Aligning Sovereign Bond Markets With the Net Zero Transition

The Role of Central banks

April 4, 2024Published by LSE Grantham Institute

Sovereign bonds represent half of global debt securities and, as financial supervisors with direct lines to governments, central banks are uniquely placed to advance the system-wide alignment of these bonds with net-zero goals, says this paper for the London School of Economics.

The paper recommends that central banks identify suitable options to reallocate parts of their sovereign portfolios and enhance disclosure practices and standards.

Sovereign bonds are highlighted as essential for maintaining financial and price stability: they provide benchmarks for national interest rates and are used in open market operations to stabilise prices and exchange rates. As low-risk and liquid assets, they are also commonly accepted as bank collateral.

The authors – Pierre Monnin, Joseph Feyertag, Nick Robins and Alexander Wollenweber – urge central banks to address the climate exposure of their sovereign portfolios, mentioning research which shows rising national climate risks can negatively impact sovereign creditworthiness, leading to increased borrowing costs and reduced bond value.

However, greening sovereign bond portfolios comes with significant policy constraints due to their stabilising monetary and financial functions. Assessing the net-zero alignment of sovereign bonds poses challenges as bond proceeds fund public projects without direct ties between specific activities and individual bond-related receipts.

A “straightforward and important” first step for central banks to address this analytical gap is to develop the methodologies needed to assess the climate risk exposure of their sovereign holdings. According to the authors, these should include consideration of whether a nation’s public expenditure contributes to sustainable goals.

While various early stage methodologies exist, there is no consensus on the best approach. Central banks can contribute by promoting best practices, setting minimum standards for methodologies and disclosure.

The authors recommend that supervisors consider green budgeting as well as international data frameworks such as the Partnership for Carbon Accounting Financials and Assessing Climate-Related Opportunities and Risks.

Central banks should also consider whether they can reallocate their domestic and foreign sovereign bond portfolios. However, as some central banks only have one sovereign bond in their main monetary portfolio, there is often limited room for divestment or reallocation within these particular portfolios.

To overcome these constraints, the authors say central banks should explore how thematic green, sustainable and sovereign sustainability-linked bonds (SLB) can be used within their particular mandate.

Sovereign SLBs are highlighted as a promising option as payoffs are linked to the achievement of environmental targets, such as national emissions progress. However, due to their changing value and the fact that only two sovereign SLBs have been issued to date, they are best suited for non-monetary funds, according to the paper.

The authors also suggest that central banks consider screening which sovereign bonds that they accept as collateral based on their alignment with the transition. Increasing the acceptance of sovereign green bonds and SLBs in refinancing operations would encourage their issuance and support the development of deeper markets for such assets.

To enhance flexibility in sovereign portfolio allocation, central banks should also explore similar policies related to sub-sovereign and supranational bonds.

Finally, central banks can use their influence to advance public engagement on green sovereign bond markets and sovereign climate risk. For instance, by supporting debt instruments that address both debt management and climate objectives, such as grant financing and debt-for-nature swaps.

This page was last updated April 4, 2024

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