Policy Contribution
Issue n?10/21 | April 2021
Marta Domínguez-Jiménez (marta.
dominguez@bruegel.org) is a Research Analyst at Bruegel
Alexander Lehmann (alexander.lehmann@bruegel.org) is a Non-Resident Fellow at BruegelThe authors are grateful for very helpful comments from Moritz Kr?mer, Patrice Cochelin and Paul Munday in the context of a related project, undertaken with Stavros Zenios.
Accounting for climate
policies in Europe’s sovereign debt market
Marta Domínguez-Jiménez and Alexander Lehmann
Executive summary
International debt investors increasingly demand assets that are aligned with environmental, social and governance objectives. Sovereign debt is being belatedly swept up in this change. This huge asset class represents a uniquely long-term claim and funds a wide range of public expenditure, both brown and green. Public capital expenditures will be a central part of the roughly �3 trillion investment budget needed to pay for the European Green Deal.
European Union countries have so far met investor appetite for climate-aligned assets through sovereign green bonds, the issuance of which has rapidly grown since 2017. The EU itself will also issue green bonds in large volumes. However, because of some inherent flaws in such instruments and as their still-weak frameworks, these bonds are unlikely to meet the environmental criteria demanded by investors, and will complicate established principles in sovereign debt management.
Much more comprehensive information is needed on the climate-related aspects of the public budgets of EU countries. Greater transparency in this respect would support stabil-ity and improve the functioning of capital markets, given that sovereign debt plays a pivotal role in all investor portfolios and also in regulatory and monetary policy.
Adoption by sovereign issuers of green budgeting principles, based on a common taxonomy of sustainable activities, would enhance transparency. It could also be driven by investors who, under new EU rules, must disclose the climate-related aspects of all financial instruments offered in the capital market..
Recommended citation
Domínguez-Jiménez, M. and A. Lehmann (2021) 'Accounting for climate policies in Europe’s sovereign debt market', Policy Contribution 10/2021, Bruegel
Investor strategies in relation to
sovereign debt are complicated by a lack of transparency about sustainability-related public expenditures
21 Introduction: shifts in sovereign debt markets
The European Climate Law, agreed in principle on 21 April 2021, makes net-zero greenhouse gas emissions legally binding for the European Union by 2050. Other advanced and emerging markets, including South Korea and Japan, and numerous municipalities and cities, have adopted similar targets. This low-carbon transition will require additional annual investment of around �340 billion in the EU alone, with the bulk to be financed by public sector budgets (EIB, 2021).
Capital markets could be a key source of funding for Europe’s low-carbon transition. In a remarkable shift in debt capital markets, environmental, social, and corporate governance (ESG) measures have become central to the investment process. Investors have expanded their search for green assets beyond private issuers, for which carbon footprints and align-ment with sustainable activities can be relatively easily pinned down, to sovereign issuers that support international climate goals.
Sovereign debt is by far the largest asset class in European capital markets, with �9.1
trillion of EU bonds owed by EU governments at all levels, and total debt equivalent to nearly 90 percent of GDP at end-20201. It is the pivotal asset class that defines pricing of all other financial contracts, a core part of most investors’ portfolios, and of course the largest holding on the balance sheets of the European Central Bank and other EU central banks.
However, investor strategies in relation to sovereign debt are complicated by a relative lack of transparency about sustainability-related public expenditures, or about medium-term plans for such expenditures. An EU classification, known as the taxonomy2, has defined what amounts to sustainable activities, yet green budgeting, which would consistently account for the alignment of national public expenditures under such a classification, is in its infancy in the EU, and even more so in national expenditure frameworks.
In an effort to appeal to investors who want to take into account ESG performance, EU states have started issuing green bonds, with ten having done so by March 2021 (see Table 1 in section 3), following in the footsteps of large supra-national issues including the World Bank and European Investment Bank. These instruments commit issuers to use funds raised for activities deemed sustainable, in particular climate mitigation and adaptation. With about �82 billion of cumulative issuance, EU sovereign green bonds are a niche market, though one that is expanding rapidly. A new asset type appears to have emerged in a market that to date was highly homogeneous.
Even though these bond issues have been eagerly taken up by investors, how they meet investors’ needs for portfolios aligned with sustainability goals is unclear. Unlike corporate bonds, attributing government bond financing to any individual capital expenditure is made difficult by the integrated treasury management of EU member states’ budgets. In some cases funds are largely dedicated to refinancing past expenditures, clearly undermining any notion that bond funding would incentivise additional climate-aligned capital spending. From the perspective of the issuer, the parallel trading of both conventional and green bonds fragments liquidity in the market and may in fact undermine the traditional objectives of efficient sovereign debt funding.
1 Figures refer to general government debt in the third quarter 2020, based on the Eurostat press release of 21
January 2021, available at https://ec.europa.eu/eurostat/documents/portlet_file_entry/2995521/2-21012021-AP-EN.pdf/a3748b22-e96e-7f62-ba05-11c7192e32f3.
2 See https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en.
Policy Contribution | Issue n?10/21 | April 2021
3In the EU, all asset managers and financial advisors must, since March 2021, disclose measures of sustainability of assets offered in the market3. A search is underway for metrics that could guide investors towards climate-aligned issuers, not just towards individual secu-rities labelled as ‘green’. Major asset managers are committed to full disclosure of the climate impact of their funds. European sovereign bonds of similar credit risk will show major differ-ences in their ‘warming potential’, which could lead to a significant reallocation of capital. This paper examines how information about the climate policies of EU member states, as reflected in their spending, could be more effectively communicated to sovereign debt investors. Three measures would create the needed transparency: publishing standardised measures of climate-relevant budget expenditures based on a common taxonomy of green activities; more rigorous green bond frameworks that deliver better on investor mandates; and metrics designed by financial firms that gauge the climate-alignment of national policies. Jointly, the measures we propose should help channel capital market funds to the sovereign issuers most aligned with the objectives of the European Green Deal. This would help bridge the widening gap between the low-carbon investment that is needed and funds actually mobilised.
We start by examining changing investor needs, which reflect ESG criteria but face the obstacle of very limited transparency in national budgetary policies. We then (section 3) review European sovereign green bonds as one way to overcome this information problem. We find these instruments will likely have limited value for investors who truly prioritise sus-tainability and in any case, they seem to make little difference in changing national expend-iture policies. We therefore review (section 4) two other types of disclosure measure, which can be backward or forward-looking. We conclude in section 5 with some recommendations on green bond standards, financial disclosure metrics and transparency in national budgets.
2 ESG investors and sovereign debt
Investment oriented around environmental, social and governance criteria is quickly becom-ing the norm. The vast majority of institutional investors have subscribed to broad principles of responsible investing, even though verification and enforcement of such standards is often weak. Most investors will reflect some kind of ESG measure in their investment processes. There are also more specialised sustainability-oriented investment funds whose total assets under management in 2020 were estimated at �1.1 trillion within a roughly �25 trillion Euro-pean asset management market4. But how can investors be sure that they are, in fact, invest-ing sustainably? More than 1,000 different ESG measures are offered in the market, which may well lead to investor confusion and indecision and open the door to greenwashing by major issuers (Carney, 2020; Berg et al, 2019).
Bond investors have long displayed a short-term investment horizon as significant but distant risks show little impact on risk premia (ESMA, 2019). Fiscal risks from population ageing, for instance, have only recently been priced in a more systematic way. Risks from climate change are now also rapidly incorporated in investment processes on the back of better data and clearer climate scenarios. The understanding of the fiduciary duty of investment managers is also increasingly interpreted as requiring long-term risks to
sustainability to be taken into account, and a number of EU provisions were amended to that
3 As per the Sustainable Finance Disclosure Regulation ((EU) 2019/2088), which applies since
March 2021. The regulation is available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN.
4 Figures are from the Financial Times, 16 February 2021, based on Morningstar, and EFAMA (2020). Growth in 2020
was particularly brisk, with 253 existing funds repurposed under an ESG mandate and 505 ESG funds launched.
Policy Contribution | Issue n?10/21 | April 2021
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