Climate Risk Could Hit Already Vulnerable Nations With a Double Whammy

(Bloomberg) --

When investors thought about how climate change might affect their portfolios a decade ago, their attention was usually focused on the companies they were investing in. How big was a firm's carbon footprint, for example, compared to its industry peers? These days, people looking at climate risk are increasingly focused on a new problem: the assets issued by governments.

Numerous climate- or ESG-focused sovereign bond funds have emerged in the past 18 months, launched by everyone from the giant BlackRock to smaller firms like Legg Mason and NinetyOne. FTSE Russell has a climate risk sovereign debt index. These services cater to growing demand for ways to filter out climate risk in sovereign bond portfolios, and even the European pensions and insurance regulator Eiopa is paying more attention to how climate change could present risks to government bonds. 

Investors are wary of two main climate pitfalls when choosing assets. The first is “transition risk,” where a country's economy is too reliant on polluting industries that are falling out of favor, such as selling thermal coal—much like investors eschewing oil company shares because of the rise of electric vehicles. When enough investors no longer want to own shares in a polluting company (or bonds in a country), eventually that company (or country) may get the message and shift into cleaner practices (industries). It's a case of free financial markets creating a win for nature.

The second danger, known as “physical risk,” is more complicated. If investors become worried about a company's vulnerability to wildfires, droughts, or floods, it could push executives to take needed precautions; even if that vulnerability makes the company a less attractive investment to banks and other entities that might finance such improvements. The same goes for individuals whose homes are in vulnerable areas: It could be good, overall, if banks stopped offering mortgages for houses that will likely suffer damage, which would discourage people from moving and building there. But that would be cold comfort for longtime residents who see their properties rapidly lose value while nearby areas just out of harm's way become more expensive.

Imagine that effect multiplied to the scale of entire countries, and you can see the potential for “climate risk” in sovereign bond purchases to wreak havoc.

Many of the developing countries facing heightened fiscal strain because of Covid-19 were already paying a price for their exposure to harsh weather. A working paper commissioned by the United Nations Environment Program and published by SOAS and Imperial College showed that the 20 most climate-vulnerable countries had in total paid an additional $62 billion in financing costs over the decade leading up to 2018—large sums for many of those nations who have relatively small economies. Zambia in September became the first African country to seek relief from bondholders since the pandemic struck, and it's feared more will follow.

In 2018, Moody's Investors Services identified the 37 countries with the highest exposure to climate impact risk. The list is a rundown of economically vulnerable former colonies, including Papua New Guinea, Cote d'Ivoire, and Cameroon. Zambia scores highly, too. In Angola, which ranks high on a well-known index of climate vulnerability, the government is trying hard to reassure bondholders that it won't miss a payment. Its bonds yield more than 12%, hundreds of times what similarly climate-exposed developed countries like Australia pay to borrow money. 

The irony of this is probably obvious—the countries that are most vulnerable to the effects of climate change are the ones who are least responsible for the emissions that create it. They're also often the ones most in need of cheap financing to build resilience and invest in cutting their own emissions. 

An even sharper irony is that commercial creditors—banks, pensions funds and the like—have become bigger buyers of developing countries' sovereign bonds over the past two decades, yet since the Covid-19 crisis they haven't shown great enthusiasm for temporarily allowing these countries to suspend payments on their debt. The Institute for International Finance, which represents big private sector creditors, initially signaled in April that its members should join the Group of 20 nations in pausing collecting interest payments. The next month, however, it backed away from that stance, and later warned the G-20 that it shouldn't extend its forbearance either. 

Fund managers who boast about their skill at filtering out climate risk in sovereign debt likely won't be able to have their cake and eat it too. As national budgets strain under the fallout from Covid and as the impacts of climate change grow in scale and intensity, there will probably be increasing scrutiny of how the same investors treat the most climate-vulnerable countries. Investors may have to show that protecting their own portfolios is not just worsening climate risks for others. 

Kate Mackenzie writes the Stranded Assets column for Bloomberg Green. She advises organizations working to limit climate change to the Paris Agreement goals. Follow her on Twitter: @kmac. This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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