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Climate Change and Sovereign Credit Ratings
We’re using artificial intelligence to combine credit ratings and climate-economic models to simulate the effects of climate change on sovereign ratings for 108 countries.
Our collaborative research, led by economists at University of East Anglia and the University of Cambridge, have produced the first ‘climate smart’ sovereign credit rating which shows that without a reduction in emissions, 63 nations will expect a drop in their rating within the next decade.
Challenge
Climate change is “the biggest market failure the world has seen” (Stern 2008), with wide-ranging implications for stability – financial, economic, political, social, and environmental. As estimates of the economic consequences of climate change continue to grow, financial markets and business leaders face increasing pressure to factor climate risks into decision making.
Despite a proliferation of new instruments to help sovereigns and investors better integrate climate into debt markets, several key gaps remain, preventing the full integration of nature-related risks and opportunities into debt markets at large.
How should corporate disclosures address issues largely beyond their control, such as the carbon intensity of the national electricity grid, or the direction of government flood strategies? Most disclosures present companies as if they are independent of their physical (geographical) and macroeconomic surroundings. But climate change does not just affect firms individually, it affects countries and economies systemically. No corporate climate risk assessment is complete without also considering the effect of climate on sovereign bonds. Without scientific credibility, economic evidence, and decision-ready metrics, the field of green finance is open to charges of greenwash.
Insight
Motivated to bridge the gap between climate science and real-world financial indicators, Dr Patrycja Klusak and a team of researchers were the first to use economic modelling to simulate the effect of climate change on sovereign credit ratings for 108 countries under three different warming scenarios (see Figure 1).
Their work also provides initial estimates of the effects of climate-induced sovereign downgrades on the cost of public and corporate debt around the world.
Train AI Prediction model on historical ratings | > | Adjust input data for climate change | > | Feed adjusted data to the prediction model | > | Calculate climate-adjusted ratings and cost of debt |
Figure 1 Bridging the gap between climate science and financial indicators
Figure 1 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 adjusts the macroeconomic input data for climate change, using Kahn et al (2021) and S&P (2015a,b). Step 3 feeds climate-adjusted input data into the prediction model generated in Step 1. Step 4 calculates climate-adjusted ratings and associated impacts on the cost of public and corporate debt.
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Figure 2. Global climate-induced sovereign ratings changes (2100, RCP 8.5)
The team document the key empirical findings:
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The material impacts of climate change will be seen as early as 2030 and all countries whether rich or poor, hot or cold, will suffer downgrades if the current trajectory of carbon emissions is maintained.
In one realistic scenario, the findings showed that 63 sovereigns would suffer climate-induced downgrades of approximately 1.02 notches by 2030, rising to 80 sovereigns facing an average downgrade of 2.48 notches by 2100.
Figure 2 depicts the magnitude and geographical distribution of sovereign ratings changes, showing that the most affected nations include Chile, China, Slovakia, Malaysia, Mexico, India, Peru and Canada. -
The data strongly suggests that stringent climate policy consistent with the Paris Climate Agreement will result in minimal impacts of climate on ratings – with an average downgrade of just 0.65 notches by 2100.
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The additional costs to sovereign debt – best interpreted as increases in annual interest payments due to climate-induced sovereign downgrades – were calculated to be between US$ 22–33 billion under a low emissions scenario known as RCP2.6, rising to US$ 137–205 billion under RCP8.5. These translate to additional annual costs of servicing corporate debt ranging from US$ 7.2–12.6 billion to US$ 35.8–62.6 billion in each case.
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’ve shown that climate risk can be assessed without compromising scientific credibility, economic validity or decision-readiness.
- Patrycja Klusak
Collaboration
The team comprises of researchers from UEA, Cambridge, SOAS and Sheffield University. This research was supported by a grant from the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE).
Dr Patrycja Klusak is an Associate Professor in Banking and Finance at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of Cambridge.
Her research investigates the behaviour and regulation of credit ratings agencies (CRAs), and their effects on financial systems. Her work evaluates the extent to which regulations achieve their aims, or whether they lead to unintended consequences. Her research also examines the extent of herding behaviour by CRAs, potential conflicts of interests in the CRA industry, and the effect of environmental, social, and governance (ESG) metrics on firm ratings. Her interdisciplinary work combines climate science and environmental economics with her expertise in empirical banking and applied econometrics to investigate how climate change risks have and could affect sovereign ratings. Patrycja is one of UEA’s 30 most-cited academics in the media, her research has featured in over 200 outlets across more than 40 countries since 2020.
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