Risks to Sovereign Bonds Posed by Overuse of Natural Resources Need Greater Attention, says New Report
INDIACSR News Network
LONDON/NAIROBI: Some countries’ sovereign debt ratings may be less robust than many investors may realize, if depletion of natural resources are taken into account, a new report released today suggests.
Loss of soils, forests and fisheries, as well as rising resource costs, are likely to become increasingly important to a nation’s economic health, and may affect its ability to repay or refinance sovereign debt, says the study issued by the United Nations Environment Programme’s Finance Initiative (UNEP FI).
The report suggests that factoring the way a country manages natural assets into sovereign bond ratings may not only give investors increased transparency when making investment decisions, but also encourage governments issuing sovereign debt to manage their natural resources more sustainably in order to attract investors over the medium to long term.
In its analysis of five pilot countries, the report, E-RISC: A New Angle on Sovereign Credit Risk, highlights major financial challenges due to the growing gulf between rising demands on freshwater, forests, soil, grazing land and other natural resources, and the goods and services that domestic ecosystems are able to sustainably provide.
The report, produced by UNEPFI and Global Footprint Network in collaboration with a number of asset owners, investment managers and information providers, shows that India now demands over 1.8 times more from its ecological assets than they are able to generate. Other countries are seeing similar trends.
By negatively impacting countries’ natural capital and economic stability, resource degradation has the potential to exacerbate the sovereign debt crises that have helped trigger, and deepen, the global economic downturn.
Yet despite this, such environmental risks remain largely absent from traditional models that determine sovereign credit ratings, and other traditional indicators of economic resilience.
“We are seeing a paradigm shift due to natural resource scarcities with profound implications for economies and, thus, sovereign debt risk worldwide,” said United Nations Under-Secretary-General and UNEP Executive Director Achim Steiner at the launch of the report in London.
“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,” said Mr. Steiner.
“More and more countries depend on a level of resource demand that exceeds what their own ecosystems can provide,” said Susan Burns, Founder of Global Footprint Network.
“This trend is tightening the 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,” added Ms. Burns.
Argentina, the United States and Eurozone states including Spain, Italy and Greece are among the countries that have seen their sovereign debt downgraded since 2011. The ramifications of downgrades on borrowing costs, coupled with the serious risks faced by banks and investors in exposure to sovereign debt, have led many experts to call for more refined risk indicators, which fully capture the economic realities of an increasingly resource-scarce 21st century.
To address this gap, the E-RISC report puts forward a new framework that aims to assess the likely risks connected to the planet’s depleting resources, and to allow for a more comprehensive insight into the stability of future national income.
New Methodology: E-RISC
Applied to five test countries (Brazil, France, India, Japan and Turkey), the new risk framework contained in the E-RISC report is based on a number of key indicators.
Central to the methodology is a country’s ‘Ecological Footprint’ (area of biologically productive land and water required to support the activities of a population), versus its ‘biocapacity’ (amount of productive area actually available to generate resources and absorb waste).
Footprint data, which focuses on renewable, biological resources such as fisheries, forests, cropland, grazing land, and the land needed to absorb CO₂ waste, is supplemented in the report with data on non-renewable resources such as fossil fuels, ores and minerals to provide a more comprehensive definition of natural resources.
The E-RISC methodology applies a 3-step approach to connect natural resource risks and its environmental consequences with mainstream macroeconomic indicators. This covers:
1. Trends in natural resource availability and use: patterns of natural resource consumption in comparison with the ability a country’s ecosystems to meet this demand
2. Exposure to resource risks: assessing the importance of natural resources to the country’s economy
3. Financial resilience to risks: ability of a country to cope with increases in commodity prices, or other adverse shocks related to natural resources.
Among its findings, the E-RISC report estimates that a 10 per cent variation in commodity prices can lead to changes in a country’s trade balance equivalent to over 0.5 per cent of GDP.
A 10 per cent fall in the productivity of natural resources, such as grazing land or forests, could force current trade imbalances to grow wider – equivalent to an additional 4 per cent of GDP – due mainly to a need for more imported goods.
The five pilot countries were chosen in consultation with participating financial institutions to provide variation in terms of natural resource use and economic performance.
Risk Profiles: Key Findings by Country
Brazil’s ecological footprint has tripled between 1961 and 2008, but the country’s ecosystems still generate more natural resources and services than its own population demands
Exposure to natural resource price volatility will continue to increase in coming years
Climate change may affect rainfall patterns and increase drought, reducing agricultural production in poorer regions
Sovereign debt levels are moderate, so Brazil is in a position to absorb negative shocks, although rising commodity prices pose a risk
France demands 1.4 times more from its ecological assets than they can sustainably provide. This gap has been growing at annual rate of over 1 per cent in past ten years
France is less vulnerable to changing commodity prices than the other countries studied, but is exposed to fossil fuel-related risks due to potential supply disruptions from imports
France has lower resilience to natural resource risks because of high levels of sovereign debt and budget deficits
India demands over 1.8 times more from its ecological assets than they can sustainably provide. This gap has been growing at annual rate of over 4.6 per cent in the past ten years
Deforestation, overgrazing, climate change and soil degradation are key risks
Access to energy is vital to the economy due to energy intensive industries such as steel-making and cement production
Due to population increases, an ever larger share of India’s natural resource needs will have to be met from abroad.
India has lower resilience to adverse resource price shocks due to its high budget deficit and high inflation rate.
Overuse of domestic ecological assets has tripled between 1961 and 2008
Japan met only 35 per cent of renewable natural resource needs domestically in 2008, compared to 73 percent in 1961
Increasing reliance on imports for fisheries, fuel, food, and agricultural products, exposes Japan to supply disruption risks
Economy is dominated by high-value added products, representing a lower vulnerability to changing commodity prices
High sovereign debt and government deficit give Japan little fiscal space to respond to natural resource price shocks
Turkey demands 1.5 times more from its ecological assets than they can sustainably provide. This gap has been growing at annual rate of 6 per cent in past ten years
Resource-intensive industries, e.g. textiles and food processing, constitute a large part of the economy
Water scarcity, desertification and land degradation pose major risks
Water crop demand is set to rise by 20 per cent by 2050, yet severe water shortages are expected due to climate change
Resilience to resource shocks is helped by moderate government debt levels
The E-RISC report is based on data from Global Footprint Network’s National Footprint Accounts and UNCTAD data on non-renewable resources. The report presents a weighted numerical ‘score’ representing the natural resource risks faced by the five pilot countries.
Although the framework presented in the report is only an initial step, it represents an important first look into developing standardized methods to clarify the linkages between natural resource changes, and financial and economic risks, at the country level.
The authors encourage credit ratings agencies, asset managers, asset owners and others to develop the pilot methodology into a usable and standardized tool for broad investment analysis, which more fully captures countries’ potential exposure to natural resource risks.
The development of such indicators must go hand-in-hand with concrete actions by governments to promote more sustainable methods of production and consumption, thereby reducing pressures on natural resources, and their related financial risks.
The report identifies a number of efforts by national governments to better understand how rising resource constraints are impacting economic security and citizens’ well-being.
The Philippines has launched the first national Ecological Footprint network in Southeast Asia
Costa Rica has featured the Ecological Footprint in its 2011 State of the Nation report; an overview of national social, economic and environmental issues
Ecuador has committed to keeping the country’s Ecological Footprint below the available capacity of its natural resources as part of its National Development Plan