Countries ranking higher on sovereign ratings likely to face more severe downgrades
The results of the research supported the idea that deferring green investments will increase the costs of borrowing for nations, which will translate into higher costs of corporate debt, said an author. Photo: iStock A new research has found links between the creditworthiness of countries and the impact of climate change. Without reductions in emissions, the sovereign credit rating of 59 countries, including India, could plummet and corporate debt worldwide could rise over the next decade.
Chile, Indonesia, China and India would all drop two notches. The United States and Canada would also see a fall by two and the United Kingdom by one notch, the research led by the University of East Anglia (UEA) and the University of Cambridge said.
In comparison, the economic turmoil caused by the COVID-19 pandemic resulted in 48 sovereigns suffering downgrades by the three major agencies between January 2020 and February 2021.
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Sovereign ratings assess the creditworthiness of countries and are a key gauge for investors. Covering more than $66 trillion in sovereign debt, the ratings — and agencies behind them — act as gatekeepers to global capital.
The research, published in the journal Management Science on August 7, 2023, claimed to be the first climate-adjusted sovereign credit rating.
A team of economists at UEA and Cambridge 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 next 10, 30 and 50 years and by the end of the century.
The results showed that many national economies can expect downgrades unless action is taken to reduce emissions. The study was led by Patrycja Klusak from UEA’s Norwich Business School and an affiliated researcher at Cambridge’s Bennett Institute for Public Policy.
“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 the climate warms and temperature volatility rises,” said Klusak.
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The study suggested adherence to the Paris Climate Agreement, with temperatures held under a two-degree rise, would have no short-term impact on sovereign credit ratings and keep the long-term effects to a minimum.
Without serious emissions reduction, however, 81 sovereign nations would face an average downgrade of 2.18 notches by the century’s end, with India and Canada, among others, falling over five notches and Chile and China dropping by seven.
The researchers called their projections “extremely conservative”, as the figures only track a straight temperature rise. When their models incorporate climate volatility over time — extreme weather events of the kind the world has started to witness — the downgrades and related costs increase substantially.
The team, including former S&P chief sovereign ratings officer Moritz Kraemer, found that if nothing is done to curb greenhouse gases, 59 nations could be downgraded by over a notch on average by 2030.
“From a policy perspective, the results supported the idea that deferring green investments will increase the costs of borrowing for nations, which will translate into higher costs of corporate debt,” said Klusak
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The ratings agencies took a reputational hit for failing to anticipate the 2008 financial crisis and that it was imperative that they are proactive in reflecting the much larger consequences of climate change now, she added.
The researchers said 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 science. This latest study shows they do not have to be.
“The ESG ratings market is expected to top a billion dollars this year, yet it desperately lacks climate science underpinnings,” said Matthew Agarwala, a co-author from Cambridge’s Bennett Institute for Public Policy.
As climate change batters national economies, debts will become harder and more expensive to service, he said.
“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,” said Agarwala.
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AI models to predict 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.
While developing nations with lower credit scores were predicted to be hit harder by the physical effects of climate change, nations ranking higher were likely to face more severe downgrades, according to the study.
The economists said this fits with the nature of sovereign ratings, that is, those at the top have further to fall.
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