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The focus on ESG, sustainable investing and investment stewardship has dramatically risen in recent times. However, 2020 marked a significant turning point.
Prior to COVID-19, while considerations of ESG and sustainability had become prominent, progress remained slow. However, the emergence of COVID-19 in combination with extreme events triggered by the climate crisis heightened global focus on ESG matters and starkly highlighted the challenge before us all. A perfect storm had been brewing fueled by habitat destruction, biodiversity loss and social inequality. In addition, as the COVID-19 crisis has unfolded, millions of people crashed down through Maslow’s Hierarchy of Needs, revealing the widespread nature of social inequality and insecure work practices.
Given the systemic weaknesses that were unveiled and the broad-based issues facing society, it became rapidly evident (even to the naysayers) that all participants in the investment supply chain have a role to play, including sovereign bond investors. We need to build in greater levels of system strength and resilience (economically, environmentally, and socially) as we collectively recover from COVID-19.
Historically, ESG focus has largely been on equities: this was a space where asset managers and asset owners felt comfortable and had clarity around what they could do and how to do it. Attention has also evolved to similar areas of comfort: real assets (property and infrastructure) are asset classes where the what, why and how of ESG is readily understood.
In the mind of many investors, fixed income tended to be obscured, as it perhaps felt less tangible and therefore more difficult to tackle from an ESG perspective. However, the focus has now duly turned to fixed income. This is critical, in that when we consider the capital stack, global debt markets (~$281T in size at the end of 2020) are almost triple the size of global equity markets (~$105T), yet almost all ESG focus has been in the listed equity space, leaving a large gap in approach (and potentially outcomes and impact).
In the context of fixed income, greater emphasis has tended to have been placed on corporate debt. The reason being that much of the ESG and investment stewardship knowledge, and practical experience, garnered in and from public equity markets can be transposed into how one approaches ESG in public debt markets – from issuer ESG analysis through to engagement.
Whereas, in the context of sovereign debt, it may have been conceptually overwhelming to know where to focus, e.g.:
• How to engage with a sovereign counterparty or influence change when it comes to ESG.
• Government activities are broad in nature, some of which may be detrimental from an ESG perspective, others which are either neutral or positive.
Notwithstanding, the focus is now turning to sovereign bonds. This is important given the size of the sovereign debt market which accounts for roughly two thirds of total fixed income market capitalisation. Further, we all have a role to play in driving positive change and delivering impact on the ground. We also believe that the ESG and investment stewardship lessons learned in public equity markets and listed corporate debt can be elegantly leveraged in a sovereign debt context.
Consideration of ESG factors has long been part of, and an input into, JCB’s investment decision making process as a means by which to manage risk, make informed decisions and influence positive change.
Sovereign debt investors, JCB included, have utilised ESG research and integrated ESG considerations into their investment analysis and decision-making processes for some time. While ESG factors may not drive the ultimate investment decision, they provide another lens by which to view a prospective investment opportunity. This goes to making well informed investment decisions.
In addition to this, when thinking about ESG integration, ESG factors are not only relevant as an input but can be a key output. The market has witnessed an exponential rise in green, social and sustainable debt issuances. This provides investors with an opportunity to finance impactful activities, projects and programmes at a sovereign and semi government level. Further, such issuances also “serve as a commitment device for politicians”.
Government policies and commitments can always be watered down or resiled from, however:
“...when a finance ministry creates a green-bond programme and builds out a “green curve”, backing out of specific policies may become harder...Doing so would hurt liquidity and anger investors.” [“A wave of green government bonds is flooding markets”, The Economist, 9 October 2021].
Anchored to the need for ESG integration and investing in impact, is the opportunity (and some may say obligation) to:
• Engage with issuers and other relevant parties
• Collaborate with others to influence change
Engagement and collaboration, in the context of ESG and investment stewardship, have long been the domain of listed equity investors. However, this is evolving, and sovereign debt investors increasingly recognise that they also have a role to play.
Historically, it has been posited by some that it is not appropriate for sovereign debt investors to utilise their ownership rights and engage on the basis that it may be construed as undue political influence. Our view is that such engagement is incumbent upon us as a responsible market participant, and it provides a constructive tool to:
• Communicate our approach and client expectations
• Share our key focus areas and encourage action
• Communicate our desire to see the development of more sustainable and resilient financial systems
• Maintain ongoing dialogue and conversations regarding ESG related issues
Accordingly, we are in the process of increasing our levels of engagement with issuers, originators, and other market participants as a means by which to stimulate ongoing dialogue and where possible influence for positive change regarding ESG matters. We firmly believe that having conversations can create awareness and drive positive change.
Related to active ownership, we are also seeing that the appetite to collaborate (e.g., via the PRI) has risen. JCB has recently joined the PRI as a signatory and is actively looking for ways in which to collaborate with others to influence positive change. This will also be an area of ongoing focus.
There are opportunities and benefits for sovereign bond investors who are integrating ESG and focused on participating in the Green Social and Sustainable (GSS) bond space. Specifically, consideration of ESG factors leads to better informed investment decisions, and when combined with the tools of active ownership, it provides such investors with the capacity to influence positive change.
In addition, investing in labelled sovereign GSS issuances enables the delivery of real impact on the ground. In doing so, it also provides the ability to ensure that such Government commitments to positive GSS projects and outcomes are executed on irrespective of the political cycle.
Consideration of ESG factors and investment stewardship practices, combined with participating in GSS issuances also ensures that portfolios are better aligned with client expectations and outcomes, and provides a source of portfolio diversification.
We are witnessing a maturation in ESG practices combined with the ever-growing need for capital markets to influence positive change from a social and environmental perspective. Given that sovereign debt constitutes a large part of the capital stack, sovereign investors such as JCB have a role to play in building in economic and ecosystem resilience. Particularly given that against the backdrop of COVID-19 the awareness of the intersectionality between environmental and social issues and capital markets has amplified. More is now rightly being asked of all capital market participants.
Ultimately, as an active sovereign debt investor, we feel that ESG is both an important input and output of the investment management process.
If you are interested in learning more about how sustainable investing works, view our ESG Approach to investing.