Assessing GHG Emissions from Sovereign Debt Financing in Emerging Markets: An approach by PCAF

Author

Norah Zhang

Executive Summary

  • The highest emissions financed by sovereign debts are in Africa and Asia, while the lowest are in Europe, as revealed by a global-level analysis.

  • GHG emissions resulting from sovereign debt financing tend to be highest in Least Developed Countries (LDCs), followed by emerging markets and other developing countries, and lowest in developed countries, as shown by the regional-level analysis.

  • The trend of sovereign debt-financed emissions in emerging and developing economies has been decreasing since 1990, as shown by the country-level analysis.

Introduction

The PCAF (Partnership for Carbon Accounting Financials) to help financial institutions accurately assess and disclose the greenhouse gas (GHG) emissions resulting from their loans and investments. By developing this standard, the PCAF provides a GHG accounting framework that allows financial institutions to manage climate-related risks, comply with regulations, and identify new business opportunities. Moreover, it enables these institutions to meet stakeholder expectations and maintain a positive reputation.

Understanding the financed emissions of sovereign debt is particularly important for financial institutions. The PCAF’s Financed Emissions Standard provides a framework for calculating emissions financed by sovereign debt. This is critical because it allows financial institutions to account for a holistic view of a sovereign’s responsibility in generating emissions within and outside its boundaries. PCAF requires the attribution of emissions from sovereign debt using the following methodology:

Attributed Emissions = Exposure to Sovereign Bond (USD) / PPP-adjusted GDP (international USD) * Scope 1 Emissions (tCO2e)

The goal of this analysis is to help the emerging market debt team understand and manage potential risks and opportunities associated with GHG emissions in their portfolios. This article employs the Financed Emissions Standard for sovereign debt developed by the PCAF and open-access data from the World Bank and the Emissions Database for Global Atmospheric Research (EDGAR). By utilizing the Financed Emissions Standard, the team can calculate the attributed emissions from sovereign debt and gain a more complete understanding of their investments’ impact on climate.

Key Findings

1. Global-level analysis

The highest emissions financed by sovereign debts are in Africa and Asia, while the lowest are in Europe. In other words, if a hypothetical investor were to invest the same $1 million in all countries, their investment in Asia and Africa would likely cause more GHG emissions compared to Europe. This finding is illustrated in Figure 1-1, which presents a global map of Sovereign Bond Financed Emissions in 2021.

The 5 countries with the highest GHG emissions from sovereign debt are Palau, Chad, Central African Republic, Mongolia, and Somalia. The calculation reveals that some countries have a higher ratio of sovereign emissions to PPP-adjusted GDP, which means that they have borrowed money to fund projects or operations that generate a significant amount of GHG emissions relative to the size of their economy. On the other hand, the five countries with the lowest financed emissions are Switzerland, Malta, Sweden, Denmark, and Luxembourg. Essentially, this finding suggests that these countries have a relatively low carbon footprint resulting from their sovereign debt.

To a large extent, PPP-adjusted GDP and sovereign emissions are positively correlated, and the relative levels of the two indicators determine the size of GHG emissions financed by sovereign debt. As shown in Figure 1-2, several countries with the highest sovereign debt-financed emissions, Palau (PLW), Chad (TCD), and Central African Republic (CAF), have relatively higher sovereign emissions, resulting in a higher carbon footprint for the same amount of sovereign debt, while several countries with the lowest sovereign debt-financed emissions, Malta (MLT) and Luxembourg (LUX), have relatively higher PPP, resulting in the same sovereign debt being more likely to flow to lower-emitting sectors.

2. Regional-level analysis

In general, GHG emissions resulting from sovereign debt financing tend to be highest LDCs, followed by emerging markets and other developing countries, and lowest in developed countries (see Figure 2-1). This can be attributed to several factors, including economic development, infrastructure needs, and energy systems.

LDCs and developing nations may require significant investments in energy-intensive projects to improve their infrastructure and boost their economies. For instance, they may need to build roads, airports, power plants, and other energy-intensive projects, which can generate high GHG emissions. These countries may also have less access to financing for clean and sustainable energy sources, further exacerbating their carbon footprint.

In contrast, developed countries typically have more established economies and infrastructure and may have invested more in clean and sustainable energy sources. This can result in lower GHG emissions from their sovereign debt financing. However, it is important to note that developed countries are not immune to the carbon footprint associated with sovereign debt financing, and there is still room for improvement in reducing emissions from these investments.

Emissions from sovereign debt financing vary significantly among emerging and developing economies and cannot be easily classified geographically, thus necessitating a case-by-case examination. Figure 2-2 shows that some emerging and developing economies, such as Zimbabwe, Iran, and South Africa, have high emissions resulting from sovereign debt financing, while others, such as Costa Rica, Peru, and Chile, have lower emissions.

One factor that may explain these differences is the energy mix of each country. Countries with significant oil reserves, such as Iran, may have higher emissions, while those that rely heavily on coal-fired power plants, such as Zimbabwe and South Africa, may also have higher emissions. In contrast, countries like Costa Rica, Peru, and Chile have a greater share of renewable energy sources and tropical rain-forests, which serve as carbon sinks, contributing to lower emissions.

3. Country-level Analysis

The trend of sovereign debt-financed emissions in emerging and developing economies with the highest and lowest emissions has been decreasing since 1990, as shown in Figure 3-1. It is mainly driven by the rapid growth momentum of PPP-adjusted GDP. This assumption is supported by the animation in Figure 3-2, where the circle representing the ratio of sovereign emissions and PPP-adjusted GDP gradually shrinks as they grow at different rates. Notably, China exemplifies this trend, with a large economy and emissions but a faster-growing economy than emissions, resulting in a year-to-year decrease in calculated sovereign debt-financed emissions.

Conclusion

In conclusion, the Financed Emissions Standard for sovereign debt developed by the PCAF provides a framework for financial institutions to accurately calculate and disclose the GHG emissions resulting from their investments in sovereign bonds. By utilizing this standard, the emerging market debt team can gain a more complete understanding of their investments’ impact on climate and manage potential risks and opportunities associated with GHG emissions in their portfolios.

This article’s analysis indicates that sovereign debt financing generates the most GHG emissions in LDCs and developing, and the least in developed countries. However, emissions from such financing vary considerably among emerging and developing economies, necessitating case-by-case analysis. To identify new business opportunities, manage climate-related risks, and maintain a positive reputation, financial institutions must consider each region and country’s unique characteristics and comply with regulations.