Governments are increasingly coming to realize that climate change could have a significant material 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.
Those countries with the highest consumption levels – who thus contribute 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 improving food security and reducing the economic risks facing poorer countries.
As a next step we therefore encourage both governments, investors, credit rating agencies and banks to work together with us to further investigate the linkages between environmental risks and economic and socio-political impacts, and to better integrate this information in their sovereign credit risk assessments and investment decisions.
The second Environmental Risk in Sovereign Credit analysis (ERISC) report, entitled ERISC Phase II: How food prices link environmental constraints to sovereign credit risk, will be launched on 18 May at S&P Global Ratings’ office in London. It follows publication of the first ERISC report, A new angle on Sovereign Credit Risk, launched in 2012.
ERISC Phase II focuses on food prices as one of the key transmission mechanisms between environmental risk and economic impacts at the national level. Higher and more volatile food prices can reflect environmental risks and constraints such as climate change, ecosystem degradation and water scarcity. If these impacts are significant enough, they may affect a country’s credit rating and the risk exposure of sovereign bondholders.
Fall-out from the 2008 financial crisis
The sub-prime mortgage crisis (or global financial crisis) of 2007-2008 led governments to borrow heavily on international bond markets to stimulate economic growth. As a result there was an enormous spike in outstanding government debt after 2008.
While government bonds have generally been considered safe securities, especially for most OECD countries, the 2007-2008 financial crisis and the subsequent European sovereign debt crisis may have altered this perception when credit rating agencies downgraded the sovereign debt of a number of OECD countries. The higher cost of capital resulting from deteriorating credit ratings exacerbated budget deficits and created pressure to cut spending.
Now we are entering a new era where climate change impacts, resource scarcity and other environmental risks will increasingly pose challenges for government, businesses and society in general. There is increasing evidence that the global economy overuses the available natural capital.
Global Footprint Network estimates that the Ecological Footprint of humanity, a measure of its demand for natural resources and services, is 1.6 times higher than what the planet can sustainably provide. The Millennium Ecosystem Assessment also found that about two thirds of ecosystems around the globe are used unsustainably. Until now, the missing link has been quantifying the potential effects on a country's economy of the unsustainable use of available ecosystem services.
More insight for governments
“The second ERISC report outlines the drivers of higher food prices and food price volatility and shows which countries are most vulnerable and how,” says Susan Burns, co-founder and Director of Finance for Change at Global Footprint Network.
The ERISC project aims to provide insight for governments, investors, and credit rating agencies on how environmental and resource pressures affect key macro-economic indicators such economic growth (increase or decrease in GDP), inflation (consumer price index) and whether a country is effectively a net lender or borrower (current account balance). Changes in these economic metrics in turn could affect the way banks, investors and credit rating agencies perceive the credit-worthiness of a country.
The ERISC Phase II report outlines how the global food system is vulnerable to growing environmental constraints and how climate change, along with land and water scarcity, will increasingly affect food production. 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.
Policymakers in countries that are net food importers may want to survey the report’s findings to identify their level of risk exposure as a first step toward ultimately determining how to mitigate potential food price rises.
Countries also may benefit by starting to integrate the economic value of ecosystems into national economic development plans, as a way to more systematically consider a country’s natural capital in domestic budget allocations and economic policy. UNEP’s ProEcoServ project, which ran from 2010-2014, aimed to pilot this in four selected countries – Chile, South Africa, Trinidad and Tobago and Viet Nam.
In a report titled Resource Revolution: Meeting the world’s energy materials, food and water needs (November 2011), the McKinsey Global Institute notes that resource prices should capture the true cost of their impact on the environment, for example through carbon pricing.
Countries may also need to rethink their policies on subsidies. “Governments need to consider unwinding the more than $1 trillion of subsidies on resources, including energy and water, that today keep prices artificially low and encourage the inefficient use of these commodities,” notes McKinsey, further pointing out that high prices tend to drive innovation and efficiency.
Here are a few 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 food prices and food price volatility. Water scarcity is also likely going to 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 balance are likely to hit the most vulnerable countries hardest.
- A simulated integration of the results in a country risk assessment 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.
These initial findings 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 and asset managers can already take action, for example, by integrating this information into their own internal country risk assessments and investment decisions. Credit rating agencies can also further refine the existing model and carry out more stress tests in order to estimate any significant effects of these issues on sovereign credit worthiness.
UNEP and Global Footprint Network are interested in scaling up this work and invite governments, rating agencies, investors and banks to further decipher the link between environmental risks and sovereign credit risk.
