By Eisuke Nakajima, ESG lead, Japan and Ryuichi Urino, senior manager, Japan
There’s no doubt that Japanese institutions have led the world in sustainable investment. But can they extend the approach to the least environmentally focused segment of the world’s securities markets, government bonds?
Progressive moves made by large institutional players, notably the country’s ¥178trn Government Pension Investment Fund (GPIF), have helped catalyze this striking change.
GPIF has had a major influence on Japanese asset managers and asset owners by promoting environmental, social and governance (ESG) considerations in its own investment approach. It became a signatory to the United Nations’ Principles for Responsible Investment (PRI) in 2015 and announced its intent to allocate some of its assets to funds tracking ESG indexes in 2017.
Japan’s Stewardship Code, launched in 2014 and revised in 2017 and 2020, has also encouraged asset managers to integrate ESG into their portfolios, improving sustainability standards across the board.
The most popular ESG consideration in Japan is engagement, which represents about two thirds of sustainable investment assets, followed by proxy voting. This is because Japan’s Stewardship Code focuses on listed equities. However, asset managers are also increasingly applying ESG in their corporate fixed income portfolios as they are able to utilize some of the ESG elements they have used for equities.
However, there’s one area of the global securities markets where sustainable investment has always lagged: government bonds.
According to a 2016 study by the United Nations, ESG integration is lower by asset class in sovereign, supranational and agency (SSA) bonds than in equities, infrastructure, farmland and forestry, as well as in corporate bonds.
ESG integration by asset class
Source: UN PRI, "Shifting the state of play, ESG, credit risk and ratings" (2016)
The sustainability gap is all the more surprising, given that governments are uniquely exposed to energy and climate risks: they own 78 percent of world fossil fuel reserves, and up to 20 percent of public expenditures and fiscal revenues are directly linked to fossil fuels.
Governments are also the primary source of funding for the future low-carbon infrastructure, as well as the key stakeholders in setting environment-related fiscal and regulatory measures.
The reasons for the slow adoption of a sustainable investment approach in government bonds may be inertia amongst both issuers and investors. Sovereigns’ historic reluctance to set aside funding streams for specific purposes may also have played a role.
But things are now changing.
As well as the trend towards increased "green bond" issuance by governments, there are now sophisticated tools to help investors allocate capital towards sovereign bond issuers with progressive sustainability and climate risk performance. And shifting investment flows in this way doesn’t have to come at the expense of investment performance.
One such tool is the new FTSE Nomura Climate Risk-Adjusted Carry and Roll Down World Government Bond Index Series (FTSE Nomura Climate CaRD WGBI series), the result of a partnership between FTSE Russell and Japan’s Nomura Securities.
The FTSE Nomura Climate CaRD WGBI is derived from the FTSE WGBI, an index launched in 1986 and long the most popular benchmark of investment-grade sovereign bonds amongst Japanese investors.
By comparison with the starting index, the Climate CaRD WGBI tilts index weights according to each government bond issuer’s relative exposure to climate risk, measured across three "pillars":
- Transition risk - the risks of economic dislocation and financial losses associated with the adjustment to a future low-carbon economy;
- Physical risk - the risk to a country and its economy from the physical effects of climate change;
- Resilience - a country’s preparedness and actions to cope with its level of climate-related risk exposure.
Then, as a way to optimize the expected return, the index aims to maximize the "carry" of the underlying bonds, as well as their "roll-down" factors.
Here, carry and roll-down refer to the yield earned through investing in longer-term government bonds, combined with the capital gain that can be realized through the fall in yield experienced by holding an asset that shortens in maturity against the backdrop of an upward-sloping yield curve.
The FTSE Climate CaRD WGBI methodology
By means of the FTSE Nomura Climate CaRD WGBI, which is available to Japanese investors in both a yen and a currency-hedged version, an investor can reduce the climate risk in a government debt portfolio, while also enhancing return. The index works as a concise way to mitigate climate risk when investing in sovereign bonds.
More broadly, the new index meets a growing need amongst asset owners and asset managers—to extend a sustainable investment approach to the government bond sector, which accounts for over half the global bond market by size.
By choosing the new index as the underlying for an index-tracking investment product or as the benchmark for an active portfolio, Japanese institutions can ensure their country remains at the forefront of efforts to mitigate global climate risk, without compromising on future investment performance.
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