INSIGHT by Dr. Moritz Kraemer is Chief Economist at LBBW Bank, Germany, and Senior Fellow at the Centre for Sustainable Finance at SOAS University London.
Rating agencies and institutional investors broadly concur that climate change is becoming an issue affecting all asset classes, including the biggest asset class of them all: sovereign bonds. But they also broadly concur in not acting on this insight. The reason most often heard is that climate change is just too complex in the ways it may affect the creditworthiness of nations. We would like to incorporate climate change more, so the common refrain goes, but we cannot, because the data is simply not there to estimate the impact of a hotter planet on sovereign creditworthiness.
But this excuse no longer holds. Groundbreaking new research, published last month in the scientific journal “Management Science” provides specific estimates of the havoc that climate change could wreak on the sovereign ratings of rich and poor countries alike. That said, it also provides reassurance that stabilizing the planet’s temperature in line with the Paris agreement will benefit sovereign ratings. These climate enhanced sovereign ratings have become possible due to continuously improving data on the economic impact of shifting climate patterns.
We would like to incorporate climate change more, so the common refrain goes, but we cannot, because the data is simply not there to estimate the impact of a hotter planet on sovereign creditworthiness. But this excuse no longer holds.
As estimates of the economic consequences of climate change continue to grow, financial markets and business leaders are facing growing pressure to factor climate risks into their decision-making. Fortunately, what we will always have is the Paris of the eponymous Agreement, which makes it clear that we can be the master of our climatic destiny if we can only muster the will to take control. As such, we should view the latest research not as a harbinger of doom, but as a call to arms for swift and comprehensive mitigation action.
Still, a fundamental challenge remains: decision-makers lack the risk information they need. It is not enough to know that climate change might somehow be harmful to your portfolio. Markets need credible, digestible information on how climate change translates into material risks. However, an explosion of environmental, social and governance (ESG) ratings and corporate climate disclosures has created a confusing hotchpotch of unfamiliar, incomparable, conflicting metrics.
ESG indicators allow for an excessively wide variance of outcomes for corporate and sovereign issuers alike. Depending on which indicators you choose, the same sovereign can end up at the both the top and the bottom of the ESG scale. It’s a choose-your-own-adventure story that has failed to give investors and other stakeholders reliable risk guidance.
| Climate-smart sovereign ratings
Understanding the shortcoming of current approaches is what motivated a group of environmental and financial economists at the Universities of Cambridge, Norwich, Sheffield and Frankfurt to have a stab at the world’s first “climate-smart” sovereign credit ratings. The report provides a clear warning: climate change will affect the ratings of rich and poor countries alike. And it is not something we can kick down the road: the downgrades could begin this decade.
By linking climate science with economic models and real-world best practice in sovereign ratings, the authors avoid subjective ESG go-betweens. Instead, their methods directly simulate the effect of climate change on economic outcomes and sovereign credit ratings for 108 countries under three different warming scenarios.
To that end, the authors developed a random forest machine learning model to predict sovereign credit ratings, which they trained on ratings issued by S&P Global Ratings between 2015 and 2020. Then, they combined climate economic models with S&P’s own natural disaster risk assessments to develop a set of climate-adjusted economic indicators that describe the various warming scenarios. Finally, the authors fed this climate-adjusted macroeconomic data into the ratings prediction model to simulate the effect of climate change on sovereign ratings.
| Sovereign ratings feeling the heat
Unlike much of the climate economics literature, this research found that the material impacts of climate change could be felt early as 2030. Under Representative Concentration Pathway (RCP) 8.5—a high-emissions climate scenario that closely traces recent historical emissions, leading to global warming of about 5°C by the end of the century compared to the preindustrial average—63 sovereigns (58%) will suffer climate-induced sovereign downgrades of approximately one notch by 2030. This wave of downgrades will broaden and deepen to encompass 80 sovereigns (74%) that will face an average downgrade of 2.5 notches by 2100.
The most affected nations under the adverse RCP 8.5 scenario include such large economies as Canada, Chile, China, India, Malaysia, Mexico and Peru, all of which are set receive downgrades exceeding five notches. More importantly, the results show that virtually all countries—rich or poor, tropic or temperate—will suffer downgrades should carbon emissions continue on their current trajectory.
Second, the simulations strongly suggest that stringent climate policies consistent with the Paris Agreement will result in minimal climate impacts on ratings, with an average downgrade of just 0.65 notches by 2100. Considering the multiple-decade time frame, this would be a mere blip.
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The research then estimates the likely additional interest burden for sovereigns stemming from the climate-induced downgrades. In a benign, Paris-compatible outcome, the additional interest cost could amount to $22 to $33 billion (in today’s money), an affordable amount. However, in a worst case, the annual interest burden for the 108 sovereigns included in the sample could surpass $200 billion. That would shake solvency prospects for numerous countries. On top of that, an extra $36 to $63 billion would need to be found to service corporate bonds, whose yields can be expected to move up in lockstep with that of their respective sovereigns where they are domiciled.
| It could be worse
There are, however, some caveats. Due to a lack of scientifically credible quantitative estimates of how climate change will impact society and politics, these variables are excluded from the model. For example, Honduras continues to feel the effects of the deterioration of its social fabric and domestic security that followed the devastation caused by Hurricane Mitch in 1998. This ongoing situation has contributed to the stunting of business confidence and growth prospects, while adding to the fiscal burden required maintain a modicum of law and order in the country. Similarly, climate change could lead to further corrosion of societal order, resulting in climate refugees and mass migration across the globe. None of these effects are captured by the ratings model used to calculate the ratings impact of climate change. The report’s findings are therefore likely to be conservative estimates. The actual impact on sovereign creditworthiness could be more severe still. As such, the results should be interpreted as scenario-based simulations rather than predictions.
With the publication of this scientific papers it is no longer possible for rating agencies or investors to shrug their shoulders and insisting that the challenge of climate change cannot be integrated into traditional rating methodologies.
Either way, with the publication of this scientific papers it is no longer possible for rating agencies or investors to shrug their shoulders and insisting that the challenge of climate change cannot be integrated into traditional rating methodologies. This research has shown that it can be done. It should trigger regulators and rating agencies to treat the issue more systematically. Especially the ratings on longer-dated bonds need to better reflect the cumulative harm done by changing climate and the more frequent and severe extreme weather events that come with it. Lip service is no longer enough. It is high time to act and update the methodologies of sovereign risk assessment. The research proves it is not only desirable, but also possible.
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| brief bio
Dr. Moritz Kraemer is Chief Economist at LBBW Bank, Germany, and Senior Fellow at the Centre for Sustainable Finance at SOAS University London. He is one of the authors of the study “Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness”. Before joining LBBW Moritz was, inter alia, Chief Sovereign Rating Officer at S&P Global, the world’s largest rating agency and independent nonexecutive director at Scope Ratings, Europe’s largest rating agency. He teaches at the House of Finance of Goethe University Frankfurt.
| All opinions expressed are those of the author and/or quoted sources. investESG.eu is an independent and neutral platform dedicated to generating debate around ESG investing topics.
