16 May 2016 Story Climate change

Bond Markets Must Consider Environmental Risks

Finance and capital markets have so far mostly focused on climate change in terms of the predominant environmental risk and its effect on equities. But bonds – whether government or corporate – are not shielded from the impacts of climate change, ecosystem degradation and resource constraints. With around $100 trillion in corporate and sovereign bonds outstanding, it is critical for bond markets to consider how environmental risks can affect the performance of the underlying asset.

A new report released on 18 May in London looks specifically at how environmental risks could affect sovereign credit risk. With about $40 trillion in outstanding government debt as of the third quarter of 2015, this is the largest and one of the most important asset classes for investors. 

The report, titled ERISC Phase II: How food prices link environmental constraints to sovereign credit risk, was co-authored by UNEP Finance Initiative (UNEP FI) and Global Footprint Network in collaboration with Cambridge Econometrics and seven leading financial institutions: Caisse des Dépôts, Colonial First State, HSBC, Kempen, KfW, and S&P Global Ratings. It follows the publication of the first Environmental Risk Integration in Sovereign Credit analysis (ERISC) report by UNEP FI and Global Footprint Network in 2012.

The overall objective of the ERISC project is to identify and quantify the impact of environmental risks such as deforestation, climate change and water scarcity on national economies. By modelling the impact of environmental risks on key macroeconomic indicators such as GDP, current account balances or inflation, it enables financial institutions to integrate environmental risk in their investment decision-making.

Paradigm shift
Sovereign bonds have traditionally been considered a low-risk investment, especially for most OECD countries, but the 2007-2008 financial crisis and the subsequent European sovereign debt crisis may have altered this perception. While the underlying reasons behind the European sovereign debt crisis were not related to the environment, global investment analysts ought to consider altering their forecasting models to include environmental risks such as natural resource scarcity, environmental degradation and climate change.

“Investors are increasingly seeking less carbon-intensive and more environmentally and socially friendly portfolios”, Tim Nixon, managing editor of Thomson Reuters Sustainability, wrote in a recent article for Greenbiz says. “Global bank HSBC recently reported that around 30 per cent of all assets under management are using some kind of sustainability strategy or filter. This trend is up from almost zero 10 years ago.”

Influential opinion leaders are weighing in on the issue: The 2016 Global Risk Report by the World Economic Forum found that the costs related to biodiversity loss, ecosystem degradation, water crises and failure to address climate change mitigation and adaptation were among the most severe risks the world faces. (The Forum engages the foremost political, business and other leaders of society to shape global, regional and industry agendas.)

Ivo Mulder, an expert on sustainable finance and investment with UNEP and co-initiator of the Environmental Risk in Sovereign Credit Analysis (ERISC) project back in 2012, believes we need sound analytical tools to factor environmental risks into different asset classes including sovereign bonds.

“The ERISC project presents an opportunity for forward-looking investors, rating agencies and governments: How to turn sustainability into sustained economic growth for the next decades?” says Mulder. “It may very well be that governments may be perceived as less risky if they have moved to a low-carbon, resource efficient economy... Financial institutions are looking beyond carbon footprints to also consider other material environmental issues such as deforestation rates, water scarcity and the ecological footprint.”

What’s in the new report?
While the inaugural ERISC report demonstrated that environmental risks are material to sovereign credit risk and can be quantified, the second phase of research focused on food prices as one of the key transmission mechanisms between environmental risks and economic impacts.

The report explains that the global food system is vulnerable to growing environmental constraints. Climate change, along with land and water scarcity, will increasingly affect food production on the supply side. At the same time, demand for food will increase as a result of global population and income growth. The growing imbalance between rising demand for food and the capacity to supply it will lead to greater variability in food production, higher and more volatile food commodity prices, and a higher likelihood of price shocks.

The second ERISC report models the impact of a doubling of global food commodity prices in 110 countries on three macro-economic indicators: GDP, current account balance, and the consumer price index (i.e. inflation).

Highlights from ERISC Phase II include:

  • Countries like Egypt, Morocco and the Philippines, which combine high food commodity imports and high household spending on these commodities, could see the worst effects in terms of GDP reduction, a worsening of current account balances and higher inflation.
  • A number of large emerging market countries, including China, Indonesia, and Turkey could be similarly affected.
  • Net food exporters like Brazil, Pakistan, Paraguay, Thailand, Uruguay and Viet Nam stand to benefit from food commodity price increases but are exposed to increased volatility.
  • Climate change can have a significant impact on future food production and thereby drive food prices and food price volatility.
  • Water scarcity is also likely going to be a growing constraint on future food production.
  • Countries with higher credit ratings tend to have less exposure to  food price volatility.  
  • Impacts of food price spikes on economic variables such as GDP, consumer prices and current account balance are likely to hit the most vulnerable countries hardest.
  • Net food exporters like Brazil, Pakistan, Paraguay, Thailand, Uruguay and Viet Nam stand to benefit from food commodity price increases, but are at the same time exposed to price volatility.
  • A simulated integration of the results in a country risk assessment carried out by a participating financial institution in the ERISC project found that 58 out of 78 countries experience a downgrade in the quantitative rating module of at least one notch (in a 19-notch rating scale). Sixteen countries would be downgraded by three notches or more.

Initial findings thus indicate that environmental risks, manifested through food price rises and food price volatility, have the ability to affect country risk or sovereign credit risk.

Institutional investors, asset managers and credit rating agencies can already take action by integrating the environmental risks outlined in the report into their country risk assessments and investment decisions.