The sovereign transition to sustainability

countries-must-protect-their-natural-capital

February 5, 2020

Understanding the dependence of sovereign debt on nature

Executive Summary

KEY MESSAGES

In the 2020s sovereign bonds will face the strategic challenge of achieving alignment with the Sustainable Development Goals.
Agriculture and the soft commodity trade are heavily linked to natural capital, as drivers of depletion and as processes reliant on a secure stream of ecosystem services.
The value of sovereign bonds relies in part on the management of natural capital by the countries concerned. However, this dependency is still largely ignored or mispriced in sovereign bond markets.
Pressures to achieve alignment between sovereign bonds and environmental sustainability are set to intensify in the decade ahead, with increasing focus on sovereign bonds as an asset class which connects macro-economic performance and capital markets.
To enable analysts to integrate the value of natural capital into the issuance, analysis and stewardship of sovereign bonds, we have developed a new research framework.
This identifies Argentina and Brazil as the G20 countries most dependent on natural capital for their exports. We estimate that 28 per cent of Argentina’s sovereign bonds and 34 per cent of Brazil’s sovereign bonds will be exposed to an anticipated tightening of climate and anti-deforestation policy in the 2020s, while 44 per cent and 22 per cent of their sovereign bonds, respectively, are exposed to changes in policy after 2030.
Sovereign bond issuers face a choice: either following a High Road scenario where countries actively protect and enhance the benefits of natural capital and reinforce the environmental fundamentals of sovereign bonds, or a Low Road scenario where business-as-usual undermines flows of ecosystem services, increases vulnerability to natural disasters and intensifies market risks.
For sovereign bonds to develop the required resilience in the disruptive decade that lies ahead, decisive action is needed from issuers, investors, credit rating agencies and international institutions, as well as researchers and civil society, to ensure the full value of nature is incorporated.

The 2020s: a decisive decade for sovereign bonds and sustainability

Sovereign bonds are one of the largest asset classes with an outstanding global value of
US$66 trillion. They are also one of the most systemic asset classes: sovereign bonds capture a range of macro-economic factors, influence broader capital market pricing and
system stability and are core holdings for financial institutions. Institutional investors and credit rating agencies are deepening their focus on the link between sovereign bond performance and environmental, social and governance (ESG) criteria. Academic literature is starting to highlight the key relationships between ESG considerations, climate policy and sovereign debt, and the market for sovereign green bonds is growing. The consideration of ESG factors in sovereign bonds is set to experience a step-change in the coming decade. 2030 is the deadline for the achievement of the Sustainable Development Goals (SDGs), as well as for cutting global greenhouse gas emissions by
45 per cent from 2010 levels to meet the Paris Agreement temperature target. While private sector action is vital for reducing natural capital loss, companies and their investors alone cannot address these risks without active government support.

Governments will play a critical role in the transition to a sustainable economy, by
setting whole-economy policy frameworks, and by deploying public finance, which is where the issuance of public debt through sovereign bonds becomes crucial. The task
ahead is for countries to achieve ‘sovereign health’, which we define as their capacity
to issue debt and repay it in a manner consistent with achieving the SDGs. This means recognising and valuing the fundamental dependencies of sovereign bonds on natural capital, which are currently ignored and mispriced, thereby storing up instabilities in the future.

Focusing on the linkages between sovereign bonds and ecosystem services from land

To better understand the strategic case for the structural incorporation of natural capital into the issuance, assessment and stewardship of sovereign bonds, we focus on a hitherto ignored aspect: the importance for sovereign bonds of reliable flows of ecosystem services from land.

In the past, countries with abundant natural capital have often increased agricultural
production at the expense of environmental quality (for example, through deforestation).
This practice risks damaging the flow of vital ecosystem services such as clean water and flood regulation, increasing the vulnerability to climate risks and raising the likelihood of asset-stranding as a transition is made towards a sustainable economy. For sovereign bonds, the crystallisation of these risks could lead to higher borrowing costs, impairments in credit quality and reductions in their access to finance.

We expect the interconnectedness of the nature conservation and climate change agendas to gain increasing traction among sovereign bond investors. The investor-led
Inevitable Policy Response (IPR) initiative, for example, forecasts an abrupt intensification of climate policies from the early 2020s onwards, and a range of new policies, including effective carbon markets that incentivise ambitious policies that end deforestation by 2030.

Assessing natural capital and sovereign health linked to soft commodities in the G20

For sovereign bonds, the task is to understand how natural capital factors can be incorporated into core analytical models. We have done this by building on traditional
credit rating frameworks used for evaluating sovereign bonds to identify the chain of
impact between natural capital and five key types of factor: institutional, economic,
external, political/hazard event risk and fiscal. The framework is set out in Figure S1
(p5 of the full report), highlighting the potentially material natural capital elements.

We used this framework to assess the natural capital performance of G20 countries, focusing particularly on land and climate change. From this, we identify Argentina and Brazil as the two G20 countries most dependent on natural capital for their exports. It is estimated that between 2005 and 2013 cattle ranching drove 72 per cent and soy
production 10 per cent of deforestation in Argentina; for Brazil cattle ranching drove 46
per cent and soy 33 per cent of deforestation. As soy production follows and displaces cattle ranching, their related natural capital losses go hand in hand.

Ongoing natural capital depletion will bring production risks for these two countries.
Deforestation and current management systems are expected to cause reductions in
agricultural yield via changes in rainfall driven by both local land use change and global
climate change, degradation of soil quality and fertility, reductions in biodiversity and
increased exposure to natural disasters. These risks have economic and fiscal impacts
that will affect the countries’ risk profiles, cost of capital and access to international
commodity and financial markets.

Preventing and reversing natural capital loss driven by the production of soft commodities (agricultural, forestry and fishery products) will benefit sovereign bond issuers through two channels: first, by maintaining and enhancing the flow of ecosystem services such as soil fertility, clean water and flood regulation, which sustain internal production capacity while increasing ecosystem resilience; and second, by positioning sovereign bond issuers to benefit from anticipated changes in international policy aiming to preserve natural capital. Both channels will improve the economic performance, credit profile and debt-paying capacity of these countries.

Countries dependent on natural capital face a strategic choice

Sovereign bond issuers dependent on natural capital, such as Argentina and Brazil, face two distinct choices:

1. The first option is a ‘High Road’ scenario, where countries actively protect and enhance the benefits that natural capital brings to their economies. This will underpin the long-term value of their sovereign bonds, building resilience against both the physical impacts of climate change and disruptive changes in policy and market preferences. Ultimately, such a transition will also secure long-term access to the finance these countries require to pursue their sustainable development goals.

2. The second option is a ‘Low Road’ scenario, where a continuation with current
practices undermines flows of ecosystem services, increases vulnerability to natural
disasters and intensifies market risks. Natural-capital-dependent countries that take this path would face reduced access to export markets that scrutinise environmental performance in terms of consumer preferences and trade policy. They could also miss out on significant opportunities from the shift to a sustainable global economy in terms of
the prospect of international payments via carbon markets. These risks will be increasingly evaluated by sovereign bond investors and incorporated into pricing.

Recommendations for decisive action and next steps

This is a first framework for understanding the links between sovereign bonds and natural capital, focusing on the ecosystem services that support major soft commodity producers. Considerable further work is needed within affected countries and internationally. To realise the potential of the High Road scenario for sovereign bonds, the following key players need to take decisive action:

Governments/sovereign issuers

Governments should strengthen their institutional framework to align it with the management and regeneration of natural capital. Policies should be accompanied by consistent monitoring and enforcement, as well as sufficient fiscal support.
Governments should issue green sovereign bonds that raise funds for investment in natural capital that endures over the long term. There is currently unmet domestic and international investor demand for well-designed green sovereign bonds.

Investors

Investors should strengthen their analytical framework to better identify the relationships between sovereign issuers’ natural capital and their future debt-paying
capacity. In particular, investors should recognise instances where incentives for
economic performance today are jeopardising their future sovereign health.

Investors should enhance their stewardship role with regard to sovereign bonds in
their portfolios, particularly those issued by high natural-capital-stock countries.
Engagement with the issuers of sovereign bonds on natural capital performance can help to signal the materiality of natural capital factors and identify the key data points requiring disclosure. In contrast to corporates, there is currently no consistent framework for sovereign issuers to report their climate or wider natural capital positioning or performance.

Credit rating agencies

Credit rating agencies should explicitly incorporate the links between the health of natural capital and the outlook for of natural capital factors is of particular relevance given the increasing role that environmental sustainability will play in economic development, exports and fiscal performance.

International financial institutions and coalitions

Multilateral development banks (MDBs) should incorporate natural capital factors in their work, building on experience with the integration of climate change. MDBs can be an important source of both finance and strategic expertise for natural capital-dependent economies. They can provide finance for country-driven action to invest in natural capital, as well as technical assistance in the integration of natural capital factors in government budgeting and sovereign debt issuance.
International institutions charged with overseeing the stability and functioning
of the financial system should broaden their scope to include natural capital
factors. The International Monetary Fund and Financial Stability Board have started
work to evaluate the implications of climate change for their operations; this could be extended to the wider issues of biodiversity and natural capital. Coalitions such as the Network for Greening the Financial System could also explore the role of central banks and supervisors in incorporating natural capital in sovereign bond risk analysis, not least in their own portfolios.

Researchers

Researchers in government agencies, universities and civil society can build on
the findings presented here to deepen the understanding of the dynamics between
sovereign bonds and nature. Within the rich agenda for future research there
is a need to conduct analysis in other countries and examine other dimensions
of the links between natural capital and sovereign bonds