Driving capital to support Brazil’s green transition

Nuveen’s Emerging Markets Impact Bond strategy: Increasing Brazil exposure amid an improving environmental outlook

Bottom Line Up Front: The Brazilian government’s policy platform includes a revamped focus on tackling deforestation, promoting decarbonization, and investing in climate adaptation projects – leading to a better environmental outlook.

EM Debt Performance Review – February 2024

EM hard currency debt rose for the month despite persistent dollar strength and yields moving higher as the rhetoric from monetary policymakers continued to shift in a hawkish direction. Policy officials generally emphasized that there is no urgency to cut rates given economic resilience and continued upside risks to inflation. Sovereigns rose for the month (1.0%) fully reversing January’s decline. EM corporates continued to lead for the year by posting another modest gain (0.7%). Most notable during the month was the continued divergence between investment grade (IG) and high yield (HY) as sovereign HY rose 2.6% and sovereign IG declined 0.6%. Among the sovereign gainers Egypt, Ecuador, Ukraine, and Argentina all posted double-digit returns. A similar divergence developed among corporates as HY returned 1.5% and IG only gained 0.1%. EM local continued to struggle in February as it was most directly impacted by dollar strength with FX (-0.8%) driving a negative total return for the month (-0.6%). The technical picture for EM debt funds remained weak in February (-$4.9 billion) but continued to reflect softening outflows. Local markets (-$0.2 billion) saw negative flows that was driven entirely by China-focused strategies (-$0.3 billion). Venezuela will reenter the EMBI-GD on a staggered basis in April with an estimated final weight (including PDVSA quasi-sovereigns) of 0.58% by the end of June. We remain cautious and do not anticipate adding exposure in the near term.

Brazil’s improved environmental strategy bolsters its ESG profile

Nuveen’s Emerging Markets Debt team become more constructive on Brazil sovereign and corporate debt holdings over the course of 2023. This reflected an improvement to its environmental outlook following the announcement of a green policy agenda by Brazil’s new administration. As a result, Nuveen’s sovereign ESG score for Brazil increased to a three from a two. Nuveen’s proprietary ESG scores are scaled from one to five, with five reflecting best-in-class and a three reflecting the minimum required score for eligibility within EMD ESG-mandated portfolios.

We are encouraged by the breadth of environmental policies under Brazil’s new administration as well as the speed of implementation. In August 2023, the government announced its ecological transformation plan, part of a larger $350bn infrastructure investment program that seeks to balance green transformation with economic growth and job creation. The most significant parts of the program include efforts to curb deforestation and to promote sustainable agriculture. The administration has already made significant strides fighting illegal deforestation – in the first 10 months, Amazon deforestation is estimated to be down by 56% versus the same period in 2022¹. Deforestation remains a key issue, not only for Brazil’s environmental strategy, but also for the preservation of its biodiversity as it is home to 6 different biomes (Amazon, Atlantic Forest, Caatinga, Cerrado, Pampa, and Pantanal biomes).

The current administration sees the strong renewable footprint in Brazil (88% of electricity generation is from renewable sources, especially hydropower and solar)²  as an opportunity to broaden its energy exports to include green electricity and, possibly, green steel and ammonia. Another critical area of the economic transformation program is the establishment of financial mechanisms to incentivize decarbonization, and to this end, the proposal of a mandatory regulated carbon market (cap-and-trade system) is under review in the legislature. Furthermore, in October, Brazil revised its nationally defined contribution for emissions reductions as part of the Paris climate agreement back to original targets, which had been watered down under the prior administration.

Notwithstanding a positive outlook on environmental policies, Nuveen’s overall sovereign ESG assessment for Brazil is constrained due to weaker performance on social and governance factors. These factors include high degrees of income inequality, gender disparities, human rights issues and corruption relative to its income-relevant peer set. The success of Brazil’s green program will depend on how well socioeconomic benefits accrue to people in the regions most affected by climate change and the energy transition.

All is not rosy as execution challenges remain

One criticism of Brazil’s energy transition is its concurrent goal of expanding fossil fuel production. In November 2023, state-owned oil company Petrobras announced plans to increase production from 2.8mboepd in 2024 to 3.2mboepd in 2028³. The government’s rationale is the desire to reduce dependency on oil imports and to enhance energy security while also helping finance the green transition via the export of lower-carbon barrels. We also expect Petrobras to be a relevant player in funding green investments, either directly through capital allocation or indirectly via dividend payments.

Brazil’s political dynamics also present a potential challenge to the green agenda’s progress, particularly in the context of pushing through new legislation. More conservative opposition parties in Congress have already raised challenges to the draft law for implementation of the carbon cap and trade system, pushing for exclusions for the agribusiness sector, and have put forth proposed legislation that waters down environmental and indigenous rights protections⁴. Nevertheless, we believe the government will remain focused on driving forward its green policies as quickly as possible. 2025 serves as a key near-term milestone, when Brazil hosts the UN’s COP-30 Climate Change Conference and also coinciding with Brazil's first interim decarbonization target.

Nuveen is constructive on Brazilian credit opportunities

While there are challenges, we are encouraged by the degree of ambition Brazil has set forth on its environmental program. The country’s improved ESG profile adds to our generally favorable credit view that is predicated on Brazil’s high level of reserves, diversified economy and a strong fiscal rule that provides guardrails. We also have a constructive outlook on many Brazilian corporates, which in totality represents a significant, diverse opportunity set, not only across ratings and sectors, but in terms of its relative value versus developed market peers.

Directing capital through impact to support positive environmental and social outcomes

We believe Brazil’s extensive natural resources are a key driver of economic growth, and the development of those resources will continue to be a primary draw of the country’s capital and investment. This may offer investors the ability to align with national policy and individual corporate sustainability goals by directing capital through impact bonds, including Brazil’s inaugural sustainability bond and two of the earliest Brazilian corporate green bond issuers.

Brazil’s first sustainability bond supports both green and social projects, including poverty reduction, clean transportation, renewable energy, and biodiversity. Projects reinforce one another with improved mass transit increasing job opportunities while reducing air pollution.

The Brazilian paper and pulp industry’s close ties to forestry made it one of the first to recognize that unabated use of timber resources was unsustainable. As a result, it was not a surprise that Klabin and Suzano were two of the first Brazilian issuers of green bonds and were an excellent fit for Nuveen’s Emerging Markets Impact strategy. Proceeds from these bonds focuses on sustainable forestry management, forest health, renewable energy, and native species reintroduction. This cuts through the typical perception that paper companies are only concerned with fast growing monoculture, but instead is a recognition of the long-term economic value of thriving forest ecosystems and the communities that rely on them.