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Environmental Risks Affect Sovereign Credit, UN Says

Natural resource and environmental risks are becoming financially material for sovereign credit risk, according to a study by the United Nations Environment Programme’s Finance Initiative (UNEP FI).

India now demands over 1.8 times more from its ecological assets than it is able to generate and other countries are seeing similar trends, according to E-RISC: A New Angle on Sovereign Credit Risk.

At the end of 2010, outstanding sovereign debt equaled $41 trillion, the study says. While sovereign bonds — which represent more than 40 percent of the global bond market — have traditionally been considered a risk-free investment, the report says some countries’ sovereign debt ratings may be less robust than many investors may realize if depletion of natural resources are taken into account.

Loss of soils, forests and fisheries, as well as rising resource costs, are likely to become increasingly important to a nation’s economic health, and may affect its ability to repay or refinance sovereign debt.

In the study, UNEP FI analyzed five countries — Brazil, France, India, Japan and Turkey — using a new methodology called E-RISC (Environmental Risk in Sovereign Credit analysis).

The methodology uses ecological footprint (area of biologically productive land and water required to support the activities of a population) and biocapacity (amount of productive area actually available to generate resources and absorb waste) metrics to quantify environmental risks so they can be incorporated into sovereign credit risk assessments.

Among its findings, the E-RISC report estimates that a 10 percent variation in commodity prices can lead to changes in a country’s trade balance equivalent to more than 0.5 percent of GDP (see chart). It also says a 10 percent fall in the productivity of natural resources, such as grazing land or forests, could force current trade imbalances to grow wider — equivalent to an additional 4 percent of GDP — mainly because of the need for more imported goods.

UNEP FI says the methodology is the “first step” in linking natural resource risks to sovereign credit risks, not the final product, and improvements to the E-RISC approach applied to more countries will give a more comprehensive overview.

According to Trucost executive director Lauren Smart, writing in Environmental Leader, environmental damage by business has implications when investing in sovereign debt and other fixed-income instruments. A Trucost report commissioned by UNEP and UNPRI, Universal Ownership, found that the world’s largest 3,000 companies create environmental damage valued at $2.2 trillion or 11 percent of GDP. Similarly, studies by the Chinese Academy of Social Sciences valued the total annual damage to China’s economy from environment degradation at 9 percent of GDP.

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