Environmental risks in sovereign bonds are likely to be a fast growing area of interest, according to the panelists at the launch of Global Footprint Network’s ERISC Phase II report in London.
The ERISC II report, a joint project of Global Footprint Network and the UN Environment Programme’s Finance Initiative, showed how food price shocks driven by environmental forces would affect the economies of 110 countries. The launch event at S&P Global Ratings’ London office was S&P’s largest ever ESG (environmental, social and governance) event in London. In addition to presentations by Global Footprint Network and S&P, the event featured a panel discussion with thought leaders from UNEP, S&P, First State Investments, HSBC and Kepler Cheuvreux.
“Understanding how governments are formulating their strategies around both mitigation and adaptation … is going to become increasingly prominent at the investor level,” Zoe Knight, Head of HSBC’s Climate Change Centre of Excellence, said during the panel discussion. HSBC was one of several financial institutions who collaborated on the ERISC Phase II report.
“Investors have to do their homework and think about how does a country generate income. A lot of that can come from looking at trade and … is this country dependent on high carbon goods and services or is it dependent on low carbon goods and services?” Knight added. “Thinking about how the structure of the economy operates will give investors superior insights into whether or not that country is going to be better or worse positioned in relation to a high- to low-carbon transition.”
Most Impacted Countries
Moritz Kraemer, Chief Rating Officer for the Sovereign Ratings Group at S&P Global Ratings, another ERISC Phase II partner, noted that one reason sovereign bond investors may be slow to incorporating environmental factors into their analysis is that the countries that are most impacted by environmental risks and climate change have less absolute debt outstanding.
“If we didn’t have Fiji and Bahamas on the top of the list but Italy and Japan, I think this (environmental risk) would be a lot higher on the concern list,” Kramer pointed out. However, that may be changing, he added. “One element that has started to raise many questions is the tsunami in Japan, which had major economic impacts.”
Will Oulton, Global Head of Responsible Investment at First State Investments, whose parent company is the Commonwealth Bank of Australia, said his organization is committed to ESG integration across all asset classes, but participated in the ERISC II project because there has been little work on how to extend that integration into sovereign bonds. “The other positive (of ERISC Phase II) is it gave me the opportunity to further engage our emerging market debt team,” he added. “This project really catalyzed their interest in how they can advance their understanding of the problem, which is how ESG issues can impact default risk, and they have.”
Knight suggested progress will be evident when investors actually ask for fixed-income analysis that includes environmental risk, to drive demand and competition for ERISC-style analysis across the sovereign bond landscape.
But first, Julie Raynaud, Senior Sustainability Analyst on Kepler Cheuvreux’s ESG team, said there needs to be a harmonizing of methodologies on carbon disclosure and bottom-up analysis of environmental risk exposure and how to integrate both into broader investment analysis. Raynaud recently authored a report that reviewed carbon footprinting methodologies for sovereign bonds and additional analysis that can be done around energy exposure and carbon risk.
Kraemer, whose research on how climate change can impact sovereign ratings has focused on natural catastrophes, said investors may need a way to benchmark the performance of their sovereign bond portfolio based on environmental impacts. In an unexpected plug for Global Footprint Network’s Earth Overshoot Day campaign, he suggested an index based on our Footprint data for countries – showing when countries are in ecological deficit – may be one answer.
An important element of Global Footprint Network’s Finance for Change Initiative is to foster a dialogue with national governments around climate and resource policy. Panelists and the audience explored this theme as well.
“Is it possible engage with governments? Yes, it is,” Oulton confirmed. “We have conversations with different ministries and departments. … We ask them about climate policy, policy developments. We ask them why HDI (the United Nations Human Development Index) is so low and not changing. We ask them about social programs.”
Kraemer of S&P echoed that sentiment. “We have heated discussions with governments where they disagree with how we characterize institutions or social contracts,” Kraemer said, noting that such institutional or governance issues make up about one quarter of S&P’s rating on a country. “It’s not that the economic data trumps everything else.”
Knight, meanwhile, noted one paradox to exposing and ranking a country by vulnerability to environmental risks. “Many of the most vulnerable countries don’t really need to be told, ‘You’re the most vulnerable country,’” she said. “The unintended consequence is that it raises the risk for those countries, which turns off a lot of investors, which means it’s more expensive (for the country to borrow money) to both mitigate and adapt.”
Susan Burns, director of Global Footprint Network’s Finance Initiative, addressed this challenge in her opening remarks for the launch.
“Our work in sovereign credit is not just about downgrades or selling sovereign bonds that have risk,” she said. “It’s about the policy signal between bond investors and governments. … It’s about what are credit ratings looking at and do governments understand investors are concerned about these issues.”
A key premise underpinning Global Footprint Network’s Finance for Change Initiative is that investors and credit rating agencies can send strong signals to national governments, perhaps strong enough to even shift policy that takes environmental issues into account.
We explored this connection between government and investors a week after the London launch, when Ivo Mulder, the REDD+ Green Economy Advisor for UNEP, presented our ERISC II findings during the second session of the United Nations Environmental Assembly in Nairobi, an event attended by environment ministers from around the world.
Looking ahead, it is clear that the agenda on environmental stress and sovereign risks has only just begun. One clear priority is to anticipate these potential shocks and build real resilience, particularly in vulnerable developing countries. This takes the debate to bring in a broader financial policy community, which is the focus of the UNEP Inquiry into the Design of a Sustainable Financial System, co-directed by Nick Robins, who moderated the ERISC II panel discussion in London.
The UNEP Inquiry has outlined a “quiet revolution” in actions by financial ministries, central banks, and financial regulators to start integrating sustainable development factors into their routine operations.
Robins said the new ERISC II research on sovereign risks of food price shocks raises profound questions for financial policy, including implications for monetary policy as well as fiscal strategy. Robins said, “The key take-away is the need for investors to think much more about the resilience of their portfolios and critically think through what they can do to actually support the resilience in countries themselves.”
To watch a video of the ERISC II launch and panel discussion, visit here. (ERISC II presentation starts at 14:23; the S&P presentation starts at 39:32; and the panel discussion starts at 56:05.)
For media coverage on the ERISC II launch, including articles by Forbes, Thomson Reuters and CNBC, visit here.