Sovereign debt amid a new Middle East war

Chokepoints and geopolitical risk again impact global supply chains. Even with an immediate reopening of the Strait of Hormuz, which is highly uncertain, energy markets will be disrupted for months to come. 

Sovereign debt, a key asset class of about $140bn and a core component of all portfolios, is in many ways exposed. This could be due to disruptions from energy supply rationing, the fiscal hit of supporting household incomes, or the inevitable monetary tightening as a stagflationary shock unfolds. 

Investors will need to differentiate between sovereign issuers based on their energy supply resilience and the likely feed-through of a lasting price shock to households. 

For some time, institutional investors have thought of sovereign debt as lying outside the usual scrutiny of ESG disclosures and climate risk management. National fiscal budgets are financed through a broad range of tax revenues and mobilise spending on a variety of public infrastructure and current expenditures. Assessing sovereign debt exposure to climate risk seems inherently more difficult than in the case of corporate debt or equity. 

See also: Renewables come to fore as Iran conflict continues

Regulators seem to agree. For instance, the latest EU Sustainable Finance Disclosure Regulation (SFDR) framework exempts sovereign debt portfolios from an assessment of fund strategy and risks. 

That seems short-sighted. Energy supply shock vulnerability and the resulting fiscal strain is, in many ways, an outcome of poor energy transition policies. Fiscal risks can materialise not only through physical impact of climate change or the redundancy of fossil-fuel assets, but more immediately through a lack of energy supply resilience. 

Europe is a case in point. Dependence on imported energy is seen as a key vulnerability, affecting both economies, and, by extension, national fiscal budgets. Resulting supply disruption to key industries and transport links will feed into sovereign credit quality as governments face rising costs and weaker growth.

While the 2022 Russia-Ukraine war prompted a rethink, reliance on imported fossil fuel energy is still very high. In most EU states, gas-powered energy remains the main driver of marginal pricing. Meanwhile, shares in renewables differ widely across markets. Scandinavian countries and Spain are among a set of EU countries to have sufficiently built out renewable energy to such an extent that they are now be largely sheltered from the fossil fuel price shock. 

In response to recent events, some EU states, including Austria and Germany, have reduced energy taxes and fuel duties. These measures essentially sustain demand in the face of a clear and long-lasting supply disruption. By contrast, targeted income support for low-income households, or stepped-up incentives for energy savings, as has been done in the Netherlands, have been less common. Such demand-curbing measures are more likely to drive lasting change in consumer and mobility patterns. 

Investors have long understood the need to gain exposure to the upside of the net zero transition, and to hedge against the increasingly clear risks of the fossil fuel economy. Energy resilience from a successful renewables buildout is sheltering some debt issuers from the onset of the energy price shock in the Middle East and already contributing to a differentiation in risk spreads in debt markets.

See also: A tale of two SDRs: Defence and sustainable investing explored

The instrument of choice has been the green bond. Green issuance has been popular among EU governments, and the UK was the latest to launch such a bond with a substantial ticket size of £6.6bn on the back of a financing framework that now also includes nuclear power. Yet green bonds only give the investor some visibility over the use of funds raised in the market, whereas fiscal resources are fungible and fossil fuel dependence may continue unabated.

A more intelligent instrument for both investors and issuers would be a bond that ties interest rates to success in decarbonisation. Sustainability-linked bonds commit the issuer to certain targets, and the investor stands to gain an upside should these targets be missed. So far, only one small EU state (Slovenia) has launched such a bond successfully, but a number of emerging markets have also done so, or are considering tying debt terms to their decarbonization success in this way. 

The upshot for investors is issuers that deliver on decarbonisation plans and resilient energy supply will see an uptick in sovereign debt quality. This, however, requires investor capacity to assess climate policy on the back of new data sources and engagement with national debt management offices. Governments will be keen to make their national transition plans investable in that way. 

Credible policy backing the low carbon transition in key sectors of the economy, such as transport, housing and energy, will shelter economies and public finances from geopolitical shocks such as the one we are experiencing now.