Rising temperatures, falling ratings: The effect of climate change on sovereign creditworthiness

Abstract

Enthusiasm for 'greening the financial system' is welcome, but a fundamental challenge remains: financial decision makers lack the necessary information. It is not enough to know that climate change is bad. Markets need credible, digestible information on how climate change translates into material risks. To bridge the gap between climate science and real-world financial indicators, we simulate the effect of climate change on sovereign credit ratings for 108 countries, creating the world's first climate-adjusted sovereign credit rating. Under various warming scenarios, we find evidence of climate-induced sovereign downgrades as early as 2030, increasing in intensity and across more countries over the century. We find strong evidence that stringent climate policy consistent with limiting warming to below 2°C, honouring the Paris Climate Agreement, and following RCP 2.6 could nearly eliminate the effect of climate change on ratings. In contrast, under higher emissions scenarios (i.e., RCP 8.5), 63 sovereigns experience climateinduced downgrades by 2030, with an average reduction of 1.02 notches, rising to 80 sovereigns facing an average downgrade of 2.48 notches by 2100. We calculate the effect of climate-induced sovereign downgrades on the cost of corporate and sovereign debt. Across the sample, climate change could increase the annual interest payments on sovereign debt by US$ 22-33 billion under RCP 2.

Localised economic impacts from high temperature disruption days under climate change

“…The future 'climate value at risk' of global financial assets is US$2.5 trillion in the 'business-as-usual' scenario, while the 99th percentile of the possible outcomes gives the value of approximately US$24.2 trillion (Dietz et al 2016). In addition, climate-economic models show that loses from climate change may reach 23% of the global gross product by the end of the 2100 (Klusak et al, 2021;Burke et al, 2015). Over the past 40 years (since 1980), estimations show that weather-related natural disasters alone caused losses of around US$4.2 trillion and claimed approximately 1 million lives (Munich Re, 2021).…”

Climate change and fiscal sustainability: Risks and opportunities

“…However, this backwards-looking analysis cannot be used to make inferences about the future affect of climate change on creditworthiness, which is clearly the more important question for managing the public finances over the medium-to long-run. Klusak et al (2021) is the first paper which offers a forward-look into the effects of climate on sovereign credit ratings. Combining climate-economic models with observed sovereign ratings and an AI model, they construct the world's first climate adjusted sovereign rating for 108 sovereigns under three climate scenarios.…”

“…They find that economies that are highly exposed to carbon-intensive sectors incur higher yields on their sovereign bonds. Klusak et al (2021) use an AI-based approach to estimate the additional cost of sovereign and corporate debt resulting from climate-drive downgrades under various warming scenarios. Under the low emissions scenario (RCP2.6) the UK's 0.92-notch downgrade by 2100 would amount to an increase in the annual interest payment on public debt of $2.0-3.0 billion and an increase of $250-440 million on corporate debt.…”

Escalation of global risks and threats in a pandemic condition: financial and macroeconomic aspects

“…Previous Reports have shown that the Agenda 2030 is undeliverable in many developing countries under their existing burden of debt (TDR 2015(TDR , 2019. Moreover, warming global temperatures will only worsen their prospects, fueling an even more vicious circle in developing countries, as the adverse impact on growth prospects heightens their perceived credit risks, leading to a downgrade in their credit ratings and higher borrowing costs, adding hundreds of billions of dollars in debt servicing over the coming years (Klusak et al, 2021). For many vulnerable developing countries this will add insult to the injuries already caused by unfair credit conditions.…”