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.