ESG reserves adoption challenged by reliance on sovereign bonds – Central Banking

ESG reserves adoption challenged by reliance on sovereign bonds  Central BankingESG reserves adoption challenged by reliance on sovereign bonds  Central BankingESG reserves adoption challenged by reliance on sovereign bonds  Central Banking

The central banks are increasingly focusing on incorporating environmental, social, and governance (ESG), factors into their monetary policies and reserve management operations. These institutions must overcome two major obstacles to transform their portfolios in a meaningful way.
Their key investment asset is government bond, which are generally not ESG-compliant. US Treasuries are most popular. These reserve assets are not compliant with ESG, and are irreplaceable due to their high liquidity.
The second problem is liquidity. ESG bonds offer inadequate liquidity to central banks. Despite the fact that issuances have increased exponentially over the past five year from tens to hundreds billions to hundreds billions of US Dollars, the pool of eligible assets is still small compared to the global reserve assets of central banks, which hover around $14 trillion.
Marco Ruiz (engagement manager for the World Bank’s Reserves Advisory & Management Parternship) says that central banks face the greatest challenges in balancing their portfolios. “They are heavily allocated for government bonds, making it very difficult to implement any type of ESG strategy within those instruments.”
This has not stopped international organizations, such as the World Bank or the European Commission (EC) from implementing new strategies in order to increase the issuance quality of ESG assets.
ESG surge
In the last five years, green bond issuance has risen rapidly. It was $44.6 billion worldwide in 2015, while issuances rose to $390.7 billion in the first 10 month of this year according to the Climate Bonds Initiative. The group published a market survey in October that predicted green bond investments would reach $1 trillion by 2022, according to the Climate Bonds Initiative.
Arnab Das is a global market strategist at Invesco. “Investor interest has brought forth an increase in supply,” he says. This investment surge has been aided by central banks. Central Banking’s Reserve Benchmarks 2021 shows that central banks have increased their exposures to green and social bonds over the past year.
42.9% of 42 participating central bank participants reported that they invest in these instruments, up from 30.5% for 2020. However, these assets are only a small part of most institutions’ portfolios (between 0% to 2%).
The policy response to Covid-19 has also helped to increase the issuance of Social Bonds. Social bonds were first issued by the EC’s temporary Support for Mitigating Unemployment Risks in an Emergency (Sure) in October 2020. Social bonds are used to raise funds for socially beneficial projects.
These issuances were aligned by the EC with the Social Bond Principles (International Capital Market Association). The initiative was welcomed by the markets. According to the EC, the first Sure transaction attracted the “largest-ever order book for any deal in global bond markets history, of EUR233 billion ($269 trillion).” The EC issued social bonds totalling EUR89.64 trillion in seven issuances from May 2021 to May 2021. This made it the largest social bond scheme in the world.
ESG finance has been a focus of the authorities in advanced economies, especially Europe. The emerging world is catching up and new initiatives are being very successful. In July 2021, Benin, Africa’s first social bond, issued its first international market social bond. The bond’s proceeds were to be used for financing more portable water sources. Investors demanded more than twice the EUR500 million offered by the bond.
In 2021, Chile and Mexico also issued their first social bonds. While important for the global development ESG finance, initiatives from emerging markets won’t be able to solve the liquidity problem for reserve managers. They will likely lack the credit rating required by central banks.
Liquidity gap
ESG assets are still far from being a core component of reserve portfolios due to a lack of liquidity. “While ESG issuance may be the headline number, it is not enough to reflect the size of the typical investment universe. Ruiz says that foreign reserves are an example of the $14 trillion figure.
The pool is even smaller if you exclude issuances not in compliance with central bank criteria. “We are likely talking about 5%-10% in the green bond market. He adds that if you want to implement ESG, you need to do more than thematic bonds.
A 2021 World Bank survey found that reserve portfolios around the world invest an average of 35% in government bonds, 25% into bank deposits, 14% to money-market instruments, 12% to supranational bonds, and 5% in gold. Even lower reserves are made up of equity and corporate bonds which offer more ESG security.
The limited assets available to reserve managers is due to the requirements they must follow to comply to risk management and other legal redlines included in reserve management. These include asset allocation and the universe investable assets.
Invesco’s Das says that only half of 2020 issuance would fall within traditional reserve asset classes. This includes sovereigns, government agencies, multilaterals, and multilaterals. “Currently, 13% of central bank reserves assets were invested in ‘alternatives,’ which include corporate bonds, bank loans, and local government bonds as well as equities.
Ruiz believes that a game changer would come from governments becoming more active in issuing labelled thematic bonds. He says, “That would definitely make an impact because we’re talking to the traditional investment space where central banks operate.”
Instead of issuing green bonds, governments could start to label all debt issuances green, social, or – as was the case with the World Bank – sustainable development bonds.
Mismatch between currency and geography
ESG finance is also dependent on the US government. ESG-complaint bond currently suffer from currency mismatch. The European Union is leading the charge, providing triple-A euro-denominated assets that central banks around the world can invest in to improve their ESG credentials.
However, the euro is not the global reserve currency. The US dollar accounts for 65% of global portfolios. Next comes the euro at 21%. Sterling, the Renminbi, and the Yen all follow with less than 5%. In order to increase their investment in ESG-grade government bonds, the US central banks will need to change the composition of their international reserves portfolios due to a lack of US government-issued bond.
Factually, the dollar’s dominance is even more stark when you take currency allocations across continents. Portfolios with euro holdings between 80% and 90% are common in central banks, particularly those in eastern Europe. Similar portfolio structures are found in North African countries with strong trading connections to the eurozone.
Ruiz says that central banks on other continents have almost zero euros and much higher dollar allocations. This is true for the vast majority of countries in Latin America and Asia. The dollar is still the most important reserve portfolio holder, as Brazil, Mexico and China are the only ones that are represented, with the euro only marginally behind.
ESG finance could still depend on the dollar to get into reserve portfolios. Invesco’s Das says that this imbalance is likely to change due to the Biden administration’s policy commitments to green finance and the environment. The analyst also pointed out that the UK Debt Management Office plans to issue its first Green Gilt bond in 2021.
The geography mismatch that affects the euro’s effectiveness as an ESG transmitter seems to have an impact on the interest central banks have in ESG as a reserve management option. According to the World Bank’s survey, only 17% have included ESG factors in their investment processes. Another 9% have already included ESG factors in their investment plans, while 29% are considering it. A majority of 46% have not even considered ESG as an option.
Ruiz says that ESG implementation is attracting strong interest, especially in Europe and Asia. “But if you look at other regions, you’ll find that interest is almost nonexistent.”
ESG adoption strategies
Reserve managers are faced with complex investment challenges and need to be able to explore the ESG universe of assets, while still meeting wider investment requirements. They have developed a variety of strategies to help them do this.
One is strategic asset allocation (SAA). Das says that a central bank could theoretically substitute for a green bond index in its fixed income risk allocation. This solution has a problem: a policy portfolio must be investable and replicated across all portfolio managers. He acknowledges that this strategy is unlikely to be feasible for all of the SAA because of the absence of liquidity and asset classes prevalent in ESG.
Another option, which is more common among emerging market central bankers, is to divide reserves into a liquidity portfolio or longer-term investment portfolio. “Incorporating an external or internal green bond benchmark into the investment tranche could prove more feasible due to the smaller size of the tranche, the broader investment guidelines, and the longer investment horizon,” says Das.
This approach was adopted by the National Bank of Hungary (MNB), which created an index to support a dedicated green portfolio in 2019. It is part of its Green Program. It faces some limitations that affect ESG assets.
It is a portfolio in euro, which barely represents 1% of the total reserves of the central bank. Robert Rekasi (head of foreign exchange reserve management at the MNB) says, “The reason we adopted this new asset class was because it is a marketplace we want to participate in.”
“In this way, we emphasize our commitment to climate-related objectives and offer a positive example to other investors in country.”
Another strategy is to tilt investments in favor of sustainable bonds. This can be achieved by enhancing indexation using best-in-class techniques. Invesco’s Das says that an invested portfolio replicates the main risk characteristics such as currency and duration. The portfolio manager can, however, invest in green-labelled security within a specified duration ‘bucket’ at the level of security selection.
This strategy has been implemented by the Bank of Italy. Portfolio managers follow the main benchmark but prefer issuers with higher ESG scores. Das adds that portfolio performance is measured both in financial terms as well as in terms of the resulting environment footprint compared to the benchmark.
Central banks also implement ESG principles through the use of green exchange-traded funds. They can also appoint an external manager to manage a portfolio that has an ESG mandate. According to Das, the Netherlands Bank has included ESG criteria in its selection process for two investment-grade credit managers.
The data gap
Despite these new strategies being implemented, even the most creative reserve managers are still constrained by the inability to standardize ESG scores for issuers and assets.
Different ESG classifications can be obtained by different index providers for corporates and institutions. “The scoring system to identify green assets is still evolving, and different jurisdictions have different rules. It is difficult for us,” Rekasi from MNB says.
Ruiz also agrees that ESG scores are relatively recent. It is normal to observe significant divergence. He says that it is a common occurrence with different data providers.
Alternatives for central banks include producing their own ESG scores. The World Bank has done extensive research on how to create them and offers information through its ESG data portal. Ruiz says that the World Bank will not provide this data to maintain the ratings. Instead, it will offer instruments to investors who want to create ratings according to their own criteria.
Some central banks may place more emphasis on green assets, while others might be more focused on social bonds. This may not be possible for smaller central banks in emerging countries. Ruiz says, “The problem is that you need resources in order to make significant progress.” “It is unlikely that the largest central banks can do this, as they have the most staff to manage the data and create models.

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