Advancing Net Zero Strategies: IIGCC Sovereign Bonds and Country Pathways discussion paper

Role of Institutional Investors

Institutional investors play a crucial role in facilitating a just transition to a low-carbon economy while safeguarding the long-term value of their portfolios. With climate risks escalating, sovereign issuers' credit profiles are directly impacted, posing significant repercussions not just for the environment, but also for global investment portfolios.

To fulfil net zero commitments, institutional investors must address challenges within their sovereign bond holdings. The Institutional Investors Group on Climate Change (IIGCC) has undertaken the task of refining target-setting guidance for sovereign bonds and advancing their integration into net zero investment strategies. Their efforts have led to a discussion paper aimed at assisting investors in navigating the complexities of aligning investments within this asset class to the sustainable objectives traced in the Paris Agreement.

Challenges in Integrating Sovereign Bonds

Despite being integral to institutional portfolios and constituting a significant portion of the global bond market, investors find it difficult to select assets in a way that meets their individual net zero commitments. Sovereign bonds are thus underrepresented in net zero investment strategies. Numerous obstacles hinder their integration, as identified by the IIGCC:

• Many sovereign bond holdings face liability management restrictions.
• The market is dominated by a few prominent issuers, making reducing exposure to certain sovereigns risky.
• Global policy frameworks suffer from ambition and implementation gaps.
• Limited opportunities for engagement with sovereigns, non-credible exit strategies, and a lack of success metrics.

Tools and Strategies for Net Zero Alignment

To fulfil net zero commitments, the IIGCC encourages investors to take some first steps including:

• Tracking and measuring financed emissions for sovereign bond holdings
• Creating or endorsing methodologies to assess net zero alignment at country level
• Setting net zero alignment objectives
• Mapping engagement opportunities with sovereigns
• Increasing funds to climate solutions and transition finance

Recognizing the value of the Climate Change Performance Index (CCPI) for institutional investors, the IIGCC acknowledges it as a vital tool for assessing climate compatibility of sovereign bonds. The CCPI is based on a methodology that offers valuable insights into countries' climate performance and success metrics, and serves as a crucial reference for investors navigating sovereign bond investments.

The CCPI has also a proven record of favouring engagement with sovereign issuers, fostering dialogue and cooperation to address climate-related challenges and drive sustainable policy development.  Furthermore, its methodology empowers investors to drive real-world emissions reductions without systematically reallocating capital from emerging markets with high emissions profiles.

Private institutional capital is indispensable for closing the climate finance gap in emerging markets and developing countries to align with the Paris Agreement. The CCPI's methodology, which uses the common but differentiated convergence approach, ensures fair allocation of emission shares among countries while considering equity factors, thereby preventing nations in the global south from being sidelined from climate finance due to their current high emissions. The methodology and selection of countries analyzed by the CCPI ensures that developing countries are not penalized for their current climate performance without considering their historic situation.

In conclusion, the Institutional Investors Group on Climate Change (IIGCC) is making significant strides in integrating sovereign bonds into net zero strategies, thereby simplifying the task for fixed income investors. Simultaneously, valuable data sources like the Climate Change Performance Index (CCPI) are crucial for assessing climate compatibility and enhancing engagement with sovereign issuers. This enables investors to drive real-world emissions reductions while still including high-emission emerging markets in their portfolios.