Investors in sovereign bonds are mispricing a growing risk that has the potential to trigger downgrades, according to a study by analysts at Barclays Plc.
The risk in question is the failure of countries to adequately protect their natural capital, putting water, air and soil resources in jeopardy and impacting key sectors such as agriculture, a team of analysts led by Maggie O’Neal, Barclays’ global head of ESG research, wrote in the report published on Monday.
Some of the most exposed sovereign markets are those that already carry junk ratings, including Bangladesh and Ethiopia, O’Neal and her colleagues wrote. Others with low investment-grade ratings are also in the crosshairs, such as the Philippines, Indonesia and India, they wrote.
Nature loss is “projected to cause sovereign downgrades,” with higher borrowing costs “compounding credit risk for bondholders,” they said.
Concern that financial markets aren’t taking natural capital into account is increasingly shaping regulations, amid signs that real-world losses pose an ever-greater threat to societies across the globe. According to the Barclays study, the costs are already starting to materialize and can include everything from impaired business capital to stranded assets as well as defaults.
Issuers also face disruptions to production and value chains, as well as volatile commodity prices, all of which can hurt exports and drag down the banks, investors and insurers exposed to such risks, the Barclays analysts wrote. And they warn that the arrival of biodiversity regulations has opened the door to litigation, putting bad actors at ever greater legal risk.
That’s as the European Securities and Markets Authority issues a warning that it won’t tolerate misleading biodiversity claims by investment funds. “The growing public scrutiny and increasing understanding of biodiversity risks raise expectations for biodiversity-related financial products to rapidly increase in number and size over the next years,” ESMA said last week. That warrants “increased levels of market monitoring.”
Over half of global gross domestic product is dependent on nature, O’Neal and her team wrote. “Reversing biodiversity loss is imperative to limiting physical risks and avoiding severe repercussions for the economy,” they said.
Barclays estimates that by 2030, almost $1 trillion will be needed in annual investment to protect biodiversity, compared with the roughly $160 billion being spent today. At the same time, there are about $725 billion in what Barclays identifies as “harmful subsidies” being spent on things that hurt biodiversity.
Most of the sovereign bond markets facing a biodiversity-related financial hit are junk rated, with many of these particularly exposed via export markets, according to the Barclays analysis.
Argentina, Brazil and Indonesia stand out as the most vulnerable among the G20 to biodiversity risks. And when it comes to water scarcity, no G20 nation is more at risk than Saudi Arabia, the Barclays analysis shows.
Meanwhile, there are concerns that credit ratings companies aren’t doing enough to reflect such risks. But including ESG scores in credit ratings is proving particularly sensitive, given the potential to influence an issuer’s borrowing costs. Even deciding how to measure and reflect such risks is proving controversial.
S&P Global Ratings recently abandoned an alphanumerical scale intended to capture environmental, social and governance risks associated with credit ratings, after investors found it confusing. At Moody’s Investors Service and Fitch Ratings, meanwhile, such scales remain the norm.
At the same time, experts warn that ratings companies may not be monitoring ESG risks closely enough. Climate change, for example, has “yet to be hardwired into the methodology” currently used by the three main ratings firms, according to Moritz Kraemer, who oversaw S&P’s sovereign debt ratings until 2018 and is now the head of research at LBBW bank.
In the meantime, international organizations and asset managers including Amundi and the Principles for Responsible Investment have created a publicly available database on sovereign bond issuers’ climate actions, which is now in a testing phase. And global frameworks are emerging around natural capital, including the Partnership for Biodiversity Accounting Financials and the Taskforce on Nature-related Financial Disclosures.
Investors can reduce their exposure to such risks by engaging with issuers, the Barclays analysts wrote. Or they can opt for sovereign green bonds and debt-for-nature swaps, though the allocation of proceeds tends to be skewed toward decarbonization rather than nature, they said.
“Biodiversity is a productive asset that generates crucial ecosystem services,” the analysts wrote. “However, as an asset without a price, it is systematically mismanaged.”
This article was provided by Bloomberg News.