Financial materiality of Climate Change and the Sovereign Creditworthiness

Introduction

It has been long that climate change has been recognised as one of the most significant non – traditional security issues to the nations across the globe. In addition, the World Economic Forum (WEF) has also recognised climate change and associated risks among the top risk in its annual Global Risk reports since the last decade.

A recent research study by the University of Cambridge and the University of East Anglia (UEA) reveals a link between the creditworthiness of countries and the impact of climate change. This research was published in the journal?Management Science?in August, 2023 and claims to be the first climate-adjusted sovereign credit rating. In addition, the researchers have called their projections "extremely conservative", as the figures only tracked linear/straight temperature rise in the climate models rather than including climate volatility over the time, in which the downgrades and related costs are predicted to increase substantially.

Methodology

The researchers have used artificial intelligence (AI) to simulate the economic effects of climate change on Standard and Poor’s (S&P) ratings for 108 countries over the time – span of next 10, 30, 50 years and by the end of the century (2100).?The AI models to predict the 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.?

The above figure describes a four-step process for integrating climate economics into sovereign credit ratings and cost of debt calculations.

Step 1 → Trains a random forest model on macroeconomic input data and sovereign ratings issued by S&P 2015 – 2020. Macro variables are selected from S&P’s ratings method (S&P 2017).

Step 2 → Adjust the macroeconomic input data for climate change.

Step 3 → Feeds climate – adjusted input data into the prediction model generated in Step 1.

Step 4 → It calculates the climate – adjusted ratings and associated impacts on the cost of public and corporate debt.

Key highlights

1. Pathway scenario = The occurrence of the material impacts of climate change on the creditworthiness of the nations would be evident as early as 2030, with significant deeper downgrades across the countries due to climate variability and temperature rise.
2. Scenario of sovereign credit downgrades = Without emission reductions in line with the goals of Paris agreement, the sovereign credit rating of as much as 59 countries across the globe would be downgraded on average by 2030. In comparison with the economic turmoil caused by the COVID – 19 pandemic which resulted in 48 sovereigns suffering downgrades by the three major credit rating agencies between January 2020 and February 2021.
3. Impact on debt servicing = As the climate change continues to affect the national economies, sovereign debt would become harder and more expensive to service. The additional interest payments on the sovereign debt caused by climate – induced downgrades alone could have an economic cost between U.S. $ 135 billion - U.S. $ 135 203 billion over the next eight decades.
4. Variability in credit downgrades = While the developing nations with lower credit scores were predicted to be hit hardest by the physical effects of climate change, nations ranking higher (in prime high grade AAA and high grade AA+, AA, AA-) were likely to face more severe downgrades. Under RCP 8.5, the average sovereign downgrade could reach 2.48 notches, with several countries falling 5 notches or more on a 20-notch scale.
5. The rise in corporate debts = The postponement of the green investments will increase the costs of borrowing for nations, which will translate into higher costs of corporate debt over the next decade.?
6. Alignment with Paris Agreement = With the adherence to the goals enshrined in the Paris Agreement, there would have no short – term impact on sovereign credit ratings and keep the long – term effects to a minimum, with an average sovereign downgrade of 0.94 notches and an increase in the annual interest payments of up to U.S. $ 67 billion globally by 2100.
7. Observations on ESG ratings and corporate disclosure = 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 climate science.

Key Observations

Following are some of the pictorial representation of the data provided in the aforementioned study:

This figure depicts climate - induced sovereign downgrades by 2100 under RCP 2.6. Under this scenario, 62 countries face downgrades by 2100, with an average ratings loss of 0.94 notches on the 20-notch scale. Chile and India face the largest downgrades: 7.11 and 3.73 notches, respectively.

This figure depicts climate - induced sovereign downgrades by 2100 under RCP 8.5. Under this scenario, 81 countries face downgrades by 2100, with an average ratings loss of 2.18 notches on the 20-notch scale. Chile and China face the largest downgrades: 7.43 and 6.53 notches, respectively.

For the full research paper: https://pubsonline.informs.org/doi/abs/10.1287/mnsc.2023.4869