Yesterday, we reported that more institutional investors and professional managers are using sustainability metrics to assess and make portfolio selections.
A study issued this week by the United Nations Environment Program's Finance Initiative (UNEP FI) considers what might happen if we applied those same principles to managing the risk associated with sovereign debt issued around the world.
Sovereign bonds constitute over 40% of the global bond market, and are therefore one of the most important asset classes held by investors around the world. They have traditionally been considered a reliable, risk-free investment choice by fund managers, but that's changing.
Besides the huge debt burdens we continually hear about, debt ratings would be even lower if environmental risks - such as loss of forests, fisheries and soil - were counted along with financial risks, because they underpin our economies.
Recent trends in rising costs of key commodities reverse more than two decades of stable or falling prices. Countries are therefore seeing their import bills for both biological resources (fish, timber, wheat and other soft commodities) and fossil fuels rise.
Commodity markets, food prices and food and resource security are becoming increasingly volatile, exacerbated by climate change-caused weather extremes and uncertainty. Raters, investors and governments alike will therefore need to become more aware of the repercussions of these trends on a country's economy.
In the future, countries that depend on consuming natural resources and services beyond what their own ecosystems can provide may experience profound economic impacts as resources become more unreliable or costly.
"The time has come for a better understanding of the connection between environmental risk, and sovereign credit risk. Only then will investors, credit rating agencies and governments be able to plan effectively with the kind of insight aimed at ensuring long-term economic health and stability," says United Nations Under-Secretary-General and UNEP Executive Director Achim Steiner.
UNEP's report, produced with Global Footprint Network, "E-RISC: A New Angle on Sovereign Credit Risk," analyzes five "pilot" countries - Brazil, France, India, Japan and Turkey – to demonstrate a model for taking environmental risks into account. For each country, they calculated potential financial risks stemming from excess freshwater consumption, soil erosion, and deforestation.
“More and more countries depend on a level of resource demand that exceeds what their own ecosystems can provide. This trend is tightening global competition for the planet’s limited resources and represents risks for sovereign bond investors as well as countries issuing such bonds. A more accurate description of economic reality is therefore in everyone’s interest,” adds Susan Burns, founder of Global Footprint Network.
Creating An Ecological Footprint
To measure a country's Ecological Footprint, the amount of biologically productive land and water required to support its population is compared to its biocapacity - the amount of productive area that's actually available.
Then they add in footprint information on resources available, including fisheries, forests, crop and grazing land, land needed to absorb carbon dioxide, and non-renewable resources such as fossil fuels, ores and minerals.
The report concludes that just a 10% move in commodity prices can lead to changes in a country’s trade balance equivalent to 0.2-0.5% of GDP.
A 10% decrease in natural resource productivity can affect 4% of GDP, because a country is forced to import more of its goods.
Here's the outlook for the five countries considered in the report:
Even though the country's ecological footprint tripled from 1961-2008, its ecosystems still generate more natural resources and services than its population demands.
Brazil's risks include natural resource price volatility and changing rainfall patterns from climate change that negatively impact agricultural production.
France demands 1.4 times more from its ecological assets than it can sustainably provide, and this gap has been growing 1% a year for the past decade.
France is less vulnerable to commodity price fluctuations than the other countries considered, but it has greater exposure to fossil fuel-related risks. Its high debt rate and budget deficit leave it with less resilience to natural resource risks.
India demands 1.8 times more from its ecological assets than it can sustainably provide and this gap has been growing 4.6% a year for the past decade.
Key risks are deforestation, overgrazing, climate change and soil degradation. It will need to look abroad for its natural resource needs as its population grows. Like France, it's debt and deficity load lower its resilience to adverse resource price shocks.
Japan increasingly relies on imports of fuel and food, which leaves it vulnerable to supply disruptions.
Like India and France, Japan has little fiscal wiggle room to respond to big changes in natural resource prices. As of 2008, Japan met only 35% of its natural resource needs domestically, compared 73% in 1961.
Turkey demands 1.5 times more from its ecological assets than it can sustainably provide, and this gap grew 6% a year over the past decade. Big concerns are water scarcity, desertification and land degradation.
Demand for water for its crops is expected to rise 20% by 2050, even as the potential for severe drought from climate change increases.
Here's the UNEP report: