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E-RISC: a New Angle on Sovereign Credit Risk Job Number: DTI/1618/GE

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E-RISC: a New Angle on Sovereign Credit Risk Job Number: DTI/1618/GE Phase 1 Report www.unep.org United Nations Environment Programme P. O. Box 30552 Nairobi, Kenya Tel.: 254 20 62 1234 Fax: 254 20 62 3927 E-mail: [email protected] A New Angle on Sovereign Credit Risk E-RISC: Environmental Risk Integration in Sovereign Credit 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 over 200 financial institutions that are signatories to the UNEP FI Statement on Sustainable Development, and a range of partner organisations, 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 realise the adoption of best environmental and sustainability practice at all levels of financial institution operations. Global Footprint Network Global Footprint Network is an international think tank working to advance sustainability through the use of the Ecological Footprint, a resource accounting tool that measures how much nature we have, how much we use and who uses what. Global Footprint Network coordinates research, develops methodological standards and releases annual data on the Ecological Footprint and biocapacity of 232 countries and humanity as a whole. By providing robust resource accounts to track the supply of and demand on ecological assets, Global Footprint Network equips decision-makers with the data they need to succeed in a world facing tightening ecological constraints. Disclaimer Unless expressly stated otherwise, the opinions, findings, interpretations and conclusions expressed in the paper are those of the various contributors. They do not necessarily represent the decision or the stated policy of the United Nations Environment Programme, nor the views of UNEP, the United Nations or its Member States. Neither do they represent the consensus views of the member institutions of UNEP FI. The designations employed and the presentation of material in this paper do not imply the expression of any opinion whatsoever on the part of the United Nations Environment Programme concerning the legal status of any country, territory, city or area or of its authorities, or concerning delimitation of its frontiers or boundaries. Design: Instaprint, Geneva Published in 2012 by UNEP FI and Global Footprint Network Copyright © UNEP FI, Global Footprint Network UNEP Finance Initiative International Environment House 15, Chemin des Anémones 1219 Châtelaine, Genève Switzerland Tel: (41) 22 917 8178 Fax: (41) 22 796 9240 [email protected] www.unepfi.org UNEP promotes environmentally sound practices Printed in Switzerland by Instaprint using vegetable-oil-based inks and FSC- (Forest Stewardship Council-) certified, elemental-chlorine- globally and in its own activities. This free paper. Permanent use of Stacatto random rastering enables publication is printed on 100% recycled paper, an ink-use reduction of 25 per cent, and a central water filtering plant reduces water and alcohol consumption by 75 per cent. using vegetable-based inks and other eco- friendly practices. Our distribution policy aims to reduce UNEP’s carbon footprint. Key Messages Sovereign bonds represent over 40 per cent of This report addresses how and why natural the global bond market, and are therefore one resource and environmental risks are becoming of the most important asset classes held by financially material for sovereign credit risk, investors around the world. At the end of 2010, not just in the medium term, but even in the outstanding sovereign debt was equal to USD 41 short run. The E-RISC (Environmental Risk trillion. Sovereign bonds have traditionally been in Sovereign Credit analysis) methodology considered a reliable and risk-free investment focuses on the development of metrics and of choice by fund managers. Since 2008, this methods for quantifying natural resource and perception is being increasingly challenged. environmental risks so they can be incorporated into sovereign credit risk assessments. A growing group of investors is recognising the This initiative focused on one key piece: to need for a broader understanding of emerging demonstrate the potential materiality of natural risks in the bond markets. Furthermore, there resource and environmental risks in the context is growing concern over the mounting threat of of sovereign credit risk analysis, which can systemic risks outside of the financial system, affect the underlying value of sovereign bonds. notably environmental risk, which can impact multiple financial markets. The methodology relies on the Ecological Footprint and biocapacity metrics to assess Natural resources, both renewable, biological a country’s resource situation in order to resources such as food and fiber, and non- identify how these risks might affect sovereign renewable resources such as fossil fuels, credit risk. The traditional focus on renewable ores and minerals, are critical to each nation’s biological resources by Global Footprint economy. Yet, to date, risks stemming from Network (such as fisheries, forests, cropland renewable resources in particular are not and grazing land) is supplemented with data well considered in sovereign credit risk on non-renewable natural resources including assessments. As resource constraints tighten fossil fuels, metals and minerals to provide globally, countries that depend, in net terms, a more comprehensive definition of natural on levels of renewable natural resources and resources. services beyond what their own ecosystems can provide may experience profound economic The method and metrics developed in the impacts as resources become more unreliable E-RISC project lay the foundations for enhanced or costly. analytics that can account for the growing materiality of natural resource constraints for Traditional sovereign credit risk analysis sovereign credit risk. appears to inadequately reflect pressures from increasing global natural resource scarcity, environmental degradation and vulnerability to climate change impacts. Five countries – Brazil, France, India, Japan and Results of the E-RISC project show risks Turkey – were analysed, based on consultations related to natural resource constraints and with the participating financial institutions. The their broader environmental consequences methodology should be regarded as a first can exhibit significant risks for the five step to link natural resource risks to sovereign countries studied over both short (0 – 5 years) credit risk, not a final product. Methodological to medium-term (5 -10 years) time frames. This enhancements of the E-RISC approach applied contradicts the conventional belief that natural to a larger number of countries will provide a resources risks are only relevant in the long more comprehensive overview. The first phase term. of the E-RISC project provide the following Countries have quite distinct environmental results: and natural resource risk profiles. Resource A 10 per cent variation in commodity prices dependence and exposure to price volatility can lead to changes in a country’s trade vary by factors of more than two, whereas balance equivalent to between 0.2 and 0.5 exposure to degradation effects varies by per cent of a nation’s GDP. Given the recent more than fourfold among the five case study fluctuations in commodity prices investors countries analysed. Furthermore there is no should take note of these issues in the short correlation between resource exposure and term (0 – 5 years). sovereign credit ratings or credit default swaps. A 10 per cent reduction in the productive Fixed income investors, credit rating capacity of renewable, biological resources, agencies and governments are encouraged and assuming that consumption levels remain to identify not only how natural resource and the same, could lead to a reduction in trade environmental risks can be integrated into balance equivalent between 1 and over 4 per sovereign risk models and but also which cent of a nation’s GDP. Given the growing solutions can address them. 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. France (AA+ / 97.5) Japan (AA- / 70) Brazil (BBB / 107) India (BBB- / 326) Turkey (BB / 142.50) 1 0 -1 -2 -3 % of Gross Domestic Product -4 A) Effect of 10% price volatility on trade balance B) Effect of 10% degradation of productive capacity on trade balance The X-axis shows sovereign credit ratings (foreign currency) for five countries (source: S&P) and sovereign credit default swaps (source: Markit). Sources for data shown on Y-axis: A) Global Footprint Network calculations based on UNCTAD data for 2010; B) Global Footprint Network calculations 4 UNEP FI A New Angle on Sovereign Credit Risk Foreword Achim Steiner Susan Burns UN Under-Secretary General and UNEP Founder and Senior Vice-President Executive Director Global Footprint Network Rising natural resource prices and increasing levels More and more countries depend on a level of resource of ecosystem degradation alongside the impacts of demand that exceeds what their own ecosystems can climate change are already affecting countries in both provide. This trend is tightening the global competition the developing and the developed world alike. These for the planet’s limited resources – and puts at risk the issues are relevant
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