Powering sub-sovereign investors with greater ESG disclosure

The opportunity in the sub-sovereign market 

The sheer size of Canada’s sub-sovereign bond market is a testament to its importance on the world stage. Home to nearly 40% of Canada’s population, Ontario alone has a net debt of $407.2 billion,¹ making it the world’s largest sub-sovereign borrower. Add to this the important role Canadian sub-sovereigns play in investment portfolios and the need for investors to address ESG data limitations becomes even more apparent. Nonetheless, it’s worth talking about some of the nuances associated with sub-sovereign engagement.

Traditionally, ESG-focused bond investors would want the corporate issuers in their portfolios to improve their environmental, social, and governance practices. We’re looking for something similar and are calling for improvements in overall ESG performance and disclosure from sub-sovereign issuers across the country. After all, disclosure may help ward off uncertainty about risks and could be beneficial for the investing public at large.

Furthermore, it may be advantageous for governments when positioning themselves as leaders in ESG performance and transparency. But while there’s no disputing the fact that more clarity generally leads to better-informed investment decisions, why should enhancing ESG disclosure be a priority for governments?

Sub-sovereigns are on the front line of ESG issues  

With weather-related shocks on the rise, as well as low-carbon transition commitments and policies looming that will fundamentally change the way people live, work, and move around cities, sub-sovereigns are on the front line of very real challenges. It’s for this reason that investors are adopting climate risk considerations in the management of their portfolios. Sub-sovereign issuers should be cognizant of this and make sure they’re providing the data and information that help investors understand the risks and opportunities they face.

Accordingly, a real opportunity exists for governments at the municipal and provincial levels in Canada to support strong and consistent ESG reporting, to raise the performance bar, communicate successes to different stakeholder audiences, and provide clarity for investors.

Enhanced disclosure, coupled with the execution of a sound ESG strategy, can help governments capitalize on direct investment opportunities. Ontario, for instance, issued its first green bond in 2014, and has since then become the largest issuer of Canadian dollar green bonds. Having allocated proceeds from these issues to projects centered around transportation, energy efficiency and conservation, and climate adaptation and resilience, Ontario has capitalized on raising funds at low interest rates and benefitted from green fund flows that have promoted direct investments in environmentally friendly projects.²

Sub-sovereigns stand to benefit from lower borrowing costs 

Building climate-resilient infrastructure, investing in community enhancement programs, addressing natural disasters, and setting local regulatory frameworks that incentivize clean energy are just some of the ways governments are tackling ESG issues. As an investor, the goal is to hear what governments have to say about important issues impacting their jurisdictions and get a sense of what they’re doing to mitigate risks and spur positive change.

Governments that are performing well from an ESG standpoint but underreporting their efforts could potentially become global issuers of choice for green or social capital and benefit from lower borrowing costs, if they improve their reporting of sustainability expertise and how they’re putting that expertise into practice. Better ESG scores for sub-sovereigns indicate a stronger positioning to deal with the risks that are likely to emerge with respect to climate change, climate transition, and social and governance factors.

By upping the bar on ESG, governments may also benefit from potential improvements to their credit ratings and lower borrowing costs. Research for sovereigns has demonstrated that improved ESG performance leads to lower sovereign costs of borrowing and some of the same factors might also apply to sub-sovereigns.³

The understanding of how ESG issues are material for sub-sovereigns has been rapidly evolving and gaining a foothold in investment analysis. While backward-looking data may understate the degree of materiality, issuers with better ESG performance tend to be considered to have lower default risks due to their better risk management and long-term investment plans, which would make them better prepared to deal with material ESG issues in the future.

Addressing the stumbling blocks in the rating of sub-sovereigns

Data related to sub-sovereigns are, for the most part, backward looking and subject to improvements. However, even with the current data at our disposal, we were able to create our own proprietary framework and get a good idea of the ESG risks and opportunities associated with provincial and municipal issuers in the Canadian fixed-income market.

Step 1: Identification of financially material ESG issues

We identified some of the most material ESG issues based on the work done by the PRI Sub-Sovereign Debt Advisory Committee working group. Below are the main ESG factors considered in our analysis of provinces and municipalities:

·       environmental – climate change, air quality, water resources, waste management, energy efficiency, biodiversity

·       social – participation and activism, inequality and affordability, health and safety, education, and human capital

·       governance – transparency of data, government structures, IT, and digital infrastructure

Step 2: Creation of a qualitative ESG rating structure

Inspired by the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) framework, we created a qualitative ESG rating structure that’s focused on four main pillars: governance, strategy, risk management, and metrics and targets.

Step 3: Creation of a quantitative analysis framework 

We also created a quantitative analysis framework based on the most relevant primary ESG data manually collected by our sustainable investment team. Not only did this exercise allow us to capture the actual performance of each issuer based on their most recent disclosures, but we were also able to assess the positive or negative momentum for each issuer over a four-year time period.

Step 4: Assigning proprietary ESG scores to each sub-sovereign issuer

The fourth step consisted of assigning ESG scores to each sub-sovereign issuer based on the data collected and our methodology (step 2 and 3). This paves the way for apple-to-apple comparisons from province to province and municipality to municipality.

Comparing and contrasting ESG scores

                    Comparisons across provinces and municipalities

Insights drawn from our ESG framework 

Below are two case studies that highlight the additional information uncovered in our evaluation of provincial and municipal bonds.

Case studies: analysis of provincial bonds

We uncovered nuances between two provincial issuers on their climate risk management, which couldn’t have been discovered using commercially available ESG scores. This analysis also provided further support for our view on relative credit risk between the two provinces and helped inform decisions on relative value. In our view, climate-related transition and physical risks can have tremendous impacts due to disruption in tax revenues and potential increased costs related to the repair of infrastructure and emergency responses.

We also uncovered nuances between two provincial issuers on their risks related to inequality and affordability. In our view, growing inequality may have several adverse impacts on tax revenues and expenses for a province or a municipality. Within Canada, there’s evidence of inter-provincial migration from high cost of living (COL) provinces to lower COL provinces, which has an impact on population growth. As well, there’s a potentially larger demand on social services, and the capacity of a province to provide services such as healthcare and education, when affordability concerns are exacerbated. For example, teachers and healthcare workers living in cities and provinces with higher real estate and rental costs may move to other provinces or ask for higher wages to compensate for the higher COL.

Case study: analysis of municipal bonds 

Cybercrime, an emerging threat, poses an increased level of risk, especially when conducted by state-funded entities looking to target other state infrastructure and systems. As a result, the main factors we look for on the IT and digital