Climate Change: An Investor Tool Box

14 June 2020

The Covid pandemic, understandably, has replaced the climate debate in the headlines. However, the impact of rising global temperatures will be the most important macro-issue facing investors in coming decades. Reflecting the topic’s importance, ESG investing (emphasising environmental, social, and governance factors) has expanded significantly in recent years. Sadly, the ESG sector remains a specialised niche segment of the asset management industry. Nevertheless, fund managers are giving increasing attention to climate change in their investments in individual companies, and using their clout to influence corporate and Board-level decision-making.

However, far less focus is given to assessing the impact of climate change on sovereign risk. I hope to change this. The issue should be the focal point of every investment commmitte’s global asset allocation strategic process. In this blog — the third in a series of four on the topic (the first two are available in my website’s archives) — I will introduce the tool box that I have used to develop my climatic sovereign risk assessment methodology.

I believe an effective approach must provide an in-depth assessment of each country’s current vulnerability to the consequences of altered climate patterns. I give particular consideration to physical/geographical issues, the quality of infrastructure, the robustness of the health care system, the role of agriculture, the state of the energy system, and numerous demographic issues. In addition, consideration must be given to each nation’s adaptability, e.g. the ability to make policy changes to reduce their exposure. Finally, attention must be given to the impact of climate change on traditional underlying macro-economic and credit fundamentals. For ease of presentation, I will introduce a large series of key Charts with minimal annotation….so bear with me…I think it will be worth the effort!

Physical Exposure: Nothing to be Done

  • Where you are on the planet matters, and mitigation against rising sea levels and flooding is critical. The Netherlands, numerous island and coastal nations stand out. While the USA is not vulnerable overall, specific regions, e.g. the Gulf Coast, are exposed. The following Chart illustrates the rising cost of weather related events.
  • Certain countries are blessed with access to hydroelectric power. Geography also impacts the potential usage of solar and wind power.
  • High levels of population density add to health and other risks associated with CO2 emissions. Note especially, South and East Asian countries.

Agricultural Sector: Polluter & Victim of Rising Temps

  • The agricultural sector is both a large source of Green House Gas emissions, and an area of enormous vulnerability for many countries. Agriculture accounts for roughly 25% of GHGs, especially menthane, emanating mostly from a small number of countries, e.g. China, India, Brazil, and the USA. Indonesia, Pakistan, and Australia also contribute.
  • Changing climate patterns, rising temperatures, droughts, and flooding will wreak havoc in countries with large agricultural sectors and rural populations. Note especially, African and poor Asian nations.
  • Of course, the reliability of water supply will be critical as temperatures rise. Again note the exposure of Haiti, poor African nations, South and certain certain East Asian countries, and South Africa.
  • Likewise, if food scarcity emerges, countries reliant on key imported grains (corn, rice, wheat and barley) are exposed: Japan, Korea, some Latin American nations, and again much of Africa and Haiti. On the other hand, Australia, France, Canada, Thailand, and USA are most comfortable.

Infrastructure: Keeping the Economy Moving

  • Countries will high-quality infrastructure — roads, ports, etc. — are better able to cope with the potential economic disruptions of climate change. Not surprisingly, the World Economic Forum’s index indicates these assets are best in the world’s most properous countries. Sadly, Haiti and Africa are again the most exposed.
  • Provision of electricity access is also a critical infrastructure asset. Haiti and Africa, including parts of South Africa, do not have universal provision of power to homes and industries.

Health Care System: Lessons from Covid Experience

  • As we have seen during the Covid pandemic, a robust health care system is critical to mitigating the adverse impact of health emergencies, such as climate change. There are a few excellent analyses of the global health system’s ability to respond to health crises, but my favourite is Johns Hopkins’ Global Health Security Index. They conclude that no health care system in the world is currently equipped to cope effectively with health emergencies. Even top-rated USA has much room for improvement. However, the following Chart illustrate the enormous gap in coping capabilities between rich and poor nations. Importantly, however, Thailand and Korea show that middle-low income nations can have world-class health systems.
  • There are many health metrics, but they all make the same point: while all nations must improve, the poor are the most vulnerable. The Covid experience points to the same conclusion.

Energy System: Bring Power to the People

In my last blog entitled “Climate Change: Bringing Power to the People!”, I described that the world’s energy sector is by far the largest contributor to GHG emissions growth. As the demand for electricity is likely to soar, radical reform of the power sector is vital if we are to limit the projected rise in global temperatures. The challenge is to create an energy system able to provide the power required for economic growth in an environmentally sustainable manner. Therefore, our sovereign risk appraisal must include a thorough analysis of each nation’s energy system, including its impact on both the local economy and contribution to global emissions. I offer numerous metrics I believe are important.

  • Who are the large emitters: USA, Australia, Canada, etc. Clearly, advanced countries pollute more than emerging economies…..
  • ….however, emissions are rising dramatically in rapidly-growing developing countries, especially China and India. China is now the world’s largest polluter. Also, note Europe’s impressive CO2 reductions in recent decades. The US share of CO2 emissions is also declining.
  • The World Economic Forum provides a valuable annual scorecard on the performance of each nation’s energy system. Europe remains tops. Brazil’s use of hyro and renewables helps (also in other Latam nations). China and India lag (but are improving). Again the poor are vulnerable: Africa and Haiti.
  • Nations must improve the carbon efficiency of economic activity. The next Chart illustrate compared to 15 years ago less carbon is created per unit of GDP, but there’s still a long way to go. Europe leads. Russia, China, Australia, Canada, Korea and others lag.
  • Reduced reliance on fossil fuels is a critical part of the solution. Countries vary widely. Many Asian and Middle Eastern countries are nearly completely reliant on oil, gas, and coal. On the other hand, numerous European and Latin American nations have begun to shift towards renewables and hydroelectric power. Much more to do everywhere.
  • During a climate-related emergency, energy sources may become less reliable. Net energy importers would be more vulnerable, e.g. much of Asia and Europe.

Demographics: The Poor are Most Vulnerable

It’s widely believed that underlying social and economic demographics contribute to a nation’s resiliency, i.e. the ability to adapt to and mitigate against the impact of climatic alterations. Here are a few metrics I believe are especially relevant.

  • More youthful populations are likely to be more adaptable. One of the few metrics that favours Africa…..
  • …..but there’s no getting around the virtually universal consensus that poor nations are the most at risk (despite being the smallest emitters of CO2).
  • High levels of income inequality add to risks. And, the Covid experience indicates health and economic emergencies are likely to widen income disparities. (High Gini coefficiients indicate greater inequality).
  • A well-educated workforce typically contributes to economic flexibility, adaptability, and resilience….
  • …..as does a healthy population.
  • Finally, as temperatures rise, access to robust sanitiation supports good health and economic resilience.

Dynamic Model: Must Reward Improvements

  • Analysis of sovereign risk requires both a snapshot a nation’s current situation, but must also reward improvements. The University of Notre Dame has developed a Global Adaptation Index (GAIN): an annual assessment of individual nations’ vulnerability to climate change. The next chart provides their recent scorecard…….
  • …..and the following Chart illustrates each country’s improvement since 2000. Particularly impressive improvements in China, India, and a few African nations. Less impressive dynamic performance from Venezuela, USA, and Germany. Of course, it is easier for poorly-rated nations to show improvement (from a low base)
  • ND GAIN also provides an specific additional index evaluating each nation’s institutions (legal, political, regulatory, etc), and their readiness to foster necessary policy changes to address the climate challenge. Again, weak institutions in developing countries limit the scope for necessary adjustments.

Climate Impact on Traditional Risk Metrics

  • After completing this in-depth consideration of climate vulnerability, and the ability of nations to adjust to the challenge, credit analysts must return to the more mundane task of evaluting how these factors impact traditional sovereign risk metrics. In other words, will I be repaid?!
  • A strong external balance sheet (net international investment position) helps a nation weather many uncertainties. Singapore, Taiwan, and much of Europe are in a strong position, compared to USA, Turkey, Australia, and Europe’s PIGS (Portugal, Ireland, Greece, and Spain).
  • Twin budget and current account deficits, as well as high levels of government debt, leave nations vulnerable to shifting investor sentiment during the best of times, let alone during a climate-related emergency.

Final Considerations

  • Thanks for sifting through this treasure chest of Charts. I think the final result is a useful tool kit for assessing the impact of climate change on sovereign risk. Add your own metrics into the box!
  • In the coming weeks, I will publish my last blog in the series. I will pull all the pieces together, and produce strategic recommendations.
  • In the preparation of this report, I found the following analyses very useful: University of Notre Dame’s Global Adaptation Index report, the World Economic Forum’s Energy Transition Index study, and the Bundis Entwicklung Hilft’s World Risk Index. All highly recommended!