For the first time ever, the sovereign debt issued by the world's developed nations is being indexed according to each country's climate-risk factors.
The FTSE Climate Risk-Adjusted World Government Bond Index is the latest example of the expanding migration of environmental, social and governance investing into the global fixed-income markets.
The new index, created by FTSE Russell, essentially reweights the existing FTSE World Government Bond Index (WGBI) from market capitalization to an allocation based on climate-risk factors.
While the index has not yet been licensed as an investible product, FTSE Russell chief executive Waqas Samad said it is designed to provide investors with reduced exposure to climate-related factors that could affect a country's sovereign debt.
"All the commitments governments are making to address climate issues will need to be financed," he said. "And end investors buying government debt need to start taking account of climate risk in the way they invest in bond portfolios."
The difference between the traditional cap-weighted index and the climate-risk version is subtle but telling.
The United States, for example, is the largest portion of the cap-weighted index of 22 countries at 38%, but when climate-risk factors are included, the U.S. weight drops by more than three percentage points.
At the other end of the spectrum, the United Kingdom represents just 5.2% of the cap-weighted index but balloons up to 7.7% when climate-risk factors are added.
The climate-risk index increases or decreases country weightings based on three primary criteria: transition risk, physical risk and resilience.
Transition risk reflects the impact on the country and its economy from the required efforts to mitigate climate change encompassed by the reduction in greenhouse gas emissions needed to meet the Paris conference target of less than 2 degrees of global warming and the recent trend of historical carbon emissions.
Physical risk encompasses the risk to the country and its economy from the physical effects of climate change, such as how many people live close to or below sea level.
Resilience measures a country's preparedness and actions to cope with climate change.
"Countries are scored across each of the pillars with a single combined score derived for each country," said Mr. Samad. "Country scores are then used to reweight the country's exposure in the index to provide higher exposures to countries that are more resilient to climate change risks and lower exposures to countries that are more exposed to climate change risks."
David Knutson, head of credit research for the Americas at Schroders, called the climate-risk index the "natural progression" for a bond market that has been behind the equity markets when it comes to embracing and applying ESG strategies.
"You want to tilt your capital toward countries that have a demonstrated ability to manage ESG factors," he said. "If the bond market perceives a lower risk because of ESG factors they will lower the cost of borrowing, and over time that allows the country or company to spend less on interest payments."
Mr. Knutson added that ESG investing is gaining momentum in the fixed-income markets.
"Over the past five years, we started to hear ESG mentioned in the credit markets, but over the last two year it has become part of the daily conversations with clients and prospects," he said. "The type of dialogue has moved from checking the box to 'tell me how you do it and how has it impacted your investments?' Investors are demanding ESG be incorporated into the analysis, and I think you'll see more of these kinds of indexes coming out."
According to Mr. Samad, the climate-risk analysis on the sovereign debt market is just scratching the surface of the opportunities to fine-tune and customize strategies.
He said that while the current version is designed to reduce climate-related risk exposure while keeping performance within 10 basis points of the cap-weighted index, the risk levels can be adjusted if desired.
"We can dial up or down for different types of investors," Mr. Samad said. "If investors want a more aggressive approach, they can work with us to design versions of the index that can take more tracking error but reduce even more the climate risk."