Kicking away the green ladder: the asymmetric sovereign risk from nature degradation

Evidence shows that climate change is having severe economic impacts. However, far less is known about the economic consequences from severe and rapidly increasing nature degradation, particularly on sovereign bond yield spreads. This is despite the scale of nature-related financial risks: in 2020, around half of global GDP was estimated as moderately to highly dependent on the benefits humans derive from nature.

This study provides the first empirical analysis of the financial effects of nature degradation on sovereign bonds: a critical asset class, which determines the costs of sovereign government borrowing, fiscal policy space, and which indirectly affects the cost of capital in the private sector.

The authors examine sovereign borrowing costs across 28 advanced and 25 emerging economies between 2000 and 2020 at two-, five- and 10-year bond maturities. They find substantial average impacts from within-country degradation for sovereign borrowing costs. They also reveal significant variation in impacts, with countries with elevated sovereign risk disproportionally impacted by physical and transition-related nature vulnerability.

The paper highlights that the disproportional direct fiscal consequences of degradation in biodiversity were highest for lower-income countries in Africa and Asia, many of which house global biodiversity hotspots. Given the interconnectivity of trade and sovereign debt markets, the authors argue that the financial effects are unlikely to be confined to debt-distressed, high-risk and nature-dependent countries.

Key points for decision-makers

• Countries with higher levels of biodiversity degradation pay a sovereign borrowing cost penalty: on average, around 40–75 basis points (bps) for 5- and 2-year maturities, respectively, and across three proxies for nature-related financial vulnerability.
• The sovereign borrowing cost penalty is uneven across time: government borrowing costs are higher for shorter borrowing horizons (5- and 2-year) for countries with higher levels of biodiversity degradation, even when controlling for traditional economic and institutional determinants of sovereign risk, country fixed-effects and common global market factors.
• Uneven direct fiscal consequences for lower-income countries: for countries in the 90^th percentile of borrowing costs, which tend to be lower-income countries in Africa and Asia, degradation in biodiversity is associated with up to three times higher borrowing cost consequences relative to the mean.
• Exacerbating financial fragility for nature-dependent countries: low-income countries have a higher dependency on ecosystem services, such as fertile soils and pollination, and higher economic contribution from sectors dependent on them, such as agriculture and forestry. Many also face elevated debt pressures. In this way, continued degradation of nature is likely to exacerbate macro-financial fragility for low-income countries, especially where thresholds beyond which ecosystems may not be able to maintain themselves have been transgressed.
• Implications for high-income countries: given the integrated nature of global supply chains and the systemic importance of sovereign debt for global financial stability, financial effects are unlikely to be confined to debt-distressed, high-risk and nature-dependent low-income countries.
• Macrocritical risks: with similar borrowing cost penalties to those outlined from the widely used ND-GAIN climate vulnerability index, the authors highlight that nature-related financial risks are similarly ‘macrocritical’. They argue that the substantial uneven consequences warrant closer integration and attention in macroeconomic frameworks, including debt sustainability analyses, central bank monetary policies, and economic and regulatory frameworks. This is an urgent area for action by Ministries of Finance, credit rating agencies and financial institutions.