Study reveals the increasing cost of debt caused by climate change
By: Communications
Climate change will increase the cost of sovereign and corporate debt worldwide according to new research led by the University of East Anglia (UEA) and the University of Cambridge.
Published today in the journal Management Science, the study is the first to anchor climate science within “real world” financial indicators.
It suggests that 59 nations will experience a drop in sovereign credit rating in the next decade without emissions reduction.
Sovereign ratings assess the creditworthiness of countries and are a key gauge for investors. Covering more than US$66 trillion in sovereign debt, the ratings – and agencies behind them – act as gatekeepers to global capital.
The first climate-adjusted sovereign credit rating shows that many national economies can expect downgrades unless action is taken to reduce emissions.
A team of economists at UEA and Cambridge used artificial intelligence to simulate the economic effects of climate change on Standard and Poor’s (S&P) ratings for 108 countries over the next 10, 30 and 50 years, and by the end of the century.
The study was led by Dr Patrycja Klusak, from UEA’s Norwich Business School, and an affiliated researcher at Cambridge’s Bennett Institute for Public Policy.
“This research contributes to bridging the gap between climate science and real-world financial indicators,” said Dr Klusak. “We find material impacts of climate change as early as 2030, with significantly deeper downgrades across more countries as climate warms and temperature volatility rises.
“From a policy perspective, our results support the idea that deferring green investments will increase costs of borrowing for nations, which will translate into higher costs of corporate debt.”
Dr Klusak added: “Ratings agencies took a reputational hit for failing to anticipate the 2008 financial crisis. It is imperative that they are proactive in reflecting the much larger consequences of climate change now.”
The researchers say the current mix of green finance indicators such as Environmental, Social, and Governance (ESG) ratings and unregulated, ad hoc corporate disclosures are detached from the science – and this latest study shows they do not have to be.
“The ESG ratings market is expected to top a billion dollars this year, yet it desperately lacks climate science underpinnings,” said Dr Matthew Agarwala, a co-author from Cambridge’s Bennett Institute for Public Policy.
“As climate change batters national economies, debts will become harder and more expensive to service. Markets need credible, digestible information on how climate change translates into material risk.
“By connecting the core climate science with indicators that are already hard-wired into the financial system, we show that climate risk can be assessed without compromising scientific credibility, economic validity, or decision-readiness,” said Dr Agarwala.
The team, including former S&P chief sovereign ratings officer Dr Moritz Kraemer, found that if nothing is done to curb greenhouse gases, 59 nations could be downgraded by over a notch on average by 2030.
Chile, Indonesia, China and India would all drop two notches, with the US and Canada falling by two and the UK by one.
By comparison, the economic turmoil caused by the Covid-19 pandemic resulted in 48 sovereigns suffering downgrades by the three major agencies between January 2020 and February 2021.
The study suggests that adherence to the Paris Climate Agreement, with temperatures held under a two-degree rise, would have no short-term impact on sovereign credit ratings and keep the long-term effects to a minimum.
Without serious emissions reduction, however, 81 sovereign nations would face an average downgrade of 2.18 notches by the century’s end, with India and Canada among others falling over five notches, and Chile and China dropping by seven.
Just additional interest payments on sovereign debt caused by the climate-induced downgrades alone – a fraction of the economic consequences of unrestrained emissions over the next eight decades – could cost Treasuries between US$135 and 203 billion.
The researchers call their projections “extremely conservative”, as the figures only track a straight temperature rise. When their models incorporate climate volatility over time – extreme weather events of the kind we are starting to witness – the downgrades and related costs increase substantially.
The research suggests there will be long-term climate effects for sovereign debt even if the Paris Agreement holds and we reach zero carbon by century’s end, with an average sovereign downgrade of 0.94 notches and increases in annual interest payments of up to US$67 billion globally by 2100.
The team also calculated the knock-on effects these sovereign downgrades would have for corporate ratings and debt in 28 nations. They found that corporates would see additional costs of up to US$17 billion globally by 2100 under the Paris Agreement, and up to US$61 billion without action to reduce emissions.
The research team say they were guided by the overarching principle to stay as close as possible to both climate science and real-world financial practices.
AI models to predict creditworthiness were trained on S&P’s ratings from 2015-2020. These were then combined with climate economic models and S&P’s natural disaster risk assessments to get “climate smart” credit ratings for a range of global warming scenarios.
“AI has the potential to revolutionise how we do climate risk assessment and ESG ratings, but we must ensure the evidence base is ‘baked-in,” said Dr Matt Burke, co-author from Oxford’s Smith School of Enterprise and the Environment.
While developing nations with lower credit scores are predicted to be hit harder by the physical effects of climate change, nations ranking AAA were likely to face more severe downgrades, according to the study. The economists say this fits with the nature of sovereign ratings, that is, those at the top have further to fall.
The research was supported by a grant from the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE) and the Wealth Economy Project at the Bennett Institute for Public Policy, supported by LetterOne.
‘Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness’, by Patrycja Klusak, Matthew Agarwala, Matt Burke, Moritz Kraemer and Kamiar Mohaddes, is published in Management Science.
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