Governments are increasingly coming to realize that climate change could have a significant impact on their economy. They should also recognize that the consumption patterns of their populations can have environmental and economic impacts far beyond their borders.
Countries with the highest consumption levels, thus contributing most to global environmental degradation, often face little risk themselves from the food price shocks that can occur as a consequence of environmental degradation and climate change. Conversely, countries facing the largest negative economic effects from food price shocks are poorer countries which have played little or no part in causing environmental constraints to expanded food production.
By taking steps towards more sustainable production and consumption, higher-income countries can help to alleviate the demand pressures that result in higher and more volatile food prices, thereby reducing both the food security and the economic risks facing poorer countries.
A new report, ERISC Phase II: How food prices link environmental constraints to sovereign credit risk, encourages governments, investors, credit rating agencies and banks to work together to further investigate the linkages between environmental risks and economic and socio-political impacts, and to better integrate this information into country risk assessments and investment decisions.
ERISC Phase II will be released by UNEP and Global Footprint Network in collaboration with a number of leading financial institutions at an event at S&P Global Ratings in London on 18 May. It follows the publication of the first Environmental Risk Integration in Sovereign Credit analysis (ERISC) report 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 assessing the impacts on key macroeconomic indicators such as GDP, current account balances or inflation, the research enables financial institutions to integrate environmental risks in their investment decision-making.
Growing populations, meat-based diets, water scarcity and the impacts of climate change can lead to higher and more volatile food prices. ERISC Phase II looks specifically at the effect of higher and more volatile food prices on national economies. If these impacts are significant enough, they may affect a country’s economy and potentially its credit rating and the risk exposure to bondholders. (Sovereign bonds are issued by governments. There is currently more than $40 trillion in outstanding government debt; such bonds are therefore one of the most important asset classes held by investors around the world.)
Sovereign bonds have traditionally been considered a low-risk investment by investors and rating agencies, but the 2007-2008 global financial crisis, followed by the 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 increasingly consider altering their forecasting models to take into account environmental risks from natural resource scarcity, environmental degradation and climate change.
Some are already doing so.
“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 says for Greenbiz. “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.”
Moreover, 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.)
And ratings agencies are also starting to take note: Both S&P Global Ratings and Moody’s highlighted climate change risk in recent publications.
Valuing the invisible
As environmental constraints and risks grow, countries are facing increasingly important economic impacts. This provides an additional motivation for countries to transition to a low-carbon and resource-efficient economy. Governments can benefit by starting to integrate the economic value of ecosystems into national sustainable development planning.
UNEP’s ProEcoServ project, which ran from 2010-2014 in four pilot countries – Chile, South Africa, Trinidad and Tobago, and Viet Nam – aimed to show how ecosystem assessment and economic valuation of ecosystem services can be better integrated into poverty reduction and national sustainable development planning. Taxes, subsidies and tariffs are also a powerful way through which governments can stimulate green growth thereby reducing environmental risks.
What’s in the new report?
ERISC Phase II focuses on food prices as one of the key transmission mechanisms between environmental risk and economic impacts at the national level.
The report explains that food-price volatility is partly driven by environmental factors, and that in the longer term global population growth, growing incomes (allowing more people to switch to eating more meat, for example), climate change, and increased water scarcity are likely to drive food prices upwards and make them more unstable.
ERISC Phase II models the impact of a doubling of global food commodity prices on three macro-economic indicators for 110 countries: GDP, current account balance, and inflation.
Here are some highlights from the ERISC Phase II report:
- 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 up food prices and food price volatility. Water scarcity could also be a growing constraint on future food production.
- Higher credit ratings correlate to lower food price volatility exposure. (Countries with higher credit ratings tend to be less exposed to economic risks resulting from a food commodity price spike.)
- Impacts of food price spikes on economic variables such as GDP, consumer prices and current account balances on the other hand are likely to hit the most vulnerable countries hardest.
- One of the participating financial institution in the ERISC project found that 58 out of 78 countries would be downgraded in its internal risk assessment if the results of the modelling were integrated.
These findings indicate that environmental risks, manifested through food price rises and food price volatility, have the ability to affect a country’s sovereign credit risk. Investors and asset managers can already take action, for example, integrating this information into their country risk assessments and investment decisions.
UNEP and Global Footprint Network are interested in scaling up this work and invite governments, rating agencies, investors and banks to further decipher and strengthen the link between environmental risks and sovereign credit risk.
