Pushing the Frontier in Environmental Analysis on Sovereign Bonds

Environmental Risk in Sovereign Credits (E-RISC):

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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)

E-RISC Press Conference at Bloomberg, with Ivo Mulder (UNEP FI), Susan Burns (Global Footprint Network), and Nick Nuttall (UNEP)

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.