Climate budget tagging: A discussion between sovereign debt investors and issuers

Despite being a nascent and evolving practice, information from CBT is very useful for investors seeking to incorporate climate considerations in their investments, especially sovereign bondholders assessing countries’ fiscal paths and climate-related commitments.

On 13 September 2022, the Principles for Responsible Investment (PRI) and the World Bank brought together over 100 participants, including debt management and budget department officials from 32 countries and the representatives of 12 investment firms, to discuss the purpose of CBT, how countries have started to tag climate expenditure, and its uses for debt issuance and investment analysis (see Figure 1).

The roundtable also aimed to facilitate discussions between sovereign debt issuers and investors more broadly: it offered a rare opportunity for collaborative engagement. While investors already engage with debt management offices (DMOs), this event was novel in bringing together a significant number of actors on both sides and in the topic it tackled. All parties were subject to the Chatham House Rule.

The session built on the World Bank’s guidance to sovereign issuers on enhancing their capacity to engage with investors on sustainability initiatives and performance measures, and the PRI’s guidance to investors on engagement with sovereign debt issuers.

Roundtable participants

The growth of CBT

In order to explore how and why countries are implementing CBT, the Ministry of Finance of Indonesia shared its experience, and a representative from the World Bank’s Governance Global Practice led a discussion on CBT methodologies in different countries.

The Ministry of Finance of Indonesia started implementing CBT in 2016, integrating it into the national planning and budgeting cycle. When formulating the budget, line ministries tag climate-related expenditures, which are then monitored, with results published annually in a climate expenditure report (see Figure 2).

 

Figure 2: Indonesia’s CBT journey. Source: Ministry of Finance of Indonesia

 

Other countries have followed a different process, as illustrated by the World Bank’s 2021 study of CBT, which documents how 18 countries and one regional government have implemented CBT – mostly in emerging markets. The number has grown since the publication of that report.

Governments introduce CBT for various purposes, including:

• to enhance their transparency and accountability;
• to improve interconnectivity among ministries;
• to advance climate-related discussions in ministries not traditionally involved in climate change policy;
• to prioritise government investment in climate initiatives;
• to mobilise domestic and international finance.

Relevance to sovereign debt issuance and analysis

The discussion highlighted the substantial benefits that CBT initiatives can offer to sovereign entities and investors. For sovereigns, despite the challenges of setting up a CBT framework and governing its process – including coordinating ministries, agencies and institutions – this practice allows climate-related fiscal measures to be earmarked clearly, promoting better integration between national plans and budgets.

Furthermore, it helps mainstream policies that respond to climate change by detailing the amounts governments plan to spend and conveying this information clearly to citizens. While CBT has been developed independently of countries’ funding strategies, it can also help identify eligible expenditures or performance indicators that back thematic bond issuance, facilitating tracking, monitoring and reporting.

Investors acknowledged that actual expenditures could vary from what was planned (and therefore tagged), for example because of election cycles or unforeseen events, such as the coronavirus (COVID-19) pandemic. However, they welcomed CBT as a way to enhance their analysis at the issuer level, allowing better quantification of the costs associated with a country’s climate commitments, regardless of whether thematic or traditional bonds meet funding needs. Investors also see it as a tool to strengthen such commitments and reduce the risk of greenwashing.

Sovereigns’ climate targets often have long-term deadlines. By making government commitments to climate projects more visible and measurable on an annual basis, CBT has the potential to become an increasingly useful tool for investors when assessing fiscal developments, which remain at the core of bond valuations. It is also helpful for the more focused climate-related analysis that investors are now carrying out in response to:

• a greater awareness of sovereigns’ exposure to physical and transition risks and potential opportunities;
• client demands for more significant consideration of environmental, social and governance (ESG) factors;
• changing regulations, particularly in the EU, that put greater emphasis on investors’ ability to demonstrate ESG incorporation in investment processes and decisions.

Finally, investors concurred that CBT could help strengthen the process that accompanies thematic bond issuance, for which they expect rigorous reporting and verification. As they anticipate demand for such instruments to grow, some questioned whether more issuance would encourage DMOs to increase the variety of maturity dates and possibly develop a yield curve that could be useful as a reference point for the pricing of green or sustainable bonds.

Comparability across countries

The World Bank highlighted that countries implement CBT in many ways, noting that no framework is better than another. They vary by:

• their definition of climate expenditures: whether based on international frameworks (known as objective-based definitions) or policy priorities (known as policy-based definitions);
• the area of coverage: for example, whether the tagging encompasses all sectors or whether it covers subnational budgets;
• the weighting of climate expenditures: whether and how some expenditures are given a different weight based on climate relevance;
• the allocation of responsibilities for CBT: for example, whether responsibilities are delegated to line ministries or conducted centrally.

CBT has generally emerged in response to domestic policy priorities, which has led to these differences. Investors noted that such variations limit the usefulness of CBT for sovereign debt analysis, given their need to make relative comparisons between issuers. The growing number of jurisdictions with green taxonomies adds to this challenge. However, investors welcomed the growing number of countries using CBT and noted some emerging areas of commonality. Indeed, the World Bank pointed out that many countries use the OECD Rio markers to define a relevant expenditure (see Figure 3).

The further synchronisation of approaches would help sovereign debt analysts. To this end, investors recognised the value of the World Bank’s technical assistance to sovereign bond issuers in promoting CBT best practices and providing support to develop robust and credible thematic bond frameworks. Referencing green, social and sustainability bonds specifically, one investor also advocated using green bond platforms, such as the free one from the Inter-American Development Bank or the Nasdaq Sustainable Bond Network, to enhance transparency and comparability.

In the meantime, investors need to examine how individual countries approach CBT and exercise caution when making comparisons.

 

Figure 3: Ways of defining climate expenditure. Source: World Bank

The value of collaborative engagement

Sovereign and investor representatives’ contributions to the discussion highlighted the merits of collaborative engagement versus individual engagement, which is more common. Admittedly, sovereigns sometimes engage with groups of investors, but joint meetings with multiple sovereign peers are rare.

The roundtable highlighted that sovereign peer comparisons can encourage best practices and budget discipline and promote the alignment of country policies to meet global needs.

For participating sovereign bondholders, hearing about why countries are starting to use CBT was a practical and educational session that deepened their understanding of governments’ concrete steps to tackle climate change. The event was also an occasion to explain to sovereign officials why investors need this type of information and how they use it, and to call for more timely disclosures and harmonised approaches.

Next steps

As CBT expands and advances, it will add to the toolkit of publicly available information that investors have at their disposal to better assess sovereign exposure to climate risks and government plans to transition to a low-carbon economy.

To help investors, the PRI is also working with signatories and investor networks through the ASCOR project^[1] on a new mapping tool, the goal of which is to enhance investors’ decision-making capabilities with more quantifiable climate-related information about countries. This instrument will support investors working towards net-zero goals, especially asset owners.

The PRI will also continue to use its convening power to facilitate engagement between sovereign debt issuers and investors, expanding its outreach to sovereigns in developed markets.

A pilot PRI-coordinated investor initiative on climate change has recently been launched, focusing on Australia, which is at a critical juncture following the introduction of the Climate Change Act.

 

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