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The ramifications of climate change could impact the credit ratings of India and 58 other nations, with those higher up on the sovereign ratings facing potentially more pronounced downgrades, according to recent research findings. Without substantial emissions reductions, the creditworthiness of these countries could deteriorate, potentially leading to a rise in global corporate debt within the next decade.
The research, titled ‘Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness’, conducted jointly by the University of East Anglia (UEA) and the University of Cambridge, revealed that under unchanged emissions trajectories, the sovereign credit ratings of several countries, including Chile, Indonesia, China, and India, could decline by two notches. The United States, Canada, and the United Kingdom might also experience a downgrade, with the United States and Canada potentially seeing a two-notch reduction and the United Kingdom a one-notch decline. By way of comparison, the economic upheaval caused by the COVID-19 pandemic resulted in 48 nations undergoing downgrades by significant rating agencies between January 2020 and February 2021. Archived Link
How significant are Sovereign Ratings?
Sovereign ratings serve as crucial indicators of countries’ creditworthiness and hold significant importance for investors. With a collective coverage of more than $66 trillion in sovereign debt, these ratings and the agencies that issue them play a pivotal role in determining global capital flows.
About the Study:
The study, published in the journal Management Science on August 7, 2023, introduced what it claimed to be the first-ever climate-adjusted sovereign credit rating. Utilizing artificial intelligence (AI), a team of economists from UEA and Cambridge simulated the economic consequences of climate change on Standard and Poor’s (S&P) ratings for 108 countries over various timeframes, including the next 10, 30, and 50 years, as well as by the end of the century.
Patrycja Klusak, from UEA’s Norwich Business School, and an affiliated researcher at Cambridge’s Bennett Institute for Public Policy was quoted as saying “This research contributes to bridging the gap between climate science and real-world financial indicators.”
“We find material impacts of climate change as early as 2030, with significantly deeper downgrades across more countries as climate warms and temperature volatility rises, ,” Klusak added.
The study’s findings indicated that numerous national economies could face credit rating downgrades unless significant action is taken to curtail emissions. Adherence to the Paris Climate Agreement, which involves limiting temperature rise to below two degrees Celsius, was found to have minimal short-term credit rating impact and could mitigate long-term effects. However, in the absence of substantial emissions reduction efforts, a significant average downgrade of 2.18 notches could be experienced by 81 sovereign nations by the end of the century. Countries such as India, Canada, Chile, and China could be significantly affected, with potential credit rating reductions of over five notches in India and Canada and up to seven notches in Chile and China.
The researchers highlighted that their projections were intentionally conservative, focusing solely on a linear temperature rise. When factoring in climate volatility over time, including extreme weather events, the magnitude of downgrades and associated costs escalated significantly.
The research team, which included former S&P chief sovereign rating officer Moritz Kraemer, indicated that without substantial greenhouse gas mitigation efforts, more than 59 nations could experience an average downgrade of over one notch by 2030.
Matthew Agarwala, a co-author from Cambridge’s Bennett Institute for Public Policy said “The ESG ratings market is expected to top a billion dollars this year, yet it desperately lacks climate science underpinnings.” As climate change batters national economies, debts will become harder and more expensive to service, he added.
“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 show that climate risk can be assessed without compromising scientific credibility, economic validity, or decision-readiness,” Agarwala stated.
To develop predictive models of creditworthiness, AI algorithms were trained using S&P rating data from 2015 to 2020. These models were then combined with climate economic projections and S&P’s assessments of natural disaster risks to formulate “climate-smart” credit ratings under various global warming scenarios.
Interestingly, while developing nations with lower credit scores were projected to be more severely impacted by the physical consequences of climate change, nations with higher sovereign ratings were expected to encounter more pronounced credit rating downgrades. This phenomenon aligns with the nature of sovereign ratings, as countries with higher initial ratings potentially have more significant room for decline.
References:
https://pubsonline.informs.org/doi/10.1287/mnsc.2023.4869
https://www.investopedia.com/terms/c/creditrating.asp
https://www.investopedia.com/terms/s/sovereign-credit-rating.asp
