Climate Change and Fiscal Sustainability: Risks and Opportunities

Both the physical and transition-related impacts of climate change pose substantial macroeconomic risks. Yet, markets still lack credible estimates of how climate change will affect debt sustainability, sovereign creditworthiness, and the public finances of major economies. We present a taxonomy for tracing the physical and transition impacts of climate change through to impacts on sovereign risk. We then apply the taxonomy to the UK’s potential transition to net zero. Meeting internationally agreed climate targets will require an unprecedented structural transformation of the global economy over the next two or three decades. The changing landscape of risks warrants new risk management and hedging strategies to contain climate risk and minimise the impact of asset stranding and asset devaluation. Yet, conditional on action being taken early, the opportunities from managing a net zero transition would substantially outweigh the costs.

Adjusting sovereign credit ratings to reflect climate change

Financial markets face increasing pressure to factor climate risks into decision-making. Enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: Investors lack the necessary information. This creates a potential conflict of interest and information asymmetry: Sovereigns want cheap access to capital and have an incentive to downplay climate risk, while investors want to manage climate exposure but do not know how much risk they face. Without a standardised framework and regulatory requirement for disclosing climate risk, organisations face little incentive to provide such information accurately to investors.

Existing climate risk disclosures are rare, ad hoc, voluntary, unregulated, and generally based on internal assessments rather than climate science. Credit ratings agencies are key intermediaries between investors and investment opportunities, serving an important role by rating the creditworthiness of potential investments. They use established and published methods to combine publicly available information with an ‘inside look’ to measure the ability of the issuer to repay its debt obligations. Ultimately, their role is to help reduce information asymmetries, overcome conflicts of interest, and provide investors with standardised information about risk.

We examine how well ratings agencies capture climate risks in ratings. We investigate how well the financial system factors in climate-related risk and makes such information available to investors. First, using historical evidence, we determine whether past ratings have factored in observed climate-related losses. Next, we combine forward-looking climate models with the ratings methodology from a major credit ratings agencies to compare sovereign creditworthiness in a world with climate change, versus a counterfactual world without warming (in which temperatures are held constant at their 1980-2010 average). Finally, we mobilise our extensive network in finance, climate science, and economics to develop a provocative position piece on the state of green finance and future priorities.

Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness

Enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: financial decision makers lack the necessary information. It is not enough to know that climate change is bad. Markets need credible, digestible information on how climate change translates into material risks.

To bridge the gap between climate science and real-world financial indicators, we simulate 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, we find evidence of climate-induced sovereign downgrades as early as 2030, increasing in intensity and across more countries over the century. We find strong evidence that stringent climate policy consistent with limiting warming to below 2°C, honouring the Paris Climate Agreement, and following RCP 2.6 could nearly eliminate the effect of climate change on ratings. In contrast, under higher emissions scenarios (i.e., RCP 8.5), 63 sovereigns 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.

We calculate the effect of climate-induced sovereign downgrades on the cost of corporate and sovereign debt. Across the sample, 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. The additional cost to corporates is US$ 7.2–12.6 billion under RCP 2.6, and US$ 35.8–62.6 billion under RCP 8.5.