1. Reads
  2. Deep Dives

How Does Climate Change Affect Sovereign Credit Ratings?

Mar 19, 2021 5:07 PM 5 min read

Remember the collapse of global financial markets in 2007-2009? How could one not? 

Credit rating agencies played a major role in that collapse by overinflating the value of subprime mortgages. After more than a decade since then, the ratings agencies have a new predicament on their hands - analysing the risks of climate change in their rating assessments. 

According to a study conducted by Cambridge University economists, climate change is expected to raise interest payments on sovereign and corporate debts by as much as $270bn annually by the end of this century. 

This means that as climate change begins to pummel national economies globally, debts will become more difficult and more expensive to service. By the year 2030, if the emissions and pollution levels were to continue as is, 63 countries will be facing a ratings downgrade by at least one notch. 

That is a striking thought. Let us see how imminently and vigorously we are dealing with such a prospect. 

Risks Posed By Climate Change to International Finance 

Phenomena like global warming, greenhouse effect and ozone depletion are now impacting tangible resources in a visible way. The financial aspects of climate change are related to the fact that uncertainties posed by changes in climate systems will impact policy outcomes, which in turn will increase the liability of businesses in the years to follow. 

Consider this. The physical risks of climate change include potentially higher temperatures, drought, rising sea levels, change in land-use patterns, more extreme weather events, recurring natural disasters etc. At the risk of alarming one even further (sigh!), it must be said that these physical risks could turn into "transition risks" which emanate as either after-effects of physical risks or mitigative strategies to combat them. 

For instance, rising greenhouse emissions may influence radical policy decisions like a global embargo on use of fossil fuels. As a result, countries, companies or economies holding fossil reserves will be compelled to brand them as "stranded assets", meaning that they may never be used again. So, if banks saw this coming, it would feed into their fear psychosis of funding a potentially redundant business which would then impact its creditworthiness. 

Currently, there are perhaps very few financial models in use by banks and money managers wherein exhaustion of natural resources are feeding back into the NPV calculations. Perhaps, there will be heightened efforts on integrating climate change into financial models as structural shifts in business strategies involving climate change risks start becoming a precondition to their establishment in future. 


Credit Risk and Climate Change 

If, say, your business is built around the economics of high-carbon emissions, it would significantly increase your exposure to climate change-related credit risk. 

Now, instead of a single business, imagine a nation that runs the highest risks to climate change phenomena and the lowest mitigation standards employed against them. Since banks around the world are incorporating new prudential norms by updating climate changes into their risk profiles, the loans offered to nations like the above are going to carry greater critical exposures. 

The exposure leads to a downgrade in ratings. Once these sovereign debts face major downgrades, it will trigger a cyclical impact between their ability to borrow any further and their ability to service the existing debts. 


Climate Effects of Sovereign Debt and Bond Yields 

The government's ability to issue bonds depends on its power to tax individuals, businesses and other economic activities that fall under its jurisdiction. If these activities become vulnerable to climate risks, their effective valuation will depreciate and thus their ability to back bonds will decrease significantly. 

Investors will begin demanding higher bond yields if these instruments turn riskier. The 10-year bond yields in India recently swung from 5.76% to 6.20%. Since bond yields run inversely to bond prices, higher yields would make government borrowing more difficult at the raised prices. 

Typically, sovereign yields are a function of fiscal and public debt, GDP and other metrics derived from macro indicators. But incorporating climate change variables appears to be gaining traction quickly. The Asian Development Bank says that climate shocks and resulting vulnerability triggers a steady upward growth in bond yields which becomes permanent after 12 quarters

This paints quite a negative picture, especially in the present economic climate when national governments are piling on more debts to finance their pandemic-struck economies. The Government of India, for example, has decided to exceed its fiscal deficit commitments by 30 basis points in the next two years. Add the impact of climate change to the cost of borrowings and the weight of these combined sovereign debt obligations might turn out to be quite meaningful.  

This is the nexus between climate risk and sovereign risk.


How Badly Will It Impact Economies? 

As per the Cambridge study, if the planet gets five degrees warmer, then governments around the world will face an increase in debt-servicing costs between $137-205bn by the year 2100. If countries were to somehow honour their commitments to the Paris Agreement and keep the rise in global temperature under 2 degrees, debt-servicing costs would still exceed $33bn. 

If pollution-reducing enforcement measures aren't employed seriously, 80 countries will witness an average ratings cut by 2.48 notches. India and Canada will witness a cut by five notches each. China will witness eight!!

Less developed economies tend to have relatively low debt-servicing capacities and are hence more vulnerable to the accumulation of external debt. Commensurately, these are the countries which require maximum green-financing to reduce their risk profiles if they are to even stand a chance on debt sustainability in the future. 

Even though the underlying matrix of the Cambridge study is ratings cut as an impact of climate change, regulatory and supervisory frameworks around the world are yet to bring in enforceable parameters to assess credit scores and risks based on climate change-related vulnerabilities. That is why the intensification of credit ratings' role in making revised forecasts has become all the more important. 

A member of the US government-appointment Financial Crisis Inquiry Commission called ratings agencies

...essential cogs in the wheel of financial destruction!

They artificially inflated the value of subprime mortgages. And, if they similarly inflate the value of businesses and assets without taking into account their climate vulnerabilities, they will be leading the world down the path of another crisis soon. 


There's so much happening that simply keeping up can be a task! How about a quick Quiz to help you retain? Subscribe to TRANSFIN. E-O-D and get them started.