The increasing cost of debt caused by climate change

Published by  Communications

On 18th Mar 2021

Climate change will increase the cost of sovereign and corporate debt worldwide according to a new report from the University of East Anglia and the University of Cambridge.

A new working paper, published today, is the first to anchor climate science within “real world” financial indicators.

It suggests that 63 nations will experience a drop in sovereign credit rating in the next decade without emissions reduction.

Sovereign ratings assess the creditworthiness of nations and are a key gauge for investors. 

Covering over US$66 trillion in sovereign debt, the ratings – and agencies behind them – act as gatekeepers to global capital.  

The first sovereign credit rating to directly include climate science 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 ten, thirty and fifty years, and by the end of the century. 

Dr Patrycja Klusak, from UEA’s Norwich Business School and an affiliated researcher at Cambridge’s Bennett Institute for Public Policy, said: “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 tangle of green finance indicators such as ‘Environmental, Social, and Governance’ (ESG) ratings and unregulated, ad hoc corporate disclosures are detached from the science – and the latest study shows they don’t 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, co-author from the Centre  for Social and Economic Research on the Global Environment (CSERGE) and the School of Environmental Sciences at UEA, and 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,” Agarwala said. 

The team, including former S&P chief sovereign ratings officer Dr Moritz Kraemer, found that if nothing is done to curb greenhouse gases then 63 nations could be downgraded by over a notch on average by 2030. 

Germany, India, Sweden and the Netherlands would all drop three 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 last month. 

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, 80 sovereign nations would face an average downgrade of 2.48 notches by century’s end, with India and Canada among others falling over five notches, and China dropping by eight. 

Just additional interest payments on sovereign debt caused by the climate-induced downgrades alone – a mere sliver of the economic consequences of untrammeled emissions over the next eight decades – could cost Treasuries between US$137 and 205 billion.

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 0.65 notches and increases in annual interest payments of up to US$33 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$12 billion globally by 2100 under the Paris Agreement, and up to US$62 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 co-author Matt Burke, a researcher at UEA’s Norwich Business School.

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. Economists say this fits with the nature of sovereign ratings: those at the top have further to fall. 

This research is 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.

The working paper ‘Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness’ is published by the Bennett Institute for Public Policy on March 18, 2021. 

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