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Calculating the risks

Illustration by David Doran.

Bondholders can’t exercise ac­tive ownership over a firm the same way equity investors can. Does that mean they’re not interested in driving cor­porate sustainability? Quite the contrary.

Evidence increasingly tells us that environmental challenges like weather extremes, water scarcity and ecosystem degradation can financially affect compa­nies in different sectors. The development and testing of analytical tools that assess how environmental risks affect standard financial metrics, such as EBITDA, could allow credit analysts, rating specialists and portfolio managers to factor excess envi­ronmental risk into the cost of capital for firms borrowing money.

This is important, as our dependency and impact on the Earth’s natural capital are becoming increasingly material. Wa­ter, for example, can be a vital element of a company’s production processes. The Brazilian water firm Sabesp saw the out­look on its rating changed by both Moody’s and S&P due to drought in Brazil. S&P has stated that the environmental costs of wa­ter use and infrastructure will increasingly be included in water pricing in the United Kingdom.

A 2010 study from the World Resources Institute showed that 79 per cent of the planned electrical generation capacity in India – amounting to 60 gigawatts, much of it relying on water for generation and cool­ing – will be built in areas that are already water scarce or stressed.

And it’s not just companies that are vul­nerable; countries are equally impacted. A study out of The Economics of Ecosystems and Biodiversity (TEEB) initiative calculat­ed that welfare loss due to ecosystem degra­dation through ‘cost of policy inaction’ will equate to about $50 billion (U.S.) by 2050.

The Environmental Risk in Sovereign Credits (E-RISC) project has taken that analysis a step further. It is looking at the potential materiality of natural resource and environmental risks in the context of sovereign credit risk analysis. The results of the project’s first phase found that a 10 per cent variation in commodity prices leads to changes in a country’s trade balance equiv­alent to between 0.2 and 0.5 per cent of a nation’s GDP.

These studies are helpful to raise aware­ness, but banks, investors and rating agen­cies need a way to systematically factor these issues into the way bonds are priced and rated.

 

Analytical tools, the missing link

Missing in the marketplace have been analytical tools that can factor environmen­tal risks into a company’s future financial performance. Historically, the lack of com­parable ESG (environmental, social and governance) data across and within indus­tries on a temporal and spatial scale, and the inability to link it with financial data provided by Bloomberg, Thomson Reuters and others, have proven a major barrier.

The good news is that organizations like CDP and the Global Reporting Initiative, which seek increased disclosure of ESG data, have helped bring richer databases to banks and investors. This has given mo­mentum to the Natural Capital Declaration (NCD), a CEO-endorsed and finance-led initiative launched in 2012.

The initiative, which is aimed at main­streaming the integration of natural capital considerations with bonds, equities, loans and other financial products, has embarked on a number of pilot projects that focus on developing practical analytical tools for fi­nancial institutions.

The tools are being designed to quantify how specific changes to natural capital ele­ments, such as water availability and defor­estation risk, can affect the financial perfor­mance of companies that either depend on these resources or have significant impacts on them.

Two NCD pilots aim specifically to de­velop and test tools for corporate and sov­ereign bonds. The first is a “Corporate Bond Water Risk Tool,” which investors can use to assess how water scarcity in certain sectors affect the credit quality of corporate bonds. The second builds on the E-RISC project by modelling a forward-looking range of potential economic impacts that countries are likely to face due to the changing avail­ability of and demand for renewable natural resources. It will also estimate the potential effect on a country’s sovereign credit rating.

How does this empower bondholders? A company that is increasingly facing water stress – that is, there is a growing gap be­tween demand and supply of water – could be faced with higher operating costs or ad­ditional capital expenditure, such as the need to build a desalination plant.

A higher debt-to-EBITDA ratio can undercut a firm’s ability to make timely payments to bondholders. Using the new analytical tools, the potential effect of water scarcity on default risk could be modelled and – if applied – could affect the credit rating of companies and, subsequently, the coupon on interest that needs to be paid to cover any additional risk for newly issued bonds.

Water risk is just one example. Analysts and rating specialists would have a way to model how a range of environmental risks might affect the value of a bond. If such tools are mainstreamed, bondholders could become principal drivers of sustainability by pricing unsustainable (or more sustain­able) corporate and governmental practices into the cost of capital.

Given that the bonds market is about twice as big as the combined value of the world’s stock exchanges, the importance of such tools in the context of sustainability cannot be overstated.

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