Sovereign natural capital risks are the tip of the iceberg for OIC financial institutions

• IMF highlighted oil-exporters' risks from peak demand estimated by 2040, the impacts from which will have economy-wide impacts
• New research also shines light on how sovereign bonds are being affected by physical climate risk, which will reverberate economy-wide
•  OIC countries' climate risks are higher both by a higher dependence on natural resources & economic value created by natural capital

Countries within the Organisation of Islamic Cooperation (OIC) are uniquely vulnerable to issues relating to natural resources and natural capital. Many are commodity exporters and have faced challenges in achieving broader economic diversification. Others have economies dependent upon agriculture for sizeable proportions of their GDP or labour force or both. Addressing issues related to natural resources and natural capital is critical for these governments to achieve the Sustainable Development Goals by 2030. They haven’t been seen as relevant to financial institutions, but they should be.

Just in the past week, the IMF released a report with an assessment that energy efficiency and climate change mitigation efforts will lead to global peak oil demand in the next 20 years, stressing the fiscal sustainability for Gulf Cooperation Council countries. The IMF estimated that the amount of government spending in excess of revenues needed to maintain current levels of fiscal spending will deplete the region’s financial buffers as early as 2034.

A separate report from Planet Tracker and the Grantham Research Institute on Climate Change and the Environment found that sovereign credit ratings more broadly were vulnerable to degradation of natural capital.

Climate change provides a link between the two different risks facing OIC countries: transition risk on the one hand and physical risk on the other. Transition risks could have a drastic impact from stranding valuable sovereign assets through demand curtailment. Physical risks are most widely felt as spill-over effects reverberate across the economy driven by destruction of natural capital by climate change. It reflects the direct impact on sectors such as agriculture and the indirect impacts felt much more broadly across the economy.

Many individual financial institutions and investors see these risks as too distant and too out of their control to impact the way they manage their business. It leads them to act too slowly, or not at all, in the face of changes that will endanger their future financial performance. Inaction is particularly tempting even among domestically-oriented financial institutions aware of climate change who feel resigned to not having the power to influence the needed change. These domestic financial institutions within the most impacted markets must take sovereign (and global) decisions as a given, but will nonetheless be affected by climate change. As susceptible as they are to exogenous changes, they retain the ability to adapt their financing decision-making process to mitigate climate-related risks.

A common thread runs through the most critical issues for financial institutions and regulatory institutions: financial performance, risk management, and systemic stability. These key issues have been adopted as central to responsible finance and are built into frameworks such as the Task Force for Climate-related Financial Disclosures (TCFD)

Financial institutions and investors who recognize the risks have many tools to take action, whether in response to natural resource or natural capital risks. Although they are different sides of the same problem, natural resource and natural capital risks involve similar issues from the perspective of a financial institution. Investment today will create rewards in the future, or a lack of investment today will result in risks that will begin to be priced in starting now.

In the case of the natural resource transition risks, the IMF concluded that: “At the current fiscal stance, the region’s financial wealth could be depleted by 2034. Fiscal sustainability will require significant consolidation in the coming years. Its speed is an intergenerational choice. Fully preserving current wealth will require large upfront fiscal adjustments. More gradual efforts would ease the short-term adjustment burden but at the expense of resources available to future generations.”

In relation to natural capital risks, Planet Tracker and the Grantham Research Institute explained that “the task ahead is for countries to achieve ‘sovereign health’, which we define as their capacity to issue debt and repay it in a manner consistent with achieving the SDGs [by 2030]. This means recognising and valuing the fundamental dependencies of sovereign bonds on natural capital, which are currently ignored and mispriced, thereby storing up instabilities in the future.”

The link is the degree of intertemporal trade-off created either by retaining business as usual or by disrupting it. The role of the financial sector is to adequately price the risks and rewards between today and the future through decisions about what to finance and what conditions to attach to the provision of finance, either through restrictive covenants, pricing incentives for actions that improve outcomes, or engagement by equity shareholders.

What has past experience taught us? 

During the early 2000s, we learned that leaving decision-making to the financial sector alone does not provide optimal outcomes. In that experience there was a reallocation of capital that primarily benefited the financial sector at the expense of the real economy and society. After the Great Financial Crisis, the process of decision-making became more focused on benefiting the real economy and considering the immediate effects of financing on society.  We are now seeing the limits of this approach as the time horizon on which decisions are made is too short compared to the problems we face, and the interests of future generations are ignored.

Investors are waking up to this idea and trying to identify how heavily to weight longer-term issues of intergenerational equity and the value of natural capital. Regulators are interested in this process because if investors and financial institutions collectively get it wrong, climate-related events could trigger a rapid repricing of risk, at the cost of financial stability.

And that matters even for a domestic financial institution operating only in a single OIC country which is looking at that country’s economy and trying to invest in its future development. If the institution sees an economy dependent upon agriculture, and relies upon the natural capital including the soil quality, rainfall, and frequency and severity of natural disasters that support or disrupt it, the next question is how to adapt the financing provided to mitigate the risks of a changing climate.

Creating moral harbour through ESG

There is little expectation that a single domestically focused financial institution can change the country’s economy, but this doesn’t insulate that institution from the impacts. Recognising and preparing for the consequences of high exposure to natural capital means working to offset some of that risk when deciding what activities to finance, and what if any conditions to place upon that financing.

We all accept that the presence of insurance may cause a behavioural change (moral hazard) that affects the outcome for the insurer. When a financial institution takes account of natural capital or another source of information through the lens of environmental, social and governance (ESG), it is doing the reverse and creating a moral harbour from the effects that are taking place in a wider context. By doing so, a financial institution is prepared no matter whether the government takes a high or low road approach to responding to the risks of their natural resource or natural capital dependence.

Planet Tracker and the Grantham Research Institute explain: “Sovereign bond issuers face a choice: either following a High Road scenario where countries actively protect and enhance the benefits of natural capital and reinforce the environmental fundamentals of sovereign bonds, or a Low Road scenario where business-as-usual undermines flows of ecosystem services, increases vulnerability to natural disasters and intensifies market risks. For sovereign bonds, the crystallisation of these risks could lead to higher borrowing costs, impairments in credit quality and reductions in their access to finance.”

In the context of natural capital and financial institutions, it is up to the sovereign whether to take the high or low road on protecting the sources of future economic and social stability. It is up to every investor and financial institution whether they acknowledge the risks and opportunities that could affect their future earnings. They may need to expand their capacity to understand how to measure and evaluate these risks and opportunities, but there are resources to help from regulators developing taxonomies, peer learning opportunities, and frameworks like the Task Force for Climate-related Financial Disclosures (TCFD).

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