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December 6, 2021updated 23 Jun 2022 9:48am

How sustainable can sovereign debt be?

As another emerging economy gears up to tap international markets with a green bond, Capital Monitor explores how much potential there is for governments to make their debt sustainable.

By Chris Papadopoullos

sovereign debt, sustainable, green

Bangladesh needs to advance its economy and plans to raise capital for sustainable development. (Photo by StanislavBeloglazov via Getty Images)
  • Bangladesh is readying more international and green bonds to spur its economy and sustainable policies.
  • Green, social and sustainable bonds can offer a so-called ‘greenium’ but also benefit cross-government policy coordination.
  • Sustainability-linked bonds are likely to be easier to scale for sovereigns than use-of-proceeds bonds, but no government has issued one yet.

Sustainable investment opportunities were a key feature of Bangladesh’s London investment summit last month as the fast-growing Asian economy sought to woo international investors with plans to issue its first green sovereign debt.

One area of policy focus has been adaptation. “We’ve focused a lot on managing natural disasters,” Shibli Rubayat Ul Islam, chair of the Bangladesh Securities and Exchange Commission, told Capital Monitor at the summit. Extreme weather events such as cyclones are causing far fewer casualties in the country than in the past, he added.

Another area of focus is mitigation. “We have scrapped plans for a new fleet of coal power stations and are investing in nuclear and transitioning from petrol to electric cars,” Rubayat Ul Islam explained. (A broader overview of Bangladesh’s development and policy package can be found at sister publication Investment Monitor.)

Bangladesh hopes to finance its sustainability drive by issuing more international bonds, including green bonds. Details on how it intends to achieve this are thin on the ground, but if successful this would put the country on the small but growing list of emerging economies that have used the green, social and sustainability (GSS) labels to tap international pools of capital at lower interest rates and bigger volumes.

There’s a big incentive for emerging markets to issue GSS debt, because you access a new category of investors where you might be able to do larger transactions [and] longer tenors and achieve tighter pricing. Nicholas Pfaff, International Capital Market Association

Egypt’s green bond is trading 75 basis points below the country’s vanilla debt, says Sean Kidney, chief executive of the Climate Bonds Initiative (CBI), which has helped numerous countries bring GSS bonds to market.

And Chile, a serial GSS bond issuer, has also seen benefits in pricing, he tells Capital Monitor. “They got the cheapest interest rate they’d ever received for the peso, dollar and euro version of the green bond. They got a lot of attention around the world.”

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There’s a big incentive for emerging market governments to issue GSS debt, “because you access a new category of investors where you might be able to do larger transactions [and] longer tenors and achieve tighter pricing”, Nicholas Pfaff, head of sustainable finance at the International Capital Market Association (ICMA), tells Capital Monitor. “We’re seeing a lot of emerging market issuers look at it from that point of view.”

New government coordination

There are savings available for advanced economies too. The UK achieved a slight ‘greenium’ on its debut sovereign gilt issued in September, saving £28m on a £10bn issue.

But the main benefits of issuing a GSS bond are not limited to a few basis points knocked off debt servicing costs; there are key benefits in terms of policy coordination.

“What we’ve found, even with OECD issuers, is it creates a situation where, for the first time, the finance ministry or treasury talk to the environment ministry, and then a government task force is set up and everybody gets concerned about what they are doing on sustainability policy and how it’s being implemented,” Pfaff says.

“Even with major sovereigns, the stories we’ve heard back are amazing in terms of getting policymakers collectively engaged in a manner they never would have done before," he adds. "If you’re serious about sustainability, this [GSS bond issuance] is a great way of getting organised, getting clarity, getting everybody on board.”

When the finance ministry or treasury is helping to drive sustainable policy it can hold more sway with other government departments than when the ministry responsible for the environment acts on its own.

That has been the case in certain markets, CBI’s Kidney says. “It happens in Ireland, in France and in the UK at the moment. Issues are so successful that finance ministries are looking for other projects to find. That internal dynamic is important. It puts pressure in a positive direction.”

Limits to sovereign debt sustainability

Use-of-proceeds debt, such as green, social and sustainable bonds, comes with costs. New systems must be put in place to report on how the money is invested, the impact of projects needs to be measured, and external verifiers are brought in to provide second opinions.

However, Pfaff says most of the costs are incurred during the first issuance. After that, most of the processes have been established and issuing further use-of-proceeds bonds is a much easier process. This means GSS bonds are easy to scale once the first issuances are out of the way.

Perhaps the most ambitious issuer so far is Chile. The country's GSS issuance of $25bn accounts for 17% of its sovereign bond issuance, a proportion comfortably ahead of advanced economy sovereigns.

Could such large chunks of sovereign debt being issued under GSS labels become the norm? There is certainly a growing focus among institutional investors on the sustainability of government debt in relation to risks around burning issues such as climate and human rights.

Kidney can see more scope for further use-of-proceeds bonds issuance. Investors like them, he says, because they introduce transparency. Linking GSS bonds to more expenditure items could also ensure climate goals are being considered across more policy areas.

The entire government apparatus should have a "climate filter", Kidney argues. "Whether it’s energy efficiency, garbage collections, buildings, mitigation [or] agricultural policy. It would be a way to assess if governments are doing the right kind of thing. In everything we do, there needs to be a mitigation focus and [an] adaptation focus.”

Sustainability-linked bonds a good option?

However, Pfaff thinks there may be more potential for scale with sustainability-linked bonds (SLBs), though no government has entered this market yet. Such instruments are linked to a single target or a small number of overarching targets, rather than underlying projects.

“I think that for a sovereign there are limits to the use-of-proceeds concept," he adds. "At some point you’re going to face a problem, because general government expenditure is going to be difficult to slot under these categories."

The “social” label could add to the scope, Pfaff says, but investors may become sceptical if more run-of-the-mill government expenditure items are included under that label.

Moreover, SLBs have clear, binary targets, which could bring more accountability. “If you are in a situation where you want to argue that a government is not hitting a target, you’re going to be in a fairly straightforward situation when there’s a target, a metric and an independent verifier,” Pfaff says. "The sovereign will then need to explain the reason for the shortfalls."

With use-of-proceeds bonds, the underlying impact and various targets tend to be greater in number, and attention on any single one less focused. Such a lack of precision was highlighted as an issue when the UK was preparing to issue its first green gilt.

Given that corporate issuance has laid some groundwork with around $40bn of SLB issuance (according to Capital Monitor sister company GlobalData), perhaps the first sovereign SLB is not too far away.

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