How the market is underestimating the impact of environmental risk on sovereign bonds

Investors in sovereign bonds are mispricing a growing risk that has the potential to trigger downgrades, according to a study by analysts at Barclays Plc.

The risk in question is the failure of countries to adequately protect their natural capital, putting water, air and soil resources in jeopardy and impacting key sectors such as agriculture, a team of analysts led by Maggie O’Neal, Barclays’ global head of ESG research, wrote in the report published on Monday.

Some of the most exposed sovereign markets are those that already carry junk ratings, including Bangladesh and Ethiopia, O’Neal and her colleagues wrote. Others with low investment-grade ratings are also in the crosshairs, such as the Philippines, Indonesia and India, they wrote.

Nature loss is “projected to cause sovereign downgrades,” with higher borrowing costs “compounding credit risk for bondholders,” they said.

Concern that financial markets aren’t taking natural capital into account is increasingly shaping regulations, amid signs that real-world losses pose an ever-greater threat to societies across the globe. According to the Barclays study, the costs are already starting to materialize and can include everything from impaired business capital to stranded assets as well as defaults.

Issuers also face disruptions to production and value chains, as well as volatile commodity prices, all of which can hurt exports and drag down the banks, investors and insurers exposed to such risks, the Barclays analysts wrote. And they warn that the arrival of biodiversity regulations has opened the door to litigation, putting bad actors at ever greater legal risk.

That’s as the European Securities and Markets Authority issues a warning that it won’t tolerate misleading biodiversity claims by investment funds. “The growing public scrutiny and increasing understanding of biodiversity risks raise expectations for biodiversity-related financial products to rapidly increase in number and size over the next years,” ESMA said last week. That warrants “increased levels of market monitoring.”

Over half of global gross domestic product is dependent on nature, O’Neal and her team wrote. “Reversing biodiversity loss is imperative to limiting physical risks and avoiding severe repercussions for the economy,” they said.

Barclays estimates that by 2030, almost $1 trillion will be needed in annual investment to protect biodiversity, compared with the roughly $160 billion being spent today. At the same time, there are about $725 billion in what Barclays identifies as “harmful subsidies” being spent on things that hurt biodiversity.

Most of the sovereign bond markets facing a biodiversity-related financial hit are junk rated, with many of these particularly exposed via export markets, according to the Barclays analysis.

Argentina, Brazil and Indonesia stand out as the most vulnerable among the G20 to biodiversity risks. And when it comes to water scarcity, no G20 nation is more at risk than Saudi Arabia, the Barclays analysis shows.

Green bonds and litigation

So-called sovereign green bonds have been all the rage in recent years. These are public debt issues that are linked to the funding of projects that combat climate change. Last year, more than €700 billion were raised worldwide with bonds of this type. But these, too, could be impacted by nations’ failure to protect their natural capital.

On Monday, Frank Elderson, a member of the Executive Board of the European Central Bank, delivered a keynote speech to address another kind of risk associated with the climate and environmental crises: the rise of litigation. “It is particularly important at a time when non-financial but also financial companies, including banks, are becoming the direct targets of such litigation,” he noted. Globally, some 560 new cases have been filed since 2021.

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