In many ways, 2022 could be seen as the year when sovereign risk took centre stage again. With the ongoing Ukraine war and a series of food and energy crises, investors were forced to re-think the implications of ESG issues on sovereign debt risks.
Even before last year, investors have increasingly recognised the impact that sustainability topics have on security prices. This is true not only for equities and corporate bonds, but also for sovereign issuers. Integrating ESG factors into the traditional investment process can help to better identify and manage credit risks linked to governments.
Historically, sovereign debt investors have paid the most attention to governance factors. However, environmental and social issues are gaining in prominence as well (see Figure 1). According to a survey from the CFA Institute from 2018, 12% of market participants indicated that environmental factors had an impact on sovereign debt prices in 2017, but 31% expected that these would have an impact in 2022.
Figure 1: The impact of ESG issues on security prices – aggregated market participant’s views
How are environmental risks material to sovereign debt prices?
It is estimated that USD 44 trillion of economic value, or over half of the world’s total GDP, is moderately or highly dependent on nature and its services. Biodiversity, the diversity of all living things, is a fundamental part of natural capital, and is essential to the functioning of the ecosystem and its services. However, as humanity’s use of natural capital has increased more than ever over recent decades, scientists are warning that we are already witnessing our planet’s sixth mass extinction. As alarming as it may seem, this threat is still under-appreciated by many investors, and under-reported by many sovereigns. An analysis of USD 783 billion worth of sovereign bonds issued in 2020 with long-dated maturities found that three-quarters did not disclose any climate- or nature-related risks in their prospectuses.
Investors therefore need to pay closer attention to the state of a country’s natural capital, and monitor actions taken by sovereigns to halt biodiversity loss. According to the World Bank, climate and nature risks can lead to macroeconomic instability, raising the probability of a sovereign debt default. What countries do today to manage their natural capital will largely determine their future, as well as the health of the planet.
Assessing environmental factors for sovereign credit
At Bank J. Safra Sarasin, we have been assessing the sustainability of countries since 2002. Our methodology incorporates various environmental aspects and indicators, including but not limited to:
- Agricultural and Forest Land
- Mineral Wealth and Depletion Trends
- Net Forest Depletion
- Renewable Water
- National Biodiversity Index
- Ecological Footprint
The last two factors have become widely used metrics for natural capital and ecosystem accounting.