Fund Solutions

Debt Instruments Can Help Fight Against Deforestation

New Fitch report says investors should look at new asset classes such as green bonds to help tackle biodiversity damage in countries such as Brazil and Sri Lanka.

Investors are being urged to take a financial carrot rather than stick approach to help tackle the problem of biodiversity and nature damage in emerging market (EM) countries.

A new report from Fitch Ratings – ‘Investors Grapple with Stemming Biodiversity Loss’ – says investors seeking to demonstrate a positive impact on biodiversity and nature could utilise green ‘debt for nature’ swaps and sovereign green bonds that tie interest rates to environmental targets for countries, financial institutions and corporates.

This, it added could “circumvent the challenges of using engagement or divestment mechanisms on biodiversity issues, avoid unfairly penalising emerging markets and help contribute to debt sustainability”.

The report outlined that some of the most indebted nations in the world – such as Sri Lanka, with debt interest payments at 50% of government revenues, and Brazil at 30% – often have some of the worst biodiversity challenges such as deforestation and threats to species.

Debt for Nature

Fitch said debt for nature swaps, which link substantial reductions in debt owed to creditors to environmental outcomes, could play a key role going forward in tackling biodiversity loss as well as debt restructuring for these heavily indebted EM countries.

According to Fitch, Argentina is one prime example, having initiated bilateral arrangements with the US and other countries.

In addition, both the IMF and the World Bank have committed to developing an ‘organising framework’ for connecting debt to countries’ plans for investing in climate and conservation activities, including an advisory platform.

Fitch said the issuance of sovereign green bonds or nature performance bonds could also play a role. The latter are being developed by the World Bank and allow debtors to tap into the demand for green, social and sustainability linked debt and the “rapidly increasing demand for impact investments, which typically accept lower bond yields in return for measurable outcomes in terms of sustainability performance”.

According to recent figures from the Climate Bonds Initiative total volumes for labelled green, social and sustainability (GSS) bonds, sustainability-linked bonds (SLB) and transition bonds reached US$496.1 billion in the first half of 2021, up by 59% on the same time last year.

Notably SLBs – forward-looking, performance-based debt instruments issued with specific key performance indicators and sustainability performance targets in place – recorded first-half issuance of US$32.9 billion.

There is also increasing focus on the sustainability characteristics of sovereign bonds and their issuers among asset owners. The recently launched Assessing Sovereign Climate-related Opportunities and Risk (ASCOR) framework is being developed to enabling investors to measure, monitor and compare sovereign issuers’ current and future climate change governance and performance fairly and appropriately.

Systemic risks of biodiversity loss

Biodiversity is certainly rising higher up the agenda this year such as COP26 and the One Planet Summit in October focused on mobilising finance to address climate change and nature degradation. However, the partial postponement of the UN Convention on Biological Diversity in Kunming, China, will delay finalisation of a global biodiversity standard until next year.

In addition, Fitch stated that there is a growing recognition among policymakers and investors that many of the systemic risks of biodiversity loss, such as ecosystem collapse and associated increased in physical climate risk exposure, are likely to materialise as financial risks across a range of industries and markets.

As such major regulators such as the EU are exploring integration of biodiversity risk screening into supply chain due diligence requirements. Biodiversity loss is also likely to lead to systemic risks, it added, to the financial system, such as assets no longer being able to be insured at a reasonable cost.

Despite this Fitch added that opportunities for investors to drive positive changes are often more limited than for other environmental risks.

This is because, it explained, of the dominance of private companies within soft commodity supply chains, limited exposure to those companies or sovereign debt among asset owners as well as ethical problems entailed by engaging governments on policy issues.

The ratings agency added that there was a lack of clear data and transmission channels linking land use change and biodiversity loss to company activities and that the financial materiality of biodiversity loss to corporate performance was also less clear than other climate change issues.

 

 

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