E-RISC: Environmental Risk Integration in Sovereign Credit Analysis

UNEP Finance Initiative and the Global Footprint Network have collaborated with a number of institutional investors, asset managers and information providers to demonstrate the materiality of natural resource and environmental risk to sovereign credit worthiness. The report "A New Angle on Sovereign Credit Risk" addresses how and why natural resource and environmental risks are becoming financially material for sovereign credit risk, not just in the medium term, but even in the short run.

Genève, 23 November 2012: Sovereign bonds represent over 40 per cent of the global bond market, and are therefore one of the most important asset classes held by investors around the world. A growing group of investors is recognising the need for a broader understanding of emerging risks in the bond markets. Furthermore, there is growing concern over the mounting threat of systemic risks outside of the financial system, notably environmental risk, which can impact multiple financial markets.
 
Five countries – Brazil, France, India, Japan and Turkey – were analysed, based on consultations with the participating financial institutions. The first phase of the E-RISC project provide the following results: A 10 per cent variation in commodity prices can lead to changes in a country’s trade balance equivalent to between 0.2 and 0.5 per cent of a nation’s GDP. Given the recent fluctuations in commodity prices investors should take note of these issues in the short term (0 – 5 years). A 10 per cent reduction in the productive capacity of renewable, biological resources, and assuming that consumption levels remain the same, could lead to a reduction in trade balance equivalent between 1 and over 4 per cent of a nation’s GDP. Given the growing body of scientific evidence on ecosystem degradation and climate change impacts, governments, bondholders and credit rating agencies should take note of these issues in the short to medium term.
 
Results of the E-RISC project show risks related to natural resource constraints and their broader environmental consequences can exhibit significant risks for the five countries studied over both short (0 – 5 years) to medium-term (5 -10 years) time frames. This contradicts the conventional belief that natural resources risks are only relevant in the long term. Countries have quite distinct environmental and natural resource risk profiles. Resource dependence and exposure to price volatility vary by factors of more than two, whereas exposure to degradation effects varies by more than fourfold among the five case study countries analysed. Furthermore there is no correlation between resource exposure and sovereign credit ratings or credit default swaps. Fixed income investors, credit rating agencies and governments are encouraged to identify not only how natural resource and environmental risks can be integrated into sovereign risk models and but also which solutions can address them.
 
E-RISC methodology
 
The methodology should be regarded as a first step to link natural resource risks to sovereign credit risk, not a final product. Methodological enhancements of the E-RISC approach applied to a larger number of countries will provide a more comprehensive overview. The E-RISC methodology focuses on the development of metrics and methods for quantifying natural resource and environmental risks so they can be incorporated into sovereign credit risk assessments. This initiative focused on one key piece: to demonstrate the potential materiality of natural resource and environmental risks in the context of sovereign credit risk analysis, which can affect the underlying value of sovereign bonds.
 
The methodology relies on the Ecological Footprint and biocapacity metrics to assess a country's resource situation in order to identify how these risks might affect sovereign credit risk. The traditional focus on renewable biological resources by Global Footprint Network (such as fisheries, forests, cropland and grazing land) is supplemented with data on non-renewable natural resources including fossil fuels, metals and minerals to provide a more comprehensive definition of natural resources. The method and metrics developed in the E-RISC project lay the foundations for enhanced analytics that can account for the growing materiality of natural resource constraints for sovereign credit risk.
 
You can download the report here.
 
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