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(Bloomberg) — Investors are saving the world! Look at them out there: filing shareholder resolutions, threatening to divest from fossil fuel companies—sometimes actually doing so! Even the investment managers and pension funds that don’t do these things are often at pains to point out that they instead “engage” with companies on their concerns about climate change.
Yet companies aren’t the only significant actors on climate change, any less than they’re the only ones affected by it. Eventually, investors concerned about how climate change will affect their portfolios will have to contend with other asset classes, including sovereign debt.
Some countries are more dependent on high-emissions industries than others. Russia, Australia, Saudi Arabia, and Indonesia, for instance, have economies that are heavily dependent on fossil-fuel exports. If demand for these exports falls as a result of a transition to lower-carbon alternatives, that may become a problem for their creditors. To take one example: Norway’s central bank plans to exclude some oil company shares from its huge sovereign wealth fund to reduce its own exposure to a long-term decline in oil demand.
Even those less dependent on fossil fuels are going to have to enact wrenching economic changes. Only a handful have made commitments that are consistent with limiting warming to below 2C, as the Paris Agreement states, according to Climate Action Tracker, a nonprofit research initiative. And just two—Morocco and Gambia—are 1.5C-aligned.
Governments need financing just as much as companies, so sovereign debt holdings should in theory give investors a way to tailor their tolerance for climate risk and a lever to pull with some of the most powerful political decision-makers. The fact that it’s possible to buy information about environmental, social, and governance risks of sovereign bonds from ratings agencies and other information providers suggests there’s some interest in it already from the investor community.
So far, however, there hasn’t been much sign that investors are either punishing or rewarding governments for their climate exposure via capital markets. While poor political governance has long been a predictor of higher borrowing costs for sovereigns, there’s little evidence to date that climate exposures attract a similar penalty.
A new paper from London School of Economics’ Grantham Institute, together with Planet Tracker, an nongovernmental organization, argues that will change over the coming decade. This focus may be particularly acute for the bigger exporters of agricultural products—particularly Argentina and Brazil—because their ability to repay debt is more dependent on “natural capital,” which will be stressed by a combination of resource depletion, changing demand, and climate impacts.
There are a few signs of this investor focus already emerging, even if it’s not yet showing up in prices. Sweden’s Riksbank last year sold its holdings of debt from Canada’s Alberta province and the Australian states of Queensland and Western Australia on the basis that these governments are highly exposed to rapid cuts in global carbon emissions. Alberta exports an expensive and high-emissions form of crude from its oil sands, while mining of thermal coal and iron ore is a significant earner in the Australian states.
The governments in question don’t seem to be worried that the Riksbank decision will catch on. They may be assuming that the characteristics of sovereign debt markets will make it harder for climate-sensitive investors to make their displeasure felt.
It’s hard to envisage large numbers of investors following the Riksbank’s lead in the very near future, especially at a time when the hunger for safe assets has driven the interest rate on swathes of the government bond market below zero. Investors have typically demurred on passing specific comment on government policies, instead preferring broad statements exhorting all governments to act. Debt investors may be particularly constrained: They’re “often obliged to hold specific bonds when benchmarking an index or because of credit rating constraints,” according to a paper on ESG and sovereign debt published in October by the UN Principles for Responsible Investment, or PRI. “It remains to be seen how ESG integration can play a role.”
Still, it would be a mistake to bet that sovereign debt will remain immune forever. The PRI, one of the biggest sustainable finance initiatives in the world, already has a program dedicated to it. The World Bank last year launched an ESG data portal on sovereign debt and plans to release a guide to help investors engage more effectively with issuers in the next few months.
It wasn’t so long ago that people doubted divestment campaigns would ever directly affect the cost of capital for fossil fuel companies, either—but nowadays coal executives are constantly complaining about the withdrawal of finance, and even BlackRock Inc (NYSE:). has promised to join the debt-divestment crowd. Sovereign debt issuers, especially those that are smaller or “semisovereign” states and provinces, may be more vulnerable than they realize.
Kate Mackenzie writes the Stranded Assets column for Bloomberg Green and advises organizations working to limit climate change to the Paris Agreement goals. Follow her on Twitter: @kmac. This column does not necessarily reflect the opinion of Bloomberg LP and its owners.