Climate Risks Come for Sovereign Credit
Bloomberg Markets|October - November 2021
FOR YEARS climate scientists have warned about the ferocious wildfires and hurricanes that are now overwhelming many communities. Today alarms are ringing about a related financial danger: risks lurking within government bonds, the biggest part of the global debt market.
JILL WARD

A growing number of investors, academics, policymakers, and regulators are questioning whether credit ratings—the ubiquitous scores that underpin much of the financial system—are accounting for the impact that extreme weather events and policy changes related to global warming will have on borrowers. Once those risks materialize, they threaten to trigger the kind of sudden, chaotic asset collapse described by the late economist Hyman Minsky. The effects would sweep through pension funds and the balance sheets of central and commercial banks.

“A lot of this looks like it’s years and decades ahead, but when you look at the financial implications, you run into risks of Minskytype moments and rapid devaluations,” says Steven Feit, an attorney at the Center for International Environmental Law in Washington who focuses on climate liability and finance. “The climate time scale is decades or a century long. The financial timeline is right now.”

The Big Three credit rating companies—Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings—all say they take climate-related factors into account when assessing government borrowers and defend their methodology as robust. But investors remember the 2008 credit crisis, when structured products with AAA ratings suffered significant losses. Now studies are highlighting potential long-term risks to government debt that aren’t showing up in today’s ratings.

For instance, 10 of the 26 members of the FTSE World Government Bond Index, including Japan, Mexico, South Africa, and Spain, will default on their sovereign debt by 2050 if there’s a “disorderly transition”—that is, if governments’ attempts to reduce carbon emissions are late, abrupt, and economically damaging. That’s according to research by FTSE Russell, an index provider owned by London Stock Exchange Group Plc.

“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, says Moritz Kraemer, who oversaw sovereign debt ratings at S&P until 2018. “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.”

Earlier this year, Kraemer—who’s now chief economist for CountryRisk.io—and a team of academics used artificial intelligence to simulate the effect of rising temperatures on sovereign credit ratings in research for the University of Cambridge. They found that 63 out of 108 sovereign debt issuers, including Canada, Germany, Sweden, and the U.S., would experience climate-induced downgrades by 2030 under a scenario in which emissions reductions failed to meet global targets. The research, led by Patrycja Klusak, a lecturer in banking and finance at the University of East Anglia, showed that climate-induced downgrades could cost national treasuries from $137 billion to $205 billion.

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