Do Sovereign Ratings Reflect Growing Climate Risks?

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Insight Summary

  • Sovereign credit ratings are forward looking, independent assessments of the creditworthiness of a country or sovereign entity. But are they discounting the long term risks of climate policy?
  • A growing number of investors, academics, policymakers, and regulators question whether credit ratings are accounting for the impact of growing climate risks.
  • If these risks materialize, they threaten to trigger climate-induced sovereign downgrades as early as 2030.

What are sovereign credit ratings?

Sovereign credit ratings are independent assessments of the creditworthiness of a country or sovereign entity. The Big Three credit rating companies—Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings — are largely responsible for interpreting the level of investment risk associated with the debt of a particular country. However, a growing number of investors, academics, policymakers, and regulators question whether credit ratings are accounting for the impact of growing climate risks. If these risks materialize, they threaten to triggerclimate-induced sovereign downgrades as early as 2030.

Do sovereign ratings reflect growing climate risks? 

In December 2020, Fitch Ratings acknowledged that climate change will adversely affect sovereign ratings, however “intrinsic uncertainties make it challenging to robustly quantify the impact” (source). Fitch mentioned that scenarios, models, heatmaps and rankings can be a useful starting point, but don’t offer definitive answers or necessarily address the materiality of risks. 

While projections aren’t definitive, Moritz Kraemer, who oversaw sovereign debt ratings at S&P until 2018, noted that “we have these really well-understood structural challenges coming our way over the time horizon of two, three, four decades, and that is in no way reflected” in credit ratings. Meanwhile, “some countries issue much longer-dated bonds—50- or 100-year bonds—and they’re all rated the same as a two-year bond. And I think that’s not appropriate.” Credit ratings are forward-looking and factor-in broad expectations about the future, yet they seem to be discounting the long term risks of climate policy.

How climate policy impacts debt ratings

While climate projections span years and decades ahead, when you look at the financial implications, public policy decisions made today will have rippling long term effects. The Bennet Institute for Public Policy highlighted this in their working paper Rising Temperatures, Falling Ratings

The study simulated 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, they found evidence of climate-induced sovereign downgrades as early as 2030, increasing in intensity and across more countries over the century. The severity of downgrades depends on the public policy decisions made today.

For example, with stringent climate policy limiting warming to below 2°C (honoring the Paris Climate Agreement and following RCP 2.6), we could nearly eliminate the effect of climate change on ratings. However, under a higher emissions scenario following RCP 8.5, sovereigns will experience climate-induced 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.

*Representative Concentration Pathway 2.6, which corresponds to a temperature rise well under 2C, relative to pre-industrial levels. †RCP 8.5, which corresponds to a temperature rise of 4.5C to 5C, relative to pre-industrial levels.
Source: Bennett Institute study: “Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness” – Bloomberg: A Climate Reckoning Is Coming for the World’s Government Debt

The study also estimates that climate change could increase the annual interest payments on sovereign debt by US$ 22–33 billion under RCP 2.6, rising to US$ 137–205 billion under RCP 8.5.From a policy perspective, this supports the idea that deferring green investments will only increase costs of borrowing for sovereigns. On top of that, a majority of this cost will be incurred by some of the largest economies in the world expected to receive the largest downgrades, namely China, Mexico, India, Canada and the US.

Conclusion

Climate change is no longer a future problem. It is a now problem. The Bennet Institute for Public Policy’s study highlights the importance of public policy decisions on future global climate change, yet new and updated climate commitments continue to fall short of what is needed to meet the goals of the Paris Agreement. Instead, we are on track for a global temperature rise of at least 2.7°C this century (source), meaning we cannot assume a stringent climate policy scenario limiting warming to below 2°C. So the question remains, why aren’t the structural challenges of rising global temperatures being reflected in sovereign credit ratings?

About Impact Capital Partners

At Impact Capital Partners, our mission is to connect institutional capital with the growing impact investment market to address the world’s most pressing challenges. By utilizing impact investments, institutional investors are able to generate positive, measurable social and environmental impact alongside a financial return. We are constantly finding new impact strategies in both emerging and developed markets, targeting market-rate returns. Schedule a call with us HERE if you’re interested in learning more about our impact strategies.

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