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The sovereign transition to sustainability Understanding the dependence of sovereign debt on nature Alexandra Pinzón and Nick Robins with Matthew McLuckie and Gabriel Thoumi
The Grantham Research Institute on Climate Change and the Environment
was established in 2008 at the London School of Economics and Political Science.
The Institute brings together international expertise on economics, as well as
finance, geography, the environment, international development and political
economy to establish a world-leading centre for policy-relevant research,
teaching and training in climate change and the environment. It is funded
by the Grantham Foundation for the Protection of the Environment, which
also funds the Grantham Institute – Climate Change and the Environment
at Imperial College London. www.lse.ac.uk/grantham/
Planet Tracker is a non-profit financial think tank aligning capital markets with
planetary limits. It was launched in 2018 by the Investor Watch Group whose
founders, Mark Campanale and Nick Robins, created the Carbon Tracker Initiative.
Planet Tracker was created to investigate market failure related to ecological
limits. This investigation is for the investor community where, in contrast to climate
change, other ecological limits are poorly understood and even more poorly
communicated, and not aligned with investor capital. https://planet-tracker.org/
About the authors
Alexandra Pinzón is a policy fellow in conservation finance at the Grantham
Research Institute.
Nick Robins is professor in practice for sustainable finance at the Grantham
Research Institute.
Matthew McLuckie is director of research at Planet Tracker.
Gabriel Thoumi is director of financial markets at Planet Tracker.
Acknowledgements: This report benefited from the comments of Giles Atkinson,
Chris Baldock, Archie Cage, Maria Cantore, José A. Clavijo Michelangeli, Patrice
Cochelin, Ben Combes, Pablo Cortinez, Rupert Edwards, Sam Fankhauser, Patrick
Faul, Greg Fishbein, Felipe Gordillo, Kathy Hochstetler, Mike Hugman, Dalia A.
Kader, Justin Kew, Olha Krushelnytska, Raj Kundra, Juliana Lopes, Claudio Lutzky,
Fergus McCormick, Mariana Micozzi, John Palmisano, Joseph Potvin, Samantha
Power, Dirk Price, Tiago Reis, Diego Sueiras, Nitin Sukh, Lauren van Biljon, Peeyush
Varshney, John Waugh, Vikram Widge, Heather Wright and Ming Yang.
Editing and production management by Georgina Kyriacou.
This report was first published in January 2020 by the Grantham Research
Institute on Climate Change and the Environment and Planet Tracker.
© The authors, 2020
Permissions requests should be directed to the Grantham Research Institute.
Declaration of conflict of interest: The authors declare: funding from the
Gordon and Betty Moore Foundation through the Finance Hub for the submitted
work; Nick Robins had financial support from the Grantham Foundation for the
submitted work; Matthew McLuckie and Gabriel Thoumi had financial support
from the Gordon and Betty Moore Foundation for the submitted work; no other
relationships or activities that could appear to have influenced the submitted work.
This policy report is intended to inform decision-makers in the public, private
and third sectors. It has been reviewed by internal and external referees before
publication. The views expressed in this report represent those of the authors
and do not necessarily represent those of the host institutions or funders.
This report is funded by the Gordon and Betty Moore Foundation through
the Finance Hub, which was created to advance sustainable finance.
Suggested citation: Pinzón A and Robins N with McLuckie M and Thoumi G (2020) The sovereign transition to sustainability: Understanding
the dependence of sovereign debt on nature. London: Grantham Research Institute on Climate Change and the Environment, London
School of Economics and Political Science, and Planet Tracker.
Contents
Executive summary 4
1. Introduction 9
Natural capital and sovereign debt investing – what are credit
rating agencies and investor groups doing already? 9
Natural capital: an emerging interest for sovereign investors 11
Structure of the report 11
2. Natural capital and the sovereign health model 12
Summary points 12
The impact of agriculture and soft commodity trading on natural capital 12
Domestic and macroeconomic impacts of the impairment of natural capital 12
Balancing natural capital, agriculture and societal welfare 13
Assessing sovereign health: setting out the model 13
Stocktake of natural capital and risks in the G20 14
Shifts in policy in response to the accumulating risks to natural capital 19
3. Argentina: Natural capital and sovereign health 22
Summary points 22
Context: Argentina’s financial situation and sustainable finance agenda 22
Emerging sovereign health risks in Argentina 25
Argentina at a crossroads: what are its choices? 28
4. Brazil: Natural capital and sovereign health 30
Summary points 30
Context: Environmental policy, green finance, debt and the importance
of agribusiness in Brazil 31
Emerging sovereign health risks in Brazil 32
Brazil at a crossroads: what are its choices? 36
5. Conclusions and recommendations 38
Strategic choices for sovereign issuers 38
Building an agenda for further research 39
Recommendations for immediate action 40
References 42
Appendix: Data on natural capital and natural hazard risks in the G20 44
The sovereign transition to sustainability 3
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 the achievement of the Sustainable
sovereign bonds and sustainability Development Goals (SDGs), as well as for
cutting global greenhouse gas emissions by
Sovereign bonds are one of the largest asset 45 per cent from 2010 levels to meet the Paris
classes with an outstanding global value of Agreement temperature target. While private
US$66 trillion. They are also one of the most sector action is vital for reducing natural
systemic asset classes: sovereign bonds capital loss, companies and their investors
capture a range of macro-economic factors, alone cannot address these risks without
influence broader capital market pricing and active government support.
Sovereign health: system stability and are core holdings for Governments will play a critical role in the
The capacity of
countries to issue
financial institutions. Institutional investors transition to a sustainable economy, by
debt and repay it in and credit rating agencies are deepening setting whole-economy policy frameworks,
a manner consistent their focus on the link between sovereign and by deploying public finance, which is
with achieving bond performance and environmental, social where the issuance of public debt through
the Sustainable and governance (ESG) criteria. Academic sovereign bonds becomes crucial. The task
Development Goals
literature is starting to highlight the key ahead is for countries to achieve ‘sovereign
Natural capital: relationships between ESG considerations, health’, which we define as their capacity
The stock of renewable climate policy and sovereign debt, and the to issue debt and repay it in a manner
and non-renewable market for sovereign green bonds is growing. consistent with achieving the SDGs.
assets from which
humans derive
The consideration of ESG factors in sovereign This means recognising and valuing the
benefits through bonds is set to experience a step-change in fundamental dependencies of sovereign
ecosystem services the coming decade. 2030 is the deadline for bonds on natural capital, which are currently
4 The sovereign transition to sustainability
EXECUTIVE SUMMARY
Figure S1. The natural capital and sovereign health model
TRADITIONAL CREDIT NATURAL CAPITAL LINKS
RATING FACTORS TO SOVEREIGN HEALTH
1. Institutional assessment ENVIRONMENTAL GOVERNANCE: Environmental policy,
Policymaking and political such as Nationally Determined Contributions, natural capital
institutions protections policies – i.e. no deforestation, use of fires,
Transparency and accountability input control, protected species – and their implementation,
Debt payment culture monitoring and enforcement.
LOST PRODUCTION AND INCREASED VULNERABILITY VIA
2. Economic assessment
SOVEREIGN ISSUER CREDIT RATING
NATURAL CAPITAL IMPACTS: Changes in production
Gross domestic product capacity due to natural capital loss from soil and water
Inflation degradation, changes in agro-ecologic zones for production,
Monetary base increased vulnerability to natural disasters and climate
impacts, and potential breakdown in ecosystem services.
LOST MARKETS FOR NATURAL CAPITAL-INTENSE PRODUCTS:
3. External assessment Changes in current account revenues from natural capital-
Current account receipts intense products such as soft commodities at risk from
and payments more stringent environmental policies and natural capital
External debt degradation/climate change. Subsequent impact on exchange
rates and debt profile.
4. Political and hazard LOST PRODUCTION AND WELFARE DUE TO FREQUENT
event risk NATURAL DISASTERS: Economic, social and environmental
Political risk losses due to greater impact from and potentially higher
Natural disasters frequency of natural disasters.
FISCAL BALANCE DETERIORATION TO SUSTAIN
5. Fiscal assessment WELFARE IN THE MIDST OF SHOCKS: Changes in tax
Affected Debt and government revenues and expenditure as a result of changes in
by 1, 2, 3 debt/GDP production capacity, reduction in external markets, and
and 4 Net financial assets losses linked to greater political and hazard event risk.
Cost of infrastructure to replace ecosystem services.
Source: Authors
ignored and mispriced, thereby storing This practice risks damaging the flow of vital
up instabilities in the future. ecosystem services such as clean water and
flood regulation, increasing the vulnerability
Focusing on the linkages between to climate risks and raising the likelihood of
sovereign bonds and ecosystem asset-stranding as a transition is made
services from land towards a sustainable economy. For sovereign
bonds, the crystallisation of these risks could
To better understand the strategic case lead to higher borrowing costs, impairments
for the structural incorporation of natural in credit quality and reductions in their access
capital into the issuance, assessment and to finance.
stewardship of sovereign bonds, we focus We expect the interconnectedness of the
on a hitherto ignored aspect: the importance nature conservation and climate change
for sovereign bonds of reliable flows of agendas to gain increasing traction among
ecosystem services from land. sovereign bond investors. The investor-led
In the past, countries with abundant natural Inevitable Policy Response (IPR) initiative, for
capital have often increased agricultural example, forecasts an abrupt intensification
production at the expense of environmental of climate policies from the early 2020s
quality (for example, through deforestation). onwards, and a range of new policies,
The sovereign transition to sustainability 5
EXECUTIVE SUMMARY
including effective carbon markets that external, political/hazard event risk and
incentivise ambitious policies that end fiscal. The framework is set out in Figure S1
deforestation by 2030. (p5), highlighting the potentially material
natural capital elements.
Assessing natural capital and We used this framework to assess
sovereign health linked to soft the natural capital performance of G20
commodities in the G20 countries, focusing particularly on land
and climate change. From this, we identify
For sovereign bonds, the task is to Argentina and Brazil as the two G20
understand how natural capital factors can countries most dependent on natural capital
be incorporated into core analytical models. for their exports (see Table 1 for summary).
We have done this by building on traditional It is estimated that between 2005 and 2013
credit rating frameworks used for evaluating cattle ranching drove 72 per cent and soy
sovereign bonds to identify the chain of production 10 per cent of deforestation in
impact between natural capital and five Argentina; for Brazil cattle ranching drove 46
key types of factor: institutional, economic, per cent and soy 33 per cent of deforestation.
Table S1. Sovereign health and natural capital assessment for Argentina and Brazil
ARGENTINA BRAZIL
1. Environmental governance: Yale Environmental Environmental governance: Environmental
Institutional Performance Index ranking of 74 out of 180, Performance Index ranking of 69 out of 180,
assessment Climate Action Tracker defines NDC highly Climate Action Tracker defines NDC as
insufficient, native forest loss 3 million-plus insufficient, Amazon deforestation of around
hectares from 2007–17, with 24% deforestation 9 million hectares from 2007–18, Cerrado
in high and medium conservation value forest. deforestation of 12 million-plus hectares.
Deforestation linked to cattle and soy. Deforestation linked to cattle and soy. Forest
Code developed, full implementation needed.
2. Lost production via natural capital impacts: Lost production via natural capital impacts:
Economic 0.1% annual soybean production loss associated Literature predicts a potential 33% reduction
assessment with soil degradation-induced yield reductions, in soybean yield by 2050 and a potential 6%
equivalent to approx. US$13.7 million. Significantly reduction in Mato Grosso’s soybean production
higher at full agricultural level. under ongoing deforestation scenarios. Between
0.06% and 0.1% of soy production value at risk
from soil degradation.
3. Lost markets for natural-capital-intense Lost markets for natural-capital-intense
External products: 4.8% of Argentina’s soy exports and products: Around 9% of Brazilian soy exports
assessment 0.18% of beef exports could be at risk from more (by value) are at risk from the impacts of
stringent deforestation policy with a potential deforestation or other natural capital conversion.
global market loss under deforestation bans.
4. Lost production and welfare impacts due Lost production and welfare impacts due
Hazard to frequent natural disasters: US$3.9 billion to frequent natural disasters: 20% of gross
event risk harvest loss due to drought in 2017–18 season. agricultural production value under long-term
Floods with a loss of US$1.7 billion in 2017 and droughts in the North East. Reduction in yields
US$2 billion in 2019. Drought in 2018 caused a after floods. Losses of US$9 billion/year due to
reduction of 0.85% GDP. natural disasters.
5. Fiscal balance deterioration to sustain Fiscal balance deterioration to sustain welfare
Fiscal welfare in the midst of shocks: US$1.7 billion in the midst of shocks: Agricultural production
assessment government revenue estimated at risk under loss brings government revenues equivalent to
zero-deforestation international trade. US$1.7 18% of production value, which can be lost
billion in tax revenue lost due to 2018 drought. proportionally with reduced production. Reduction
of 33% in soybean yield in Mato Grosso (in a high
deforestation scenario) could cause a loss
equivalent to 0.1% of federal tax receipts.
Note: NDC = nationally determined contribution [to the Paris Agreement].
Source: Authors
6 The sovereign transition to sustainability
EXECUTIVE SUMMARY
As soy production follows and displaces They could also miss out on significant
cattle ranching, their related natural capital opportunities from the shift to a
losses go hand in hand. sustainable global economy in terms of
Ongoing natural capital depletion will bring the prospect of international payments
production risks for these two countries. via carbon markets. These risks will be
Deforestation and current management increasingly evaluated by sovereign bond
systems are expected to cause reductions in investors and incorporated into pricing.
agricultural yield via changes in rainfall driven
by both local land use change and global Recommendations for decisive action
climate change, degradation of soil quality and next steps
and fertility, reductions in biodiversity and
increased exposure to natural disasters. This is a first framework for understanding the
These risks have economic and fiscal impacts links between sovereign bonds and natural
that will affect the countries’ risk profiles, capital, focusing on the ecosystem services
cost of capital and access to international that support major soft commodity producers.
commodity and financial markets. Considerable further work is needed within
Preventing and reversing natural capital affected countries and internationally.
loss driven by the production of soft To realise the potential of the High Road
commodities (agricultural, forestry and scenario for sovereign bonds, the following
fishery products) will benefit sovereign key players need to take decisive action:
bond issuers through two channels: first,
by maintaining and enhancing the flow of Governments/sovereign issuers
ecosystem services such as soil fertility, clean • Governments should strengthen their
water and flood regulation, which sustain institutional framework to align it with the
internal production capacity while increasing management and regeneration of natural
ecosystem resilience; and second, by capital. Policies should be accompanied
positioning sovereign bond issuers to benefit by consistent monitoring and enforcement,
from anticipated changes in international as well as sufficient fiscal support.
policy aiming to preserve natural capital. • Governments should issue green sovereign
Both channels will improve the economic bonds that raise funds for investment in
performance, credit profile and debt-paying natural capital that endures over the long
capacity of these countries. term. There is currently unmet domestic
and international investor demand for
Countries dependent on natural well-designed green sovereign bonds.
capital face a strategic choice
Investors
Sovereign bond issuers dependent on • Investors should strengthen their analytical
natural capital, such as Argentina and framework to better identify the
Brazil, face two distinct choices: relationships between sovereign issuers’
1. The first option is a ‘High Road’ scenario, natural capital and their future debt-paying
where countries actively protect and capacity. In particular, investors should
enhance the benefits that natural capital recognise instances where incentives for
brings to their economies. This will economic performance today are
underpin the long-term value of their jeopardising their future sovereign health.
sovereign bonds, building resilience • Investors should enhance their stewardship
against both the physical impacts of role with regard to sovereign bonds in
climate change and disruptive changes in their portfolios, particularly those issued
policy and market preferences. Ultimately, by high natural-capital-stock countries.
such a transition will also secure long-term Engagement with the issuers of sovereign
access to the finance these countries bonds on natural capital performance can
require to pursue their sustainable help to signal the materiality of natural
development goals. capital factors and identify the key data
2. The second option is a ‘Low Road’ scenario, points requiring disclosure. In contrast to
where a continuation with current corporates, there is currently no consistent
practices undermines flows of ecosystem framework for sovereign issuers to report
services, increases vulnerability to natural their climate or wider natural capital
disasters and intensifies market risks. positioning or performance.
Natural-capital-dependent countries that
take this path would face reduced access Credit rating agencies
to export markets that scrutinise • Credit rating agencies should explicitly
environmental performance in terms of incorporate the links between the health
consumer preferences and trade policy. of natural capital and the outlook for
The sovereign transition to sustainability 7
EXECUTIVE SUMMARY
sovereign credit ratings. Incorporation their scope to include natural capital
of natural capital factors is of particular factors. The International Monetary Fund
relevance given the increasing role that and Financial Stability Board have started
environmental sustainability will play work to evaluate the implications of climate
in economic development, exports and change for their operations; this could be
fiscal performance. extended to the wider issues of biodiversity
and natural capital. Coalitions such as the
International financial institutions Network for Greening the Financial System
and coalitions could also explore the role of central banks
• Multilateral development banks (MDBs) and supervisors in incorporating natural
should incorporate natural capital factors capital in sovereign bond risk analysis, not
in their work, building on experience with least in their own portfolios.
the integration of climate change. MDBs
can be an important source of both Researchers
finance and strategic expertise for natural- • Researchers in government agencies,
capital-dependent economies. They can universities and civil society can build on
provide finance for country-driven action the findings presented here to deepen the
to invest in natural capital, as well as understanding of the dynamics between
technical assistance in the integration sovereign bonds and nature. Within the
of natural capital factors in government rich agenda for future research there
budgeting and sovereign debt issuance. is a need to conduct analysis in other
• International institutions charged with countries and examine other dimensions
overseeing the stability and functioning of the links between natural capital and
of the financial system should broaden sovereign bonds.
8 The sovereign transition to sustainability
1. Introduction
The transition to sustainability is the strategic challenge sovereign The relationship between natural capital
bonds face in the 2020s. Overcoming this challenge requires and the performance of sovereign bonds
that the financial system recognises the fundamental economic is rising rapidly up the investor agenda.
dependencies on nature, which are currently ignored and From issuers through credit rating agencies
mispriced, storing up instabilities for the future. to asset managers and asset owners,
a range of strategies is being deployed
Sovereign health: This report examines the case for the to incorporate environmental, social and
The capacity of structural inclusion of natural capital into governance (ESG) factors into the analysis,
countries to issue
the issuance, assessment and stewardship selection and stewardship of sovereign
debt and repay it in
a manner consistent of sovereign bonds. We make this case by bonds. To date, understanding the impact
with achieving focusing on a hitherto overlooked aspect: of environmental factors on the cost of
the Sustainable the importance for sovereign bonds of sovereign debt has focused on the physical
Development Goals reliable flows of ecosystem services from risks associated with climate change,
Natural capital:
land. How successfully the world transitions highlighting that vulnerability to climate
The stock of renewable to a sustainable economy will impact on change has a positive and significant effect
and non-renewable countries that rely on land-based natural on sovereign bond yields.
assets from which capital for their economy.
humans derive We provide an analytical framework Credit rating agencies
benefits through
ecosystem services
for evaluating the chain of impact between So far efforts from credit rating agencies
natural capital factors and the health of have centred on the transmission channels
Soft commodities: sovereign bonds. This analytical framework between ESG factors and sovereign
Internationally traded helps support the case for urging key players creditworthiness. Moody’s, for example,
agricultural and forestry
in the sovereign bond space to look at these has examined the physical climate risks for
products, such as soy,
cotton, coffee, pulp risks in more detail. We focus on the G20 vulnerable nations and the transition risks
and paper, beef and and provide the case studies of Argentina for exporters of oil and gas (Moody’s Investor
palm oil, that cannot and Brazil, as countries with high Service, 2018). Credit rating agencies are
be stored for long dependency on soft-commodity exports starting to conduct ESG appraisals and
periods of time, unlike
and high natural capital stocks. outlooks at the country level. S&P Global has
hard commodities
such as gold, silver The report is the first in a series that will produced an ESG Risk Atlas that examines
and aluminium aim to understand the relationship between a broader set of factors at the country level
natural capital and the future prospects for (S&P Global, 2019). Furthermore, there are
sovereign bonds. It is a first step in mapping intensifying efforts to mainstream ESG
areas of risk for sovereigns dependent on analysis into sovereign credit ratings.
soft commodities for their economic success. However, these assessments have not yet
It is not intended to be a final or detailed addressed natural capital in a systematic
economic assessment of those risks or their way, particularly in terms of how ongoing
interactions. We anticipate this report will natural capital loss and the transition to a
encourage stakeholders in the sovereign sustainable economy will impact countries
bond market to analyse further alternatives that rely on land-based natural capital for
to assess and incorporate natural capital into their prosperity. Exploring how to fill this
their decision-making. gap is the focus of this report.
Natural capital and sovereign Investment managers and investors
debt investing – what are credit A growing number of investment managers
rating agencies and investor are also exploring the linkages. For
groups doing already? example, Verisk Maplecroft and BlueBay
Asset Management (2019) have published
Sovereign bonds are one of the largest research highlighting that markets are
asset classes in the financial system, with not yet pricing environmental or climate
an outstanding value of US$66 trillion in change risks into sovereign bonds. In fact,
international debt securities (PRI, 2019a). they find, markets seem to incentivise
Sovereign debt securities operate as a economic expansion at the expense of
benchmark for other issuers and, in some natural capital in those countries with
geographies, sovereign debt constitutes higher natural resource stocks (ibid).
the most liquid security. These securities, Hermes Asset Management has published
particularly when issued by developed analysis, aligning with existing literature,
economies, are also a reference for safety that points to the relevance of governance
in international capital markets. to explain sovereign credit default swap
The sovereign transition to sustainability 9
1. INTRODUCTION
(CDS) spreads, while social and environmental
Box 1.1. From the literature: Environmental, factors are apparently not yet incorporated
social and governance factors and sovereign risk into market pricing of sovereign credit risk
Below are examples of academic articles that assess the through the social (Reznick et al., 2019).
relationship between environmental, social and governance Most recently, BlackRock published its
(ESG) considerations and sovereign debt or between climate proposed ESG analysis for sovereign debt,
policy and sovereign debt. This is a relatively recent area of where extreme weather and natural capital
research and for this reason the literature is currently limited. depletion feature among the environmental
indicators; and control of corruption,
Borrowing costs: Crifo et al. (2017) have examined if extra- regulatory quality and rule of law are
financial performance matters for sovereign bonds markets included among the governance indicators
across 23 OECD countries. They used rating and research (BlackRock, 2019).
agency Vigeo Eiris’s sustainability country ratings as the main Investors have been exploring the links
independent variable to try to identify the relationship between between credit, sustainability and investment
ESG factors and sovereign yields, plus control variables including for the past few years, notably under the
economic and environmental indicators from the World Bank leadership of the UN-backed Principles
and from S&P’s credit ratings. Their results show that high for Responsible Investment (PRI) and its
ESG ratings are associated with lower borrowing costs, but credit risk and ratings initiative that aims
the effect of the ESG ratings on sovereign borrowing costs to incorporate ESG factors into credit
is about three times weaker than the effect of financial ratings. ratings. This work recognises that ESG
They conclude that while extra-financial information plays a role factors and risks related to resource
in investors’ assessment of risk, they use it as a supplement to management can affect countries’ tax
financial information. levels, trade balance and foreign investment
and highlights the commitment of credit
Sovereign spreads: Capelle-Blancard et al. (2017) have rating agencies to evaluating the credit
analysed the extent to which ESG performance affects sovereign relevance of ESG factors for different
bond spreads for 20 OECD countries. They find that country issuers. The PRI has published rating
ESG performance is significantly and negatively related to agencies’ views on the ways ESG factors
sovereign bond spreads, meaning that better ESG performance are incorporated into credit ratings
is associated with lower risk and borrowing costs. They conclude and updating this integration as their
that the relationship between country ESG performance and understanding evolves, maintaining
long-term sovereign bonds spreads is stronger than between resources to deliver high quality ratings,
a country’s ESG performance and short-term bonds spreads. and participating in industry efforts
When differentiating impact from various ESG dimensions, to incorporate ESG factors into credit
governance appears to have a stronger financial impact than ratings and into dialogues with investors
social criteria, and environmental performance seems to have to identify the role of these factors in
no impact. creditworthiness (PRI, 2019c).
The PRI has also issued a guide, building
Performance: Battiston and Monasterolo (2019) have on the research described above, outlining
presented a modular approach to the assessment of climate the strategic agenda for the integration
risks and opportunities and their impact on the default of ESG considerations into sovereign
probability of investors’ portfolios, focusing on the energy debt analysis (PRI, 2019a). In the guide,
sector. They consider the impact of climate policy scenarios the PRI highlights the need for investors
on countries’ debt to GDP ratio, expected economic growth to consider time horizons and materiality
and the value of 10-year sovereign bond spreads and sovereign as well as the resilience sovereign issuers
bond value. They apply their analysis to the sovereign bond may have to withstand environmental,
portfolio of the Austrian central bank with securities issued social or other external shocks. It
by OECD countries. The largest negative shocks on individual recommends that investors undertake
sovereign bonds correspond to Australia and Norway, given in-house country-level research and
the relevance of fossil fuels for their gross value added and develop materiality frameworks that
the projections from climate models regarding the future can highlight red flags and define the
participation of this sector. The greatest positive shocks need and process for engagement.
correspond to Austria and Southern Europe due to their larger While investors in sovereign bonds
share of renewable energy in their gross value added and the consider some ESG metrics in their
forecast trends for this market under specific climate scenarios. research, ESG integration is yet to be
Countries with a high share of nuclear energy do not show systematically applied in investment
positive impacts due to the expected large contribution of analysis for this asset class (PRI, 2019a).
nuclear under all climate policy forecasts considered. Latin The World Bank recently launched its
American sovereign bond values would be negatively impacted Sovereign ESG Data Portal to help investors
by climate policy shocks, with the extent of the impact varying align ESG analysis with sustainable
by issuer. development policy indicators, increase
data transparency and support private
10 The sovereign transition to sustainability1. INTRODUCTION
sector investments in emerging markets
and developing countries (World Bank,
2019). The links between environmental
performance and sovereign credit risks
are emerging in the academic literature as
well (see Box 1.1.), pointing to governance
as an important factor to reduce sovereign
bond risk.
Natural capital: an emerging interest
for sovereign investors
The links between the state of natural capital
and responsible investment are now highly
visible, notably with investors’ focus on the
implications of deforestation. Following fires
across the Amazon Rainforest in 2019, 246
investors representing approximately US$17.5
trillion in assets signed a statement on
deforestation and forest fires (PRI, 2019b).
The statement asks investee companies
to increase their efforts in eliminating
deforestation from their supply chains,
including disclosure and implementation
of zero-deforestation policies, assessing
and minimising deforestation risks in their
operations, establishing transparent
monitoring systems and reporting on the
management of their deforestation risk.
Some investors such as Nordea have
indicated that they will extend their
focus on deforestation to their sovereign
bond holdings by quarantining Brazilian
government bond purchases and revising
existing holdings.
Globally, the green bond market has
been expanding strongly and by July
2019, 12 countries had issued green
sovereign bonds. This market provides
an important opportunity for issuers
to raise funds that are specifically linked
to their sustainability agenda.
Structure of the report
In Chapter 2 we set out how natural
capital is related to the macroeconomic
performance of sovereign issuers, which
in turn contributes to sovereign debt
repayment ability. We also provide an
assessment of G20 countries, to identify
countries with material exposure to land-
based natural capital. Chapters 3 and
4 present case studies of Argentina and
Brazil – the two G20 countries that have
the most nature-dependent exports. Chapter
5 closes the report with conclusions and
policy recommendations for stakeholders
across the sovereign bond system. Data
on natural capital in the G20 and risks
that threaten its health are provided
in the Appendix.
The sovereign transition to sustainability 112. Natural capital and the sovereign
health model
SUMMARY POINTS
•
We present a 5-step model linking environmental factors to the components of
sovereign credit risk assessments: governance, economic, external, political and
hazard event risk, and fiscal assessments.
•
While the production and trade of soft commodities bring significant global economic
and social benefits, they are directly causing natural capital losses that will reduce
countries’ future internal capacity to produce soft commodities, with negative
impacts on their economic performance and sovereign credit quality.
•
Institutional, economic, external and hazard event risks can either promote or hinder
sustainable development goals. These factors are also affected by natural capital
and ecosystem services via demand shocks such as sustainable trade efforts, and
production shocks such as reduction in water and soil quality and biodiversity.
•
In the G20, Indonesia has the highest land use change emissions, followed by Brazil,
then Argentina. Argentina has the highest natural capital export dependency, followed
by Brazil, then Indonesia.
The impact of agriculture and soft altered and more than 85 per cent of the
commodity trading on natural capital wetlands area lost (IPBES, 2019). Biodiversity
loss in agriculture is making agricultural
Natural capital is the stock of renewable and systems less resilient to climate change,
non-renewable resources that combine to pests and pathogens. For terrestrial and
yield a flow of benefits to people (Natural freshwater ecosystems, land use is the
Capital Coalition, 2019). These benefits are largest driver of impact, with agricultural
known as ecosystem services. The Economics expansion being the most significant form
of Ecosystem Services and Biodiversity (TEEB) of land-use change (ibid).
initiative defines four categories of these The agricultural sector has expanded
services: provisioning services (such as food alongside the trade of soft commodities.
and raw materials), regulating services Countries whose economies are significantly
(regulating local climate and air quality, reliant on soft commodities that are exposed
for example), habitat or supporting services to natural capital risks may face future
(providing habitats and maintaining genetic reductions in soft commodity production
diversity), and cultural services (such as space capacity, with knock-on effects on exports,
for leisure). We exclude cultural ecosystem government revenues and employment.
services from our analysis due to their less All these risks are captured by sovereign
direct relationship with economic factors. debt. In certain circumstances, a higher
Agriculture is now one of the leading causes risk of natural hazard events may lead to
of natural capital deterioration. Around 73 an increase in government expenditure
per cent of deforestation in tropical and because of the need to absorb the
subtropical countries between 2000 and consequent losses for citizens and for the
2010 was associated with agriculture (FAO, economy. Furthermore, the link between
2016). While agricultural expansion can natural capital deterioration and soft
generate significant economic benefits, commodity production can affect countries’
when unmanaged it comes with a huge future access to markets as the transition
environmental cost. Not least, deforestation to a sustainable global economy accelerates.
is the second leading source of greenhouse
gas emissions after fossil fuel combustion, Domestic and macroeconomic
releasing an estimated 20–24 per cent of impacts of the impairment of
global emissions in 2010 (FAO, 2018). natural capital
The Intergovernmental Science-Policy
Platform on Biodiversity and Ecosystem It follows that natural capital deterioration
Services, in its global assessment of should have impacts on the factors
biodiversity, highlights that 77 per cent of assessed by credit rating agencies. We focus
the land surface area has been significantly on the soft commodities produced by the
12 The sovereign transition to sustainability2. NATURAL CAPITAL AND THE SOVEREIGN HEALTH MODEL
agricultural sector, as their dependency on global temperatures. The preservation “The issue of
on healthy natural capital is direct. Soft of natural capital is increasingly being natural capital
commodities are a direct outcome of demonstrated as critical for the long-term loss is hugely
provisioning services (raw materials), but welfare of societies within high natural- complex since
their current and future production relies capital-stock countries too. Therefore this is
international
heavily on regulation services, such as not only an international issue; addressing
pressures
climate and hydrological regulation, risks to natural capital requires the proactive
maintenance of soil fertility and pollination. engagement of the governments in these
to conserve
Examples of expected future impacts from countries as part of their mandate to natural capital
natural capital deterioration at the sovereign prioritise the welfare of their people, with emerge from
level include changes in the location and their citizens being the primary stakeholders. its global
extent of agro-ecological zones suitable for National governments and international relevance”
agricultural and soft commodity production, stakeholders must carry out further analysis
and reductions in yields due to worsening soil of the implications of balancing the risks
and climatic conditions, as well as increased emerging from ongoing natural capital
frequency of natural disasters, such as floods deterioration with the benefits of additional
and droughts. A weakened agricultural sector agricultural expansion. This understanding is
and soft commodity production and trade critical for incentivising countries to take the
will impact the sovereign issuer’s ability best decisions for both domestic and global
to produce soft commodities, affecting welfare purposes.
macroeconomic performance.
At the international level, changes Assessing sovereign health: setting
in demand and more scrutiny of the out the model
environmental footprint of trade can restrict
the sovereign issuer’s access to external We define ‘sovereign health’ as the capacity
markets, with consequences for their current of countries to issue debt and repay it in
account performance and external debt alignment with the Sustainable Development
profile. These factors could reduce the Goals (SDGs). Alignment with the SDGs
sovereign issuer’s ability to produce and trade benefits sovereign debt quality by enhancing
commodities, which reduces tax revenue. countries’ internal capacity to produce soft
In some circumstances, these changes may commodities in the long term by preserving
even induce parallel increases in government locally important natural capital, and by
expenditure to compensate for economic enabling countries’ capacity to trade in
and social welfare losses. international markets that increasingly
Without strategies to manage risks value globally relevant natural capital.
emerging from further natural capital loss Sovereign credit risk has so far been
at the local and global levels, sovereign gauged fundamentally on economic,
issuers’ exposure to hazard event risks will institutional and political criteria, regardless
be heightened. All of these shocks will then of the state of the country’s natural capital
impact on production, growth and exports, and the synergies as well as trade-offs
with negative effects on government between economic, environmental and social
revenues and expenditure. Weakened fiscal performance. Neglecting these dynamics is
performance will increase these countries’ no longer viable for countries’ economic and
sovereign credit risk. financial stability, their achievement of the
SDGs or effective risk mitigation for investors.
Balancing natural capital, agriculture Furthermore, natural capital shocks affecting
and societal welfare countries’ internal long-term production
capacity and access to international markets
Notwithstanding the environmental risks and can lead to reallocation of capital from
natural capital loss caused by agricultural investors, changes in their credit ratings
expansion, the sector is vital to many with consequences for their sovereign cost
countries across the world. Thus there are of capital, and reduced access to institutional
development trade-offs to consider, which investors (when below investment grade).
are within the scope of a sovereign issuer’s Further, these shocks have knock-on effects
decision-making. Countries that are strongly in the domestic economy by affecting the
endowed with natural capital are at a cost of capital and access to certain investor
crossroads in their development journey. The pools by local firms (Almeida et al., 2016).
issue of natural capital loss is hugely complex These risks are particularly material for
since international pressures to conserve sovereign debt, which typically has maturities
natural capital emerge from its global spanning decades.
relevance – take the example of the Amazon To develop our model we have built on the
Rainforest and the impact of its destruction standard sovereign credit risk assessment
The sovereign transition to sustainability 132. NATURAL CAPITAL AND THE SOVEREIGN HEALTH MODEL
model, which considers the performance sustainability in these areas defines its
of sovereign issuers across institutional, sovereign credit rating. The state of natural
economic, fiscal, external and political/ capital is relevant to each of these areas,
hazard event risk factors. A country’s as set out in Figure 2.1.
Figure 2.1. The natural capital and sovereign health model
TRADITIONAL CREDIT NATURAL CAPITAL LINKS
RATING FACTORS TO SOVEREIGN HEALTH
1. Institutional assessment ENVIRONMENTAL GOVERNANCE: Environmental policy,
Policymaking and political such as Nationally Determined Contributions, natural capital
institutions protections policies – i.e. no deforestation, use of fires,
Transparency and accountability input control, protected species – and their implementation,
Debt payment culture monitoring and enforcement.
LOST PRODUCTION AND INCREASED VULNERABILITY VIA
2. Economic assessment
SOVEREIGN ISSUER CREDIT RATING
NATURAL CAPITAL IMPACTS: Changes in production
Gross domestic product capacity due to natural capital loss from soil and water
Inflation degradation, changes in agro-ecologic zones for production,
Monetary base increased vulnerability to natural disasters and climate
impacts, and potential breakdown in ecosystem services.
LOST MARKETS FOR NATURAL CAPITAL-INTENSE PRODUCTS:
3. External assessment Changes in current account revenues from natural capital-
Current account receipts intense products such as soft commodities at risk from
and payments more stringent environmental policies and natural capital
External debt degradation/climate change. Subsequent impact on exchange
rates and debt profile.
4. Political and hazard LOST PRODUCTION AND WELFARE DUE TO FREQUENT
event risk NATURAL DISASTERS: Economic, social and environmental
Political risk losses due to greater impact from and potentially higher
Natural disasters frequency of natural disasters.
FISCAL BALANCE DETERIORATION TO SUSTAIN
5. Fiscal assessment WELFARE IN THE MIDST OF SHOCKS: Changes in tax
Affected Debt and government revenues and expenditure as a result of changes in
by 1, 2, 3 debt/GDP production capacity, reduction in external markets, and
and 4 Net financial assets losses linked to greater political and hazard event risk.
Cost of infrastructure to replace ecosystem services.
Source: Authors
Stocktake of natural capital and risks global gross domestic product (GDP).
in the G20 They are also home to a considerable stock
of natural capital, including globally
In this section, we map particular natural significant forests, water sources and soil
capital stocks and risks that are relevant organic carbon. In addition to these three
for sovereign health performance, across indicators we have looked at a further three:
the G20 countries. We identify the main arable land, bird species and reptile species,
institutional, economic and external sector with data provided by G20 country in Table
risk factors, following our sovereign health A1 in the Appendix.
model (see Figure 2.1 above). To summarise:
• The country with the highest stock
Natural capital stocks in the G20 of forest in the G20 is Russia, followed
The G20 countries are the world’s dominant by Brazil, Canada and the United States,
economies, accounting for 86 per cent of in descending order.
14 The sovereign transition to sustainability2. NATURAL CAPITAL AND THE SOVEREIGN HEALTH MODEL
• The country with the highest percentage of indicators across 10 issue categories covering
renewable internal water resources is Brazil, environmental health and ecosystem vitality,
followed by Russia, Canada, China and the with governance being a key factor to
United States, in descending order. balance the sustainability dimension. This
• More than 70 per cent of global soil organic index is a measure of how close these
carbon (SOC) stocks is held by 14 countries, countries are to meeting environmental
nine of which are in the G20: Russia, policy goals; a low ranking is positive. There is
Canada, the United States, China, Brazil, a wide variability in rankings within the G20,
Indonesia, Australia, Argentina and India. from France ranked number 2 to India ranked
Thirty-one per cent of the global stock is 177 in the world (Wendling et al., 2018).
concentrated in the tropics and 63 per cent Regulations and policies addressing
in forests, savannas and shrublands environmental issues in the G20 countries
(FAO and ITPS, 2018). focus especially on climate change and,
• Brazil emerges as the G20 country with within this area, on the energy sector.
the highest concentration of natural Climate actions that overlap with protecting
capital in terms of renewable internal natural capital more broadly are those
water resources, forest land, arable land, related to improving water security and
and species of birds and reptiles. Brazil reducing deforestation. Within the G20
is the only country in the G20 with a only Canada, Germany and Indonesia
concentration of 10 per cent or more classify improving water security as one of
on four of the six indicators. Russia their core climate actions (Climate Cation
and the United States follow, featuring Tracker, 2019). All of the G20 countries
particularly in the water, forests and participate in actions related to the removal
arable land indicators. of deforestation from supply chains, mostly
through business-led initiatives.
Next we look at the different risk factors Countries’ nationally determined
for natural capital in the G20. contributions (NDCs) to the Paris Agreement
are another source of information regarding
Inadequate governance as an their climate commitments. The link between
institutional risk factor to natural capital NDCs and natural capital is most evident in
The Yale Center for Environmental Law policies regarding the Agriculture, Forestry
and Policy produces and publishes the and Other Land Use (AFOLU) sector.
Environmental Performance Index, which However, none of the countries in the G20
ranks 180 countries on 24 performance has made a pledge for emissions mitigation
Figure 2.2. Greenhouse gas emissions (2014), nationally determined
contributions (NDCs) and credit risk in the G20
Notes: ‘IPR Ratchet
1’ represents the
climate warming
5.5 aim behind the first
Total emissions including LULUCF international policy
US strengthening step
5.0
Saudi Arabia Russia under the Inevitable
Japan
Turkey Policy Response
NDC warming pathway, °C
4.5 (IPR) initiative, as
South Africa Argentina implementation
4.0 of commitments
Republic of Korea is assessed. ‘Paris’
Indonesia
3.5 China
highlights the climate
Canada UK Australia Italy Brazil warming objective
under the Paris
3.0
France Agreement (to keep
Germany Mexico global temperature
2.5 rise well under 2°C).
India
IPR Ratchet 1 LULUCF= land use,
2.0 land use change and
forestry. Size of bubble
Paris
1.5 represents emissions.
For more explanation
of the graph, see p16.
1.0
0 2 4 6 8 10 Source: Authors using
Credit risk data from CAIT WRI,
Climate Action Tracker,
S&P, Moody’s, Fitch
The sovereign transition to sustainability 152. NATURAL CAPITAL AND THE SOVEREIGN HEALTH MODEL
“Brazil is the action in this sector that is aligned with directly) and a decrease in content is directly
G20 country the Paris Agreement target. The largest associated with a decrease in soil fertility.
with the contributor to the G20’s total greenhouse Deforestation and land management
greatest gas emissions from land use is Indonesia, systems affect soil carbon content, but
followed by Brazil, India, Canada and the specific impacts vary depending on the
number of
Argentina, in descending order. stressor and the area affected. For instance,
risk factors
Figure 2.2 presents G20 countries’ total soil carbon falls by around 25 per cent when
associated emissions in 2014 (size of the bubble), tropical forests are converted to annual
with its use climate warming pathway of their NDCs crops and by 30 per cent when they are
of natural (vertical axis) and their sovereign credit risk converted to perennial crops. Peatlands store
capital” profile: countries that have a lower credit huge amounts of carbon that are released
rating get a higher score (shown on the when the land is drained for agricultural
horizontal axis). use (FAO and ITPS, 2015). Within the G20,
Across the G20 countries the extent to relatively low soil organic carbon poses a
which the AFOLU sector represents a carbon major nationwide risk to agricultural yields
sink or source varies. The sector constitutes in Turkey, India, Saudi Arabia, Australia and
a carbon sink in France, Germany, the UK South Africa. (For all of the G20 countries’
and the United States. However, in Indonesia, soil organic carbon scores, see Table A3
Argentina and Brazil, the sector is a net in the Appendix.)
source, contributing 68, 21 and 21 per cent of In addition, soil erosion caused by wind
total greenhouse gas emissions respectively. and water is likely to result in a reduction
In these cases, emissions derive from the in agricultural yields. This is a problem
conversion of natural habitats to other uses, for Argentina and Brazil, as discussed in
usually to agriculture. These emissions cannot Chapters 3 and 4. In extreme cases, soil can
be abated unless deforestation is halted. be completely lost, leading to total loss of
production capacity over time. In the case
Economic risks emerging from of soy, for example, it is estimated that yields
natural capital depletion and fall by 95kg per hectare for each centimetre
risk aversion strategies of soil that is lost (Irurtia and Mon, 2000).
Brazil is the G20 country with the greatest Vegetation regeneration is one way of
number of risk factors associated with its helping to recover soil quantity, quality
use of natural capital. This use is causing and soil water retention, particularly in
harm in the form of high deforestation previously naturally forested areas. In
rates, significant threat to species survival, addition, improved agricultural practices
high emissions from land-use change, and that prioritise preservation of soil organic
ecological threats from cropland expansion carbon can support the maintenance
and the associated high percentage of soft of soil biodiversity and nutrients. These
commodity exports, which we define as strategies will need policy and financial
nature-dependent. (For details of natural incentives to be implemented.
capital depletion in Brazil and the other Agriculture is a major user of water,
G20 countries see Table A2 in the Appendix.) threatening supply in places. As shown in
Indonesia follows Brazil in terms of the Figure 2.3, on average the G20 countries
number of risk factors, also experiencing high use around half of their water withdrawals
deforestation rates, as well as the highest for agriculture but in some countries the
number of mammal species threatened proportion is much higher. Partly as a result
within the G20, the highest land-use of this usage (and largely in some countries
emissions, significant cropland expansion – e.g. India), several of these countries are
and significant reliance on nature-dependent exposed to high or extremely high water
exports. After Indonesia comes Argentina, stress, which relates water availability to
due to high deforestation, land-use emissions, water withdrawal (the higher the proportion
cropland expansion and the highest soft- of available water abstracted, the closer
commodity export dependency in the G20. to water stress).
Deteriorating soil organic carbon and water Drought risk, measured as the average
quality and supply are two types of depletion length of time of dryness in the droughts
causing economic risks. occurring in a particular area, indicates
Soil is a non-renewable resource; in the the strength of a specific drought event.
long term, unaddressed soil degradation Measured in this way, drought risk can be
has the potential to cause soil loss in absence high even for countries with significant water
of ameliorative measures. Soil organic resources. Some countries that have low
carbon is a measure of the carbon content water stress due to significant availability
in soil by weight (used as a proxy for soil of water, such as Argentina, Brazil and
organic matter, which is difficult to measure Indonesia, rank from medium to medium-
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