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Climate Change Risk and Sovereign Bond Investments

A little more than a month after 196 countries signed a historic climate agreement in Paris at COP21, United Nations secretary general Ban Ki-moon will address influential members of the finance community this Wednesday, at the 2016 Investor Summit on Climate Risk, in New York.

This will be the first major event on climate change for investors to discuss the far-reaching implications of the agreement. Just as countries now must figure out how to meet ambitious goals to reduce their carbon emissions, momentum is building for investors to decarbonize their portfolios.

To date, portfolio decarbonization activity has focused on equities. The divestment movement’s momentum around stranded assets is the latest example. But investors are now starting to realize that the global push to slash carbon emissions also has implications for the $41 trillion sovereign bond market.

French investors are on the front lines of this new reality. A French legal requirement announced in May 2015 will require that institutional investors disclose their carbon exposure. The law takes effect this year and provides further impetus for full integration of climate change risk into all asset classes, including sovereign bonds, and introduces new tools and methodologies to make such integration possible.

Only a small but growing number of asset owners and managers — primarily those focused on socially responsible investing — are factoring climate change into their portfolio decisions. So far, investors have been mostly concerned with equities when it comes to decarbonization. Paradoxically, as the divestment movement becomes stronger, its ethical undertones become louder and may threaten to turn off many investors who view such ethical considerations as being in conflict with financial drivers, as some have already observed.

When considering sovereign bonds, however, climate change poses actual material risks to national economies and, consequently, creditworthiness. Going beyond disclosure, there is a need to better understand and incorporate such risks into sovereign bond investments, which, as the 2008 financial crisis revealed, are not the safe haven they were once thought to be.

Sovereign bond investors who have started to incorporate climate risk into their analysis typically examine exposure to extreme weather events or simple carbon emission totals. Research by Global Footprint Network, in collaboration with the U.N. Environment Programme’s Finance Initiative (UNEP FI) and 14 financial institutions, has shown that country risk related to climate change is far more complex. Factors contributing to such risk include the carbon intensity of a nation’s economy, whether oil and gas reserves are government owned and policy changes sparked by climate change.

Trade-related risk is another component of country risk that stands to be amplified by climate change. A new report to be released this spring by Global Footprint Network and UNEP FI will show that the impacts of climate change on food production can lead to food price volatility, with material economic impact for a majority of the more than 100 countries studied. Such impact includes a deterioration of balance of payments and an increase in the consumer price index. Many of the countries that would sustain such impacts, including Egypt and Morocco, already experienced severe unrest during the 2007–’08 food price crisis.

Furthermore, many of the countries most vulnerable to food price shocks are also highly exposed to the effects of climate change on their own agricultural production. The effects of a food commodity price crisis would be considerably worsened if they were concurrent with a shortfall in domestic production — a situation that climate change makes more likely.

This research complements other research in the field by such organizations as Standard & Poor’s and the Organization for Economic Cooperation and Development. OECD’s recent report, The Economic Consequences of Climate Change, found that climate change would result in GDP losses in almost all regions of the world. In its report titled “ The Heat Is On: How Climate Change Can Impact Sovereign Ratings,” S&P concluded the ratings of many emerging-markets sovereigns, specifically in the Caribbean or Southeast Asia, would likely come under additional pressure as a result of rising ocean levels and changing weather patterns.

S&P has called climate change a “global megatrend for sovereign risk.” Such statements from S&P are noteworthy because the major credit rating agencies have the ability to attract attention and influence investment and the interest rates that governments pay for capital. Ultimately, incorporating an evaluation of ecological risks into these ratings can motivate governments to focus on climate change and related energy policy.

Meanwhile, investors are also pushing for a more ambitious agenda. Sustainability-themed investments in France, for example, have grown nearly sevenfold in less than three years. More than 400 investors, managing a total of more than $24 trillion of assets, have signed the Global Investor Statement on Climate Change, the largest-ever number of investors supporting government action on global warming. This action is proof that we now have both the will and the historic opportunity to shape a more resilient financial system that can help fund the development of a greener economy. To summarize, by quoting Laurent Fabius, France’s minister of Foreign Affairs and International Development and the president of COP21: “It is essential that the financial system as a whole takes climate risk into account, anticipates ambitious targets and integrates this into investment decisions.”

We believe this advice rings true for all investors — those invested not only in equities but in sovereign bonds as well.

Susan Burns is co-founder and director of finance for change at Global Footprint Network, an environmental think tank based in Oakland, California. Maximilian Horster is director, financial industry, at South Pole Group, a Zurich-based organization that develops carbon reduction plans for public and private sector organizations.

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