Thursday, April 24, 2014
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Sovereign Environmental Risk

NAIROBI – Until the global financial crisis erupted four years ago, sovereign bonds had traditionally been viewed as reliable, virtually risk-free investments. Since then, they have looked far less safe. And many observers within and outside the financial sector have begun to question the models upon which credit-rating agencies, investment firms, and others rely to price the risks tied to such securities.

At the same time, it is increasingly obvious that any reform of risk models must factor in environmental implications and natural-resource scarcity. Indeed, a recent investment report underlined that the fall in prices in the twentieth century for 33 important commodities – including aluminum, palm oil, and wheat – has been entirely offset in the decade since 2002, when commodity prices tripled.

It is likely that growing natural-resource scarcities are driving a paradigm shift, with potentially profound implications for economies – and thus for sovereign-debt risk – worldwide. Indeed, many countries are already experiencing an increase in import prices for biological resources. Financial markets can no longer overlook how ecosystems and the multitrillion-dollar services and products that they provide – ranging from water supplies, carbon storage, and timber to the healthy soils needed for crop production – underpin economic performance.

In addition, we are living in a world in which over-exploitation of natural resources, unsustainable consumption, and the condition of many ecosystems have become incompatible with accelerating demographic growth, as the human population increases from seven billion today to well over nine billion by 2050.

Studies such as the The Millennium Ecosystem Assessment and The Economics of Ecosystems and Biodiversity (TEEB), conducted on behalf of the G-8, have improved our understanding of the economic, ecological, and social value of the goods and services provided by ecosystems, and have proposed better methods for pricing them. Yet this new thinking has yet to influence significantly the behavior of bond investors and rating agencies.

Some might assume that bond markets are shielded from the effects of climate change, ecosystem degradation, and water scarcity. With more than $40 trillion of sovereign debt in global markets at any given time, that is a very high-risk game.

In order to address the gap between reality and perception, the United Nations Environment Program Finance Initiative (UNEP FI) and the Global Footprint Network (GFN), together with a number of institutional investors, investment managers, and information providers, have launched E-RISC, or Environmental Risk in Sovereign Credit analysis.

The project will take center stage at a gathering of investors in London on November 19, providing an early glimpse of how environmental criteria can be factored into sovereign-risk models and hence into the credit ratings assigned to sovereign bonds.

E-RISC highlights the situation in several countries – including Brazil, France, India, Turkey, and Japan – demonstrating how importers and exporters of natural resources such as timber, fish, and crops are being exposed to the increasing volatility that accompanies rising global resource scarcity. Indeed, the E-RISC report estimates that a 10% variation in commodity prices can lead to changes in a country’s trade balance amounting to more than 0.5% of GDP.

Meanwhile, the economic consequences of environmental degradation can be severe. The report estimates that a 10% reduction in the productive capacity of soils and freshwater areas alone could lead to a reduction in the trade balance equivalent to more than 4% of GDP.

Clearly, environmental risks are potentially large enough to affect countries’ economies in ways that could influence their willingness or ability to repay sovereign debt. In addition, these risks vary widely across countries, including countries whose current credit ratings suggest similar levels of sovereign risk.

This suggests that the findings and methodologies applied in the E-RISC project bring added value to traditional sovereign-risk analysis, by providing insights into relevant but currently unaccounted-for parameters. Credit-rating agencies, institutional investors, and asset managers are encouraged to see how such factors can be incorporated into their own risk models.

The time has come for a better understanding of the connection between environmental and natural-resource risk and sovereign credit risk. Only then will investors, rating agencies, and governments be able to plan over the medium to long term with the knowledge needed to ensure long-term economic growth and stability.

Read more from our "Imperfect Indicators?" Focal Point.

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  1. CommentedJonathan Lam

    gamesmith94134: Sovereign Environmental risk

    PROCYON MUKHERJEE is right about the iron ore, aluminum fell badly because the slow economy. How about the $100-$145 to a barrel of oil, or cotton? They all have time frame in the necessity and price varies. I think Achim Steiner and Susan Burns interested in the formula of life or even eternity. As in free market, we do have code of morale in good will that protects sovereignty that is not accountable to digital, in order to make the free market and enterprising work. We must put ourselves in constraints of ethics and rules just to achieve dignity and fairness in trading among nations.

    In the recent days, we, many of those monetarist, abused the exchange rate and credit in controlling the commodity market since we are no longer produce. We trade currencies for valued added goods from foreigners that our dependency on profits made our industries worsen as in outsourcing and financing; then we fell to anemic growth and unemployment. Did we learn from the sovereignty debts and fallen banks? It was the concept of digitalization on business or livelihood. Since the days I worked in Africa, I wonder why its population doubled to the developed nations. I realize God do have a way to human race to eternity, and only human race ends its journey through; substitution is what we human can even out on technology. African multiplies and developed nations population slows down.

    Perhaps, we must know of the resources that generate growth, like financial capital equitable valued goods, humans, and natural minerals. Each carries its value and time limits to its utilization to growth. Why scarcities make it more valuable? It only counts if it change to goods after it combine or added to other that generate value. I think Mr. Steiner and Burns must do more research on cotton or iron why they fell. When some said oil should go over 200 by the end of 2000, I worry. However, we evolve and oil was substitute by green energy and nuclear power, it stands at 95-100. If European Union deals get busted, and global economy slows down more to depression, will oil go 75? It is the free market system to work. In the case of recent hot cash rushed into Hong Kong and China, it was digitally correct to gain if you pay 0.25% interest to capture 6.25% where Chinese paid on their mortgage, currently, you are not infected with inflation. Was it correctly “pegged”? What is the sovereignty environment risk to Hong Kong or China if fairness is not the issue? Or is it the morale of this story is just simple as profit while you can?

    November 19th,2012 is the day of the great dilemma on those G8 how they think of the our free market system and the currency exchange. If there is no insertion of its code of morality and good wills, it does not make sense whether their solution is digitally correct in a way they harmonize the global economy with growth and prosperity.

    Happy London Whale sighting tour, no renminbi reserves is needed?

    May the Buddha bless you?

  2. Portrait of Christopher T. Mahoney

    CommentedChristopher T. Mahoney

    I was responsible for Moody's sovereign credit group for over a decade, so I am familiar with "conventional" sovereign credit analysis. Much progress has been made in the predictive power of sovereign credit analysis since the East Asian crisis of 1997-98. Government default because they are unable to refinance their debt in the market. This may be a result of excessive reliance on confidence-sensitive funding, or because of a political inability to maintain sound fiscal policies. There have been cases in which adverse commodity price movements have affected competitiveness and the balance of payments. Some economies are overly dependent upon a single export or import item, such as oil, cod fish, or sugar. This is captured in analysis by subjecting the economy to a plausible stress scenario. For an oil exporter, that would be $40 oil; for an importer, it would be $200 oil. There is no need to forecast commodity prices to conduct such an analysis.

  3. CommentedZsolt Hermann

    The solution is simple but people do not want to recognize it because accepting the true situation and its solution would require a total paradigm shift and complete attitude change towards life and reality in general.
    Humans are part of the vast natural system around, still they consider themselves above the system, as if people could start designing and using systems, structures that are above the natural laws and principles, which lead to the present socio-economic system that is based on an illusion.
    In order to satiate a constant greed, yearning for more profit and expansion, humanity has been building bubbles on top of bubbles gradually leaving any connection with the natural system and its principles behind.
    Today's human society is in direct opposition to this natural system, and as a result all living ecosystems, starting from the individual human being through the human society to the relationship in between humanity and the environment are harmed.
    Credits, Bonds, and any other kind of financial trickery, exploring and extracting natural resources for profit instead for necessities are causing irreversible damage and volatile and unsustainable scenarios. The constant quantitative growth approach resembles cancer in a living natural organism.
    Despite all the signs being clearer with each day of the deepening crisis, despite countless scientific publications confirming the same, leaders and the public alike ignores the facts and continues pretending that this illusion is sustainable and we have credible solutions, despite all solutions leading to deeper and more complex crisis.
    The only solution is the return to the natural, necessity and available resource based economic model, and such a governing system that takes into consideration all the details and principles of the global, interdependent human network within the all inclusive natural system.
    Humanity is in dire need of leaders and public opinion former people and media, that are capable of seeing and understanding the whole system in its totality, seeing and understanding the multi-dimensional interconnections and how a general harmony and homeostasis is possible with the active partnership of humanity within this system.

  4. CommentedProcyon Mukherjee

    To substantiate the argument on commodities, let me give the first evidence in Iron Ore, where the last six months has seen a drop of 30% in prices-http://www.indexmundi.com/commodities/?commodity=iron-ore
    In Aluminum, after a brief rally around the QE3, the downward rally has seen 12% drop in the last six months-
    http://www.kitcometals.com/charts/aluminum_historical_large.html#6months and in Copper we see that over last five years we have reached the same level where we were:
    http://www.kitcometals.com/charts/copper_historical_large.html#6months

    The signs are clear where the commodities super cycle had taken us and what risks we already carry.

    Procyon Mukherjee

  5. CommentedProcyon Mukherjee

    Sorry, that such tall claims on resource scarcity has taken us into a muddle that we could have avoided; if price is the best signal, then going by Aluminum and Iron Ore prices, we are currently where we were ten years back, which says a lot on the supply glut we have created based on erroneous projections. Excessive financialization into commodities have not only created the supply glut, it has also created the virtual demand to service that supply at the cost of a dampened price that impact certain constituencies very badly; to top it all is the volatility that comes from shocks (both during contractionary and expansionary monetary policy that the central banks unfold).

    Procyon Mukherjee

  6. CommentedMarc Laventurier

    Seems like an attempt to synthesize chalk and cheese, i.e., erasable (and risible) financial figurin' and the production of humanity's most basic needs. But 'liars figure and figures lie', especially when the tote board is run like a fun-house mirror. Let's hope that whoever is doing the figurin' can resist the temptation to prop up a starving brown girl in front of her warped reflection and complement her on her figure.

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