Climate Change: Who’s Preparing, Who’s Not

28 June 2020

The expansion of ESG investing indicates that some fund managers are beginning to give additional attention to environmental, social and governance factors in the selection of company investments. Furthermore, they are using their financial clout to encourage corporate decision-makers to prioritise climate change in their business strategies. Unfortunately, however, ESG remains a niche specialisation within the asset management sector.

Furthermore, far less consideration has been given to country-level environmental performance in assessing sovereign risk. I have set out to change this. As climate change is likely to be the most important macro-issue in coming decades, global asset allocation decision-making should begin with an in-depth evaluation of the impact of rising temperatures on individual countries.

In three recent blogs (all available in the archive of my website), I offered initial observations. Today, I will present my climate vulnerability framework, the results, and initial market implications. Hopefully, the model will encourage investment committees to put the topic at the heart of their macro-strategy. In addition, I hope the results stimulate debate, and help policymakers focus on what is needed to mitigate against the impact of climate change. Drum roll please…..the country most prepared is…..Norway! The least…..Lebanon!

Critically, I have discovered that financial markets are focused on the Covid pandemic and the on-going consequences of the Global Financial Crisis (GFC), and are largely ignoring what may well be the most important long-term issue of the era. (I limit the study to 90 countries in the investible universe.)

As usual, I will make ample use of charts (some of which you may have seen in earlier blogs) for easier presentation. Adanced warning, this is a detailed study, not a breezy blog! So, sit back with your favourite beverage, and have a read…..make mine a double!! In the development of my model, I have benefited greatly from the analysis from the University of Notre Dame (my alma mater), the World Economic Forum, and Our World in Data.

Climate Vulnerability Framework

My framework consists of three key components. First of all, an evaluation is made of the current state of a nation’s vulnerability. Key metrics include an assessment of geographical factors, the status of the energy system, the quality of intrastructure, the robustness of the health care system, the role of the agricultural sector, and each country’s demographics. Secondly, countries should be rewarded for making adjustments aimed at mitigating against climate risks. In large part, this will depend on the strength of national institutions, regulatory system, rule of law, etc. Finally, I make an evaluation of each nation’s current macro conditions to determine how climate change will impact traditional sovereign risk metrics. I apply weights to these factors to produce each country’s final score.

Physical Exposure: Mitigation Against Nature

My model considers two metrics of physical exposure. The first is the proportion of a nation’s population living at below 5 metres elevation. Many beautiful mountain nations, e.g. Norway, Austria, Switzerland, Bolivia, and Zambia, have no one living under such conditions. At the other end of the spectrum, however, nearly 60% of the population resides below 5m in the Netherlands and Surinam. Many island nation are similarly vulnerable, e.g. Maldives and Bahamas, as are coastal nations, such as Gambia, Belize, Guyana, and Monaco. Much of the Middle East lives at low elevation, and 37% of Vietnam’s population lives at 5m. Even 10% of Hong Kong’s and Singapore’s residents exist at this level, and Bangladesh is 9%. Even in secure countries such as the USA, certain coastal settings are at huge risk to rising sea levels, flooding, and storms.

Meanwhile, countries will high population density are most exposed. Asia, especially the Indian subcontinent, is especially at risk, as are many some European nations (Chart above).

Energy System: Dramatic Reform Required

The world’s energy system accounts for over 50% of annual CO2 emissions. As a result, this factor receives an especially high weighting in my model. The metrics used in my assessment include: emissions per capita, reliance on fossil fuels, energy imports, emissions growth, energy efficiency (energy use/GDP), and CO2 intensity (emissions per unit energy use). Europe ranks consistently near the top. Countries reliant on fossil fuels (especially coal) rate poorly, e.g. Asia and Middle East. Australia and the USA have much room for improvement.

Agriculture: Source of GHG and Rural Risk

The agriculture sector is a major emitter of Green House Gases (GHG). China, India, Australia, USA, Brazil, Indonesia, and Pakistan account for 50% of agricultural emissions, followed by Argentina, Russia, Mexico, Ethiopia, Nigeria, and Bangladesh. Countries with a large farming and rural population will be vulnerable to rising temperatures, drought, volatile weather patterns, flooding, etc. The chart illustrates that Africa, the Indian sub-continent, and parts of East Asia (Vietnam, Philippines, Thailand, and Indonesia) are most at risk. Other metrics followed include the reliability of water supply and the dependence on cereal imports (which could become scarce in a climate emergency).


Health Care System: Lessons from the Covid Emergency

The Covid-19 pandemic has illustrated the strains put on health care systems during a health emergency. In a well-timed study (released in October 2019), Johns Hopkins rated each country’s ability to cope with crises. All nations came up wanting. Even top-rated USA scored only 74/100, indicating a still huge room for improvement. Given the importance of this variable, it receives a higher weight in my framework. The clear message from the Chart above is that the poor are most vulnerable. Fortunately, Thailand’s and Korea’s high scores indicate that even middle-income (or below) nations can produce a world-class health care system. I also include metrics on the number of doctors and hospital beds.

Infrastructure: Where the Rubber Hits the Road

High quality infrastructure will be critical in coping with climate emergencies. Again, it’s hard to avoid the message that the world’s poorest nations are at risk.

Demographics: The Poorest are Most Vulnerable

In addition to the condition of physical infrastructure, the quality of human capital will be a decisive factor in mitigating against the consequences of rising temperatures. I have considered the following: age profile, education levels, sanitation, nutrition, poverty level, and the degree of income equality. Once again, the poor are at risk (in Chart above low score indicates low risk).

Adaptability: Rewarding Improvement

Any assessment of sovereign risk must reward improving trends. Indeed, I have given this variable additional weight in my model. I include a measure of the strength of national institutions — judicial, corruption, rule of law, etc. In addition, the University of Notre Dame has been publishing its Global Adaptability Index for many years. I include the change in the index level since 2000 to assess the pattern of improvement. Should I say it again: weak governance in poor countries puts citizens at risk during emergencies.

The Results: Some Early Lessons

Lesson 1: Lost Decade: Slow Progress, Losing Momentum

The 2009/2010 climate conferences in Copenhagen/Cancun recognised the need to reduce GHG emissions. The Chart, however, illustrates that world-wide emissions continue to rise, not fall. Despite the poor track record, there have been some bright spots. While world-wide CO2 emissions have risen over 40% since 2000, the level in OECD countries declined 4%. However, this meagre achievement has been swamped by a doubling of pollution levels in rapidly-growing non-OECD nations. Europe has led the way: emissions have declined 1.5% annually during the past decade compared to 0.3% per year in the prior 10-year interval. Even in the non-OECD nations, emissions growth has cooled from 7% per year to 2.5% during the past decade (see my essay entitled Post- Covid: Crucial Decade for Climate Change).

Moreover, there is evidence that the pace of adjustment (to the degree it existed) may have slowed. Indeed, the improvements in the ND-GAIN index have slowed in most countries, and have deteriorated in some. The silver lining is the pace of change remains higher in the more vulnerable poorer nations, and the gap between the OECD and non-OECD is narrowing.

As a result of the lost decade, an even faster pace of emissions reductions is now urgently required to achieve net-carbon neutrality by 2050. In order to limit temperature increases to 2% or 1.5% above pre-industrial levels, the United Nations estimates that GHGs must decline 30% and 45% respectively by 2030. The UN projects that current policies will lead to a 3-4% rise in global temperatures by 2100. The next decade is vital.

Lesson 2: Energy Sector — Bringing Power to the People

Rising global incomes and population, as well as surging demand for electricity, will lead inevitably significantly increase the world’s power requirements. The objective, therefore, must be to create an energy system that promotes GDP growth in an environmentally sustainable manner (see my blog “Global Energy Reform: Bringing Power to the People”).

The Chart above provides key insights. First of all, lower emissions do not necessarily come at the expense of GDP growth. Indeed, OECD nations have cut CO2 levels and continued to grow. Secondly, we are consistently improving energy efficiency: we need less power per unit of GDP. What’s missing, however, is meaningful reductions in carbon intensity, e.g. the amount of carbon emitted per unit of energy consumed. This will likely require a large-scale shift away from fossil fuels towards renewable sources. The next Chart illustrates this is not happening quickly enough. Indeed, the world-wide electricity sector’s addiction to coal has not declined. And for all the talk, renewables account for only 9% of global electricity generation.

Lesson 3: Europe Provides Global Leadership

Europe is at the vanguard of mitigating against the risks of climate change. Not only is Norway #1, but 9 of the top 10 ranked countries (and 17 of the top 20) are in the region. The area receives consistently high marks on all metrics: 10 of the top 15 energy systems, 9 out of 15 on infrastructure and ability to change, and 8 of the 15 most robust health care systems. The Chart illustrates that the region has led the way on emission reductions since 1990. And, the recently passed EU Green Deal establishes a credible roadmap to carbon neutrality by 2050.

But, there’s much more to do. Part of Europe’s success stems from its usage of renewable energy sources: 19% of the region’s electricity is derived from alternatives (compared to 9% globally). However, alternatives still represent less than 9% of its total energy usage. In addition, despite huge improvements in carbon efficiency, large disparities exist within the area (next Chart). For example, France produces 40% less carbon per unit of GDP than Germany. And, there are weak links: Italy ranks #35, Greece #48, Turkey #45, Serbia #44, and Poland #33.

Lesson 4: USA Lags Behind

The USA ranks a disappointing #20. The nation enjoys many strengths, e.g. Johns Hopkins rates the health care systems as #1, and she scores well on human capital demographics. However, America’s agricultural sector produces large amounts of menthane. And, despite reducing CO2 emissions 5% during the past decade (9% in Europe), the US energy system ranks #52.

Despite meaningful gains in energy efficiency, the Chart above indicates America lags top European nations on this metric. Likewise, the earlier Chart illustrates CO2/GDP in the USA is double that of the United Kingom and other top European nations. America’s lower usage of renewables — accounting for 9% of electricity (19% in Europe) — is largely responsible. Meanwhile, Australia ranks #17, despite an energy sector at #51: 60% of the nation’s power is generated by coal. In contrast, 60% of Canada’s (#10 ranked) electricity comes from hydroelectric power. However, the nation is an inefficient user of energy; consequently, emissions are still rising.

Lesson 5: China — The Elephant in the Room

There is no ignoring the critical role China must play in the climate debate. China is now the world’s largest polluter. Even on a per capita basis, the nation exceeds the European Union. Fortunately, there has been considerable progress recently. CO2 emissions growth has slowed to 1.5% annually during the past decade compared to 14% yearly gains in the previous 10-year interval. This reflects technological advances that dramatically improved energy efficiency. Indeed, energy/GDP has declined 40% since 1985 — the best amongst all major economies. Energy efficiency is now not much different than in the USA.

However, China’s demand for power remains huge: electricity production rose 8% per year in the past decade. China’s energy mix remains a huge problem. Despite the nation’s attempt to reduce its reliance on coal, the black rock still accounts for nearly 70% of electricity generation. Likewise, despite impressive growth in the use of alternative energy, renewable sources account for only 9% (roughly the same as USA). As a result, the Chart above illustrates that China’s CO2 per unit of energy used (carbon intensity) remains the world’s highest.

Lesson #6 — Asia: Dependence on Foreign Fossil Fuels

The rest of Asia is a mixed bag. Hong Kong (#24), Singapore (#21), and Korea (#27) score well, but India (#81), Pakistan (#85), and Bangladesh (#88) are at the bottom of the table. Overall, the region ranks lower than other Emerging Market areas. The region’s CO2 emissions have doubled since 2000, and Vietnam is up 4-fold. A major source of vulnerability is the heavily reliance on fossil fuels (Chart above), much of which is imported (Chart below).

India, where emissions and energy usage has increased 6% annually during the past decade — requires special mention. Coal accounts for a staggering 75% of electricity generation. In addition, the Indian sub-continent’s huge rural population is an additional source of vulnerability.

Lesson 7: Latam — Poor Governance Puts Public at Risk

Latin America scores better than Asia. Strong energy systems, making extensive use of hydro-electric power, exist in many countries. Indeed, Uruguay ranks 4th in the world following its amazing transformation. World-class systems also exist in Costa Rica and Colombia. However, the region is plauged by weak governance and institutions: except for Chile adapatability scores are lower than total rankings. Poor governance impedes measures needed to mitigate against the climate risks faced by the public.

Lesson 9: Africa: The World’s Poor are Most Vulnerable

The correlation coefficient between my model’s vulnerabilty index and per capital GDP is 0.66. African nations represent 15 of my lowest 30 scores: Ghana #55 is the highest. The cruel irony is that these countries pollute the least (both annually and cumulatively), but remain the most vulnerable. The continent accounts for only 3% of global energy consumption and 4% of annual emissions. A financing vehicle to help these countries gain access to electricity and mitigate against climate risks will need to be an important part of the debate. South Africa ranks a disappointing #80, as nearly 90% of its electricity is generated by coal. To be fair, however, the nation’s emissions have begun to decline in the past decade.

Markets: Largely Ignoring the Risk

So, it’s time to consider how seriously financial markets are taking climate risks. Let’s start with currencies. The scatter Chart above illustrates the relationship between my model’s climate vulnerability index and the deviation of a currency from its long-run average (in real terms, or PPP value). If you see any relationship, you have a sharper eye than I do! Indeed, the correlation is only 0.09: very low and the wrong sign — I would expect an exchange rate would be stronger if the vulnerability index is lower.

This is troubling, but it creates trading opportunities, especially as many EM currencies deviate significantly from long-term average levels (Chart above). For example, the US dollar is overvalued versus Europe, despite the lower US climate score. Large gaps exist between countries with excellent climate ratings: Norway is very undervalued, but the Swiss franc is correctly overvalued. Within climate-vulnerable countries, FX performance also differs: despite have similarly poor climate scores, Bolivia is wildly overvalued while the South African Rand is rightly at a huge discount. Finally, countries with similar currency valuations can have very different climate scores, e.g. compare Switzerland and the Philippines. I could go on, but you get the point.

What about bond market risk premia, which I measure by the level of both short- and long-term real interest rates. Perhaps not too surprisingly, there is virtually no relationship between inflation-adjusted short-term rates and my climate model. Global central banks are establishing monetary conditions according to the immediate economic risks posed by Covid-19 (and the GFC), not long-term climate considerations. The relationship between real policy rates and my climate index is even weaker in the EM universe than in developed markets (correlation 0.03 versus 0.24).

Regarding 10-year bond yields, there is a relationship between risk premia and climate risks. The link is better within the developed markets (Chart above). But, the 0.44 correlation coefficient is still quite low, suggesting that even these markets are not overly focused on the issue. Appropriately, US real yields are above Europe’s. However, major anomalies exist. For example, New Zealand and Canada have much different real bond yields, despite similar climate scores. Likewise, countries with similar inflation-adjusted yields, e.g. Sweden (#4) and Turkey (#49), can have dramatically different climate performance.

Within the Emerging Markets, the relationship remains positive (higher climate risk is correctly associated with higher real yields), but is considerably weaker than in advanced economies (Chart above): correlation coefficient at 0.27. Again, big gaps in risk premia exist between countries with similar climate scores, e.g. India versus South Africa. Likewise, countries with similar real yields, such as Hungary (#25) and India (#81), can have dramatically different climate ratings.

The low correlation in emerging markets suggests investors are scrambling for additional yield rather than considering climate risks. Indeed, the correlation coefficient drops further if Frontier markets are added to the mix. If the market’s focus eventually shifts from Covid/QE to environmental considerations, large adjustments in credit yield spreads, risk premia, and exchange rates should be expected.

Strategic Considerations

  • Financial markets are focused on Covid-19 and a prolonged period of QE. Climate change is virtually being ignored.
  • Emerging/Developing countries are more vulnerable to climate risks than advanced economies, which is not reflected in current yield spreads. Risk premia are especially compressed where climate risks appear greatest. Despite the current attractions of high-yielding EM bonds, these markets (especially on the Frontier) would be most vulnerable if markets give environmental issues more attention.
  • There is virtually no correlation between FX performance and climate risks. The US dollar is at risk versus European FX. Many interesting opportunites may exist in Emerging FX, as currency markets are not adequately factoring in differences in climate vulnerability.
  • Climate change is likely to become the dominant macro-issue in coming decades. Please contact me if you would like to investigate strategic issues related to this topic (or any others).