Towards a new framework to account for environmental risk in sovereign credit risk analysis

Despite the growing body of evidence on ecosystem degradation and on-going development in measuring its economic implications, there remains a lack of understanding and integration of environmental risks into investment decision. There is, therefore, currently a weak financial rationale and a limited choice of tools to assess the materiality of environmental risk for the sovereign bond market. Improving investor understanding of the materiality of environmental risks is likely to be crucial to limiting risk exposure of important investments and to encouraging the transition to a greener more sustainable economy. This article presents the development and initial application of a framework that aims to improve the financial rationale for assessing the materiality of environmental risk in the sovereign bond market. It is the result of a collaborative and inter-disciplinary project of researchers and practitioners from a group of financial institutions, the United Nations Environment Programme Finance Initiative, and Global Footprint Network. Results not only show the long- and short-term implications of environmental risk for a wide variety of resource profiles, but also how these risks relate to macroeconomic factors that are already recognised as relevant to sovereign credit risk. This, therefore, presents a more accurate reflection of how these factors might influence the risk or return situation for an investor. More collaborative and innovative research between scientists and practitioners could improve both knowledge and methods to effectively account for the financial materiality of natural resource risks for a country's economy.