Environmental Risk in Sovereign Credits (E-RISC):

Integrating Ecological Risk in Sovereign Credit Risk Models and Investments

On November 19, 2012, the key findings of the E-RISC: A New Angle on Sovereign Credit Risk report were unveiled at an interactive event hosted by Bloomberg in London. The report found that a ten percent variation in commodity prices can lead to changes in a country’s trade balance equivalent to 0.5 percent of GDP. Further, a ten per cent reduction in the productive capacity of soils and freshwater areas alone could lead to a reduction in trade balance equivalent to over 4 per cent of GDP. (Download report as a 5MB .pdf)

Most investors have long thought that the traditional economic indicators were sufficient to comprehensively understand country-level competitiveness and the robustness of their economies. However, at no other time in history has human demand on resources been greater, the rate of which exceeds our Earth’s capacity to regenerate raw materials for food, shelter and clothing, and absorb the carbon dioxide we emit. Resources—from scarcity, to rising costs, to countries’ abilities to secure them— are increasingly becoming economic factors. At the same time, the world has become more fiscally constrained.

These twin trajectories are interconnected, and together can determine a country’s ability to remain competitive. One need only look at the news to see these concurrent challenges: ongoing debt crisis, climate change, water scarcity, food shortages, deforestation and the many other environmental crises that we face today.

Consumption, demographic and environmental degradation patterns and related issues could influence the resilience of countries to deal with changing environmental patterns in the medium- to long-term. The risk frameworks that are used to assess the exposure of financial products to local, national and global risks must better reflect the interconnected and systemic nature of the 21st century.

The availability and price of natural capital is likely to become increasingly relevant to financial security. This is the case not only for individual businesses, but for nations as well. Natural capital can be defined as the stock of ecosystems that provides a renewable flow of goods and services such as fish, crops, timber, climate regulation and many other services.

Several studies in recent years have improved our understanding of the value of ecosystem services, as well as the considerable cost ecological degradation and over-use has on society, business and nations¹.

1. For example, a 2011 study by the PRI and UNEP FI measured the magnitude of global environmental externalities to be US $ 6.6 trillion in 2008, about 11 percent of the value of the global economy. The question is whether such environmental phenomena affect the financial underpinnings of sovereign fixed income investments or other types of securities.

A country’s use and availability of ecosystem services plays a role in the health of its economy and its ability to secure a high quality of life for its citizens. Therefore, both the availability and use of these resources are likely to influence core economic indicators, such as its sovereign credit ratings and a nation’s ability to meet future debt obligations (positively or negatively).

Considerable progress has been made to assess and compare the financial performance of conventional equities with equities that embed environmental, social and governance (ESG) into financial frameworks. But to date, there have been few studies linking ESG materiality to fixed income investments, especially for sovereign bonds. This may have to do with their more passive nature of investing.

Objectives

This project aims to assess the financial materiality of ecological risks to sovereign fixed income investments, and to develop a methodology to enable asset owners, investment managers, information providers and credit rating agencies to include these factors in their sovereign credit risk models.

Global Footprint Network and UNEP FI are working together with different financial institutions (asset owners, investment managers, credit rating agencies and information providers) to analyze the linkages between ecological and financial risk. Together, we are exploring how Ecological Footprint and biocapacity trends can shed light on material risks that are not included in credit ratings. The initiative has two distinct phases:

Phase I: Assess the financial materiality of ecological risks relevant for the credit risk evaluation of government bonds, and present models for full integration into credit risk assessments."

Phase II: Work toward a methodology for credit rating agencies, investors and financial information providers to integrate ecological data in their respective models."

Approach

Global Footprint Network’s data, including Ecological Footprint and biocapacity measurements (Figure 1), will provide the basis for the analysis. The Ecological Footprint tracks the demands that humanity places upon the planet. This is compared to biocapacity, the regenerative biological capacity of Earth.

The world has been in ecological overshoot since the 1970s—that is, humanity's demands for resources have outstripped Earth's capacity to regenerate them for four decades now. In 2008, humanity demanded the equivalent of one-and-a-half planet’s worth of renewable resources (Figure 3). When the Ecological Footprint associated with a nation is greater than the domestic biocapacity, that nation is said to be in "biocapacity deficit." An increase in biocapacity deficit, coupled with the rising costs of competing for resources from foreign ecosystems also under stress, may undermine a country's economic stability, competitiveness, and resilience to cope with increasingly interconnected financial, economic and environmental shocks.

The focus of this project is on the "credit risk" rather than the "financial performance" of government bonds. We aim to make a direct link between ecological risk and sovereign credit risk. To this end, we are focusing on the integration of financially material ecological indicators into credit risk models; this is in contrast to the separate screening tools currently used that are based on qualitative environmental information. (A conceptual overview is given in Figure 1.) In the practical linkage between natural resource use and availability to the functioning of our economies, the starting point is the comparison between humanity’s demand (Ecological Footprint) and the planet's biocapacity.

Figure 1: Conceptual overview of how linkages between ecological, economic and financial risk may be addressed.

Other relevant criteria not accounted for in credit ratings will also be analyzed and integrated into the methodology. The goal is to foster shared learning from working with banks, investors and credit rating agencies, and to enable the integration of ecological risk in sovereign credit ratings and government bonds.

Figure 2: The components of the Ecological Footprint and biocapacity.

Figure 3: Comparing the global Ecological Footprint with world biocapacity.

Deliverables

Research in Phase 1 will be synthesized and communicated through a report on the methods used for analyzing the financial materiality of ecologically relevant criteria at the country level. Results of this analysis will be presented to substantiate the business case for how and why financial institutions and ratings agencies could better integrate ecological data into country credit risk analysis.

United Nations Environment Programme Finance Initiative (UNEP FI) UNEP FI is a unique partnership between the United Nations Environment Programme (UNEP) and the global financial sector. UNEP FI works closely with more than 200 financial institutions that are signatories to the UNEP FI Statement on Sustainable Development, and a range of partner organizations, to develop and promote linkages between sustainability and financial performance. Through peer-to-peer networks, research and training, UNEP FI carries out its mission to identify, promote, and realize the adoption of best environmental and sustainability practice at all levels of financial institution operations.www.unepfi.org

Global Footprint Network is an international research organization working to advance sustainability through the Ecological Footprint, a resource accounting tool that measures the planet’s biocapacity, how much biocapacity humanity demands and who uses what. Global Footprint Network coordinates research, develops methodological standards, and releases annual data on the Ecological Footprint and biocapacity of more than 130 countries and humanity as a whole. By providing robust resource accounts to track the supply of and demand on ecological assets, Global Footprint Network provides decision-makers with the data they need to succeed in a world facing tightening resource constraints.www.footprintnetwork.org

Contact us For further information about this project, please contact:

UNEP FI: Ivo Mulder: .(JavaScript must be enabled to view this email address) Margot Hill: .(JavaScript must be enabled to view this email address)

Global Footprint Network: Martin Halle: .(JavaScript must be enabled to view this email address)