Barclays (LSE:BARC) has warned that the market is underestimating the growing environmental dangers to countries’ natural capital, and only a few investors are correctly pricing sovereign bonds.
- Barclays analysts warn that bond creditors are mispricing natural capital risk in sovereign bonds.
- Countries should ensure adequate protection of their natural capital, which can prove difficult when its contribution is systematically undervalued.
- The problem is over-exploitation of natural capital can result in systemic shocks, which could undermine the stability of the financial system.
A team of analysts at Barclays Plc, under the guidance of global head of ESG research Maggie O’Neal, have published a study on sovereign bonds and the impact that growing environmental risks will have on nations’ natural capital.
Nature is central to the global economy as all operations are maintained by and within in, yet it remains an asset that is systematically undervalued. The importance of nature risk has been recognised on several occasions, as with the introduction of a new Global Biodiversity Framework Fund (GBFF) to mobilise investment against biodiversity loss, these continue to be underestimated in the face of extreme weather events and natural catastrophes.
Commercial opportunities to invest in biodiversity are limited. Biodiversity-offset markets are still on the rise, while sovereign green bonds have proven limited financial support for biodiversity projects. Debt-for-nature swaps are not a satisfactory solution either, as often only part of the transaction value involved goes towards the much needed nature conservation projects.
For this reason, investors are using strategies that employ sovereign engagement to drive positive nature outcomes, as a way to promote better economic performance while nature-smart policies become clearer.
Sovereign bonds and biodiversity
Investors, companies, policymakers and regulators have been increasingly concerned with biodiversity, and demand with increased pressure regulation for corporate disclosure of nature-related risks and opportunities is growing. Indeed, momentum is building up as September 2023 saw the release of the final version of the framework of a nature disclosure framework developed by the Taskforce on Nature-related Financial Disclosures (TNFD).
In the Barclays report, the mismanagement of natural capital assets is discussed in terms of both its physical and transition risks. The loss of underlying ecosystem services such as pollination, water security or carbon storage can result in economic and financial shocks referred to as nature-related financial risks.
That means that any failure to understanding the implications of the loss of such environmental support factors are becoming material to the credit ratings of sovereign bonds. In other words, nature risk is financial risk.
As sovereign credit ratings methods do not factor in nature-related risks, but rather their indirect effect on economic, governance or financial factors, investors employing these may be at risk of not identifying, pricing and managing risk appropriately. This will be essential to deal with the unpredictable dynamics of nature risk.
According to the report, many sovereign bond markets that already hold junk ratings, such as Ethiopia and Bangladesh, or countries that hold low investment-grade ratings, such as India and the Philippines, risk becoming the most exposed sovereign markets.
With regard to water scarcity, Saudi Arabia is presented as the most vulnerable G20 nation.
The loss of natural resources and biodiversity could result in sovereign downgrades and higher borrowing costs which would compound credit risk for bondholders. The consequences of such events, however, are already becoming measurable and involve anything from impaired business capital to defaults and stranded assets.
Further challenges for issuers, insurers and investors exposed to these risks also involve disruption to production and value chains, volatile commodity prices and legal risks via biodiversity regulations.
Environmental risks affecting the financial sector
The study particularly focused on quantifying the impacts of nature-related risks to show how dependent different nations are on natural resources. This highlights the importance of a country’s commitment to ensuring that its natural capital is adequately protected and maintained.
The growing environmental risks that threaten the health and availability of natural resources not only degrade the environment, but could have widespread economic effects on essential sectors such as agriculture. The protection of biodiversity remains a crucial aspect of economic stability, given the fact that over half of global GDP depends upon natural capital.
A report from the Bennett Institute for Public Policy warned that the implications of biodiversity loss on sovereign bonds could push nations towards sovereign credit downgrading and bankruptcy.
What is required to address future challenges?
Barclays estimates that around $1 trillion will be needed in annual investment, as opposed to the current $160 billion, to protect biodiversity by 2023. Additionally, its report identifies an approximate amount of $725 billion in ‘harmful subsidies’ – including billions in subsidy to the industrial meat industry – spent in detrimental activities nature.
By engaging with issuers, considering sovereign green bonds and debt-for-nature swaps, investors will have the opportunity to reduce exposure to climate risks. Nonetheless, the allocation of proceeds from these instruments is noted to emphasise decarbonisation over the prioritisation of nature.
Emerging global frameworks such as the Partnership for Biodiversity Accounting Financials and the TNFD are currently promising and in the process of being developed, according to the analysts.
Due to increasing evidence of global environmental degradation and biodiversity loss, the financial community stands to lose significantly if it does not take into account the risks arising from nature loss.
Appropriate estimations of risks on the natural capital of various nations will be crucial to ensure that sovereign bonds are also priced appropriately. With such recognition, bold action to reverse biodiversity loss and environmental degradation must follow.