more accurate country by country comparison and can extrapolate past trends. Not every nation is covered by our analysis.

Instead, the screen assesses the carbon footprints of the 70 countries - all with liquid bond markets - that, together, account for 80 per cent of all carbon emissions. It incorporates two metrics. The first is a country’s total carbon emissions; the second is its total emissions divided by its annual economic output, an indicator of carbon efficiency. For each dataset, we analyse the trajectory over the past four-year period.

A distinguishing feature of the approach is how we calculate carbon emissions. Our data include emissions – and emissions reductions – that stem from industrial processes and changes in a country’s land management. It takes into account the complexities of the carbon cycle and how it is affected by soil erosion, deforestation and re-forestation.¹

Beyond quantitative screens

This quantitative process has plenty to commend it. It provides a deep and broad analysis of a nation’s carbon footprint. Yet using it as the sole investment input would be ineffectual. Doing so creates a portfolio that is both too unstable and concentrated for most investors.

Our own analysis shows that a portfolio whose bond weightings were based entirely on our quantitative screen would be extremely vulnerable to, among other things, changes in economic conditions and abrupt moves in currencies and interest rates. Put differently, if investors were to use the carbon screen in isolation, their portfolio would return less and be more volatile than its reference benchmark.

Mitigating such risks is complicated. It requires a combination of qualitative judgement and sophisticated portfolio risk management techniques. Our assessment of Brazilian government bonds illustrates how the limitations of a systematic screen can be overcome.

Assessing the country’s carbon footprint solely through our quantitative screening, Brazil would have been included within the portfolio. It scores well on absolute carbon emissions and emissions per unit of GDP– the long term trends were positive in both cases. Yet those signals did not provide the full picture.

In breaking down the country’s carbon emissions by industry sector, it became clear that its performance was much weaker than first thought. Particularly troubling was the government’s poor management of its natural capital – in particular the Amazon ecosystem – and its excessive reliance on fossil fuels.

Although wind power accounts for a sizeable proportion of Brazil’s total energy consumption, the government previously led by Jair Bolsonaro had favoured investments in oil and gas exploration over wind and solar. It has also ramped up fossil-fuelled power generation to combat hydropower shortages caused by droughts in 2021, and extended the life span of its coal-based power plants.

This bleak assessment was corroborated during the next phase of our qualitative assessment – an audit of Brazil’s policy framework based, in the first instance, on data provided by the consultancy Maplecroft and on discussions with members of the Climate Government Bond Strategy’s Advisory Board (AB).²

In evaluating the environmental policies proposed by the incoming administration of the centre-left president Luiz Inacio Lula da Silva, it became clear that it would take many years for Brazil to reverse the harm caused by earlier mis-steps.

AB members concluded that, that even if President Lula’s measures were put in place almost immediately, the existing damage done to the country’s natural capital would see its carbon emissions rise for years to come.