Do sovereign bonds depend on nature? - World -

Regulation to fight climate change is coming up against the limitations of calculating the value of unknowns, as Silvia Pavoni discovers.

Natural resources are a boon to the economy. Well managed, they can boost development prospects. But their management means taking into consideration environmental, social and governance (ESG) factors.

The natural capital of a country will increasingly be safeguarded by policies aimed at containing climate change and helping transition to a greener economy. These policies could include, for example, stricter anti-deforestation laws or laws that restrict the use of land, which may limit amounts and types of produce that can be cultivated and exported. In doing so, such policy action generates a transition risk that is still poorly understood. This matters.

In capital markets terms, natural resources have a price. But transition risk is not yet priced in market instruments. In fact, the Inevitable Policy Response (IPR) says: “Markets today lack a strong basis for pricing climate transition risk, and do not seem to have priced in a forceful policy response to climate change within the near term. But our policy forecast shows this to be a highly likely outcome, leaving portfolios exposed to significant risk.” 

The IPR is an initiative by the UN’s Principles for Responsible Investment, Vivid Economics and Energy Transition Advisors. It believes that more decisive regulation to fight climate change is indeed inevitable and that what is unknown, and therefore hard to translate into exact values, is simply the timing and the specifics of those actions. 

Approaching target

The deadline for reaching the UN's Sustainable Development Goals and substantially cutting global greenhouse gas emissions to meet the Paris Agreement target is 2030. The IPR predicts “a response by 2025 that will be forceful, abrupt, and disorderly because of the delay” in taking such actions. 

There is more. Together with not-for-profit organisation Planet Tracker, the London School of Economics’ Grantham Research Institute has analysed how the IPR’s policy forecasts would affect sovereign debt issuances of G20 countries. 

The sovereign bonds market is worth $66,000bn globally and the inevitable policy response of governments around the world would have an impact on the largest economies, some more than others. Research found that Argentina and Brazil are by far the most exposed to such transition risk. They are, of course, the most dependent on soft commodity exports among all of the G20 countries. Taking into consideration bond maturities and the first and second so-called ‘ratchets’ of an expected tightening of climate and anti-deforestation policy, as predicted by the IPR, 28% of Argentina’s sovereign debt is currently exposed to policy changes between 2023 and 2028, and a considerably larger 44% after 2030. For Brazil, the figures are 34% between 2023 and 2030 and 22% after 2034.

As a result, the risk profile of these two countries and their ability to raise capital and fund their governments’ activity will suffer. This is particularly alarming for Argentina, which is already seen as a problematic issuer.

Future shock?

Plenty of forecasts have been proved wrong in the past. Predicting the future of policy action that very often depends on political will – even when it comes to climate change – is particularly challenging. But these efforts deserve attention.

According to the Grantham Institute and Planet Tracker research, governments face two options. The research note says: “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.”

As the Argentinian and Brazilian governments, along with others in Latin America, meet at the annual gathering of the Inter-American Development Bank, they may wish to consider how transition risk might affect their ability to tap capital markets and fund programmes to improve the economy and the lives of their citizens.

This is a monthly column focusing on ESG principles and how they are reshaping banking, markets and investment. We would like to hear your views on sustainable finance, how it is changing your organisation, your work and your incentives structure. Contact silvia.pavoni@ft.com and, on Twitter, @Silvia_Pavoni

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