Rising Temperatures, Melting Ratings

By Dr. Patrycja Klusak, Dr. Matthew Agarwala, Matt Burke, Dr. Moritz Kraemer, Dr. Kamiar Mohaddes 23 April, 2021

Dr Klusak, Dr Agarwala, Burke, Dr Kraemer & Dr Mohaddes share how they created the world's first climate smart sovereign credit rating

Climate change will hit markets from all directions; greening the financial system’ is welcome, but the lack of scientific foundations in risk disclosures remains a challenge
No corporate risk assessment is complete without considering the effect of climate on sovereign bonds; we are the first to simulate climate affects on future sovereign ratings
Study shows 63 countries will suffer downgrades by 2030; existing climate science & economics are capable of supporting credible, decision-ready green finance indicators

This article was first published by The Bennett Institute for Public Policy, University of Cambridge on Mar 2021. You can see the article here.


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 the economic consequences of climate change continue to grow, financial markets and business leaders face increasing pressure to factor climate risks into decision making.

Climate change is “the biggest market failure the world has seen”

Climate change will hit markets from all directions. In boardrooms and at AGMs, what were once token whispers of eco-marketing have become serious discussions of extreme weather events, reputational risks, activist movements (shareholder and consumer), regulatory and transition risks, asset stranding, and environmental litigation.

In response, investors and regulators are calling for climate risk disclosures and a clear demonstration that portfolios and business models are consistent with the Paris Climate Agreement. Central bankers, finance ministers, the International Monetary Fund and United Nations are in on the action (see PBOC’s former Chief Economist on The Future of Finance).

Such 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. Instead, an explosion of ESG (environmental, societal, and governance) ratings and voluntary, ad hoc, unregulated climate disclosures has created a confusing world of unfamiliar, incomparable, and conflicting metrics. 

‘Greening the financial system’ is welcome, but the lack of scientific foundations in risk disclosures remains a fundamental challenge…

A chief concern is the lack of scientific foundations in risk disclosures (see Fiedler et al., 2021). Climate models operate at global scales, projecting impacts over decades. Financial models do not. How should a high-frequency trading algorithm (operating in nanoseconds) adjust to the possibility that climate may reduce global output in 2100? How should corporate disclosures address issues beyond their control, such as the carbon intensity of the national electricity grid, or the direction of government flood strategies?

…No corporate risk assessment is complete without considering the effect of climate on sovereign bonds

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

This is what motivated us to bridge the gap between climate science and real-world financial indicators (Klusak et al., 2021). We focused on a familiar metric: the sovereign credit rating. By linking climate science with economic models and real-world best practice in sovereign ratings, we simulate the effect of climate change on sovereign credit ratings for 108 countries under three different warming scenarios (see Figure 1). 

We simulated the effect of climate change on sovereign credit ratings for 108 countries

We were guided by a single overarching principle: to remain as close as possible to climate science, economics, and real-world practice in the field of sovereign credit ratings. We are the first to simulate the effect of climate on future sovereign ratings under multiple warming scenarios. We also provide initial estimates of the effects of climate-induced sovereign downgrades on the cost of public and corporate debt around the world.

Sovereign ratings are reported using a 20-notch scale, where AAA is ‘prime high grade’ and anything below BBB- is considered ‘speculative’ (or informally, ‘junk’). We convert this into a numerical scale and use a machine learning model to predict creditworthiness, training it on ratings issued by S&P (one of the largest credit ratings agencies) from 2015-2020. Next, we combine climate economic models and S&P’s own natural disaster risk assessments to develop a set of climate-adjusted data. We use these to simulate the effect of climate change on sovereign ratings. Finally, we calculate the additional cost of corporate and sovereign debt due to climate-induced sovereign downgrades (Figure 1, purple).

Sovereign ratings are already used in a range of financial decision-making contexts…

…downgrades will increase the cost of public & corporate debt

We focus on sovereign ratings because they are already used in a range of financial decision-making contexts (e.g. under Basel II rules, ratings directly affect the capital requirements of banks and insurance companies). They cover over US$ 66 trillion in sovereign debt, acting as ‘gatekeepers’ to global financial markets. Sovereign downgrades increase the cost of both public and corporate debt, influencing overall economic performance and significantly affecting fiscal sustainability. 

We document three key empirical findings.

Study found 63 sovereigns will suffer downgrades by 2030…

…Chile, China, Slovakia, Malaysia, Mexico, India, Peru & Canada most affected

First, in contrast to much of the climate-economics literature, we find material impacts of climate change as early as 2030. In one realistic scenario, we find that 63 sovereigns 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. More importantly, our results show that virtually all countries, whether rich or poor, hot or cold, will suffer downgrades if the current trajectory of carbon emissions is maintained.

Second, our 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. 

Additional cost to sovereign debt is between USD137-205bn under RCP8.5

Third, we calculate the additional costs to sovereign debt – best interpreted as increases in annual interest payments due to climate-induced sovereign downgrades – in our sample to be between US$ 22–33 billion under a low emissions scenario known as RCP2.6, rising to US$ 137–205 billion under RCP 8.5. 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. 

There are caveats. There are no scientifically credible quantitative estimates of how climate change will impact social and political factors, so these are excluded from our model (Oswald and Stern, 2019). Thus, our findings should be considered as conservative. Moreover, our results should be understood as scenario-based simulations rather than predictions. We do not comment on the relative probabilities of any given warming scenario playing out in practice. 

Existing climate science and economics are capable of supporting credible, decision-ready green finance indicators

The key take-home message is that existing climate science and economics are capable of supporting credible, decision-ready green finance indicators. Governments issue ever-longer dated bonds, of which life insurance companies and pension funds are eager buyers, thus enabling them to match their own long-term liabilities.

Therefore, investors should consider the long-term creditworthiness of sovereign issuers. Currently, there is no reliable yardstick for assessing sovereign creditworthiness beyond the current decade and this research fills this gap. Based on the methodology applied here future research could focus on developing ultra-long ratings not only for sovereigns but also for other issuers including corporates.


Further Reading

  • The CWR Survival Guides to Avoiding Atlantis – Sea levels can be 3m by 2100, putting urban real estate equivalent to 22 Singapores underwater in just 20 APAC capitals & cities. With US$5.7trn of annual GDP at stake, get on top of the new risk landscape to survive
  • Sovereigns At Risk: Lots Of Capital In Vulnerable Spots – Clustered nature of rising coastal threats plus lax govt action put APAC sovereigns at risk. CWR’s analysis of GDP, trade, markets & bank loans reveal intense concentration of risks. As no-sense strategies pervade, see who’s in CWR’s watchlist
  • Wipeout – 8 Reasons Why Stress Testing For Chronic Risks Will Strand Assets – Systemic shocks from water risks are inevitable unless action is taken to reduce emissions. CWR’s Dharisha Mirando & Debra Tan share 8 things you need to know about stress testing your portfolio
  • It Happened – Central Banks And Water Risks – Half a dozen new reports by the NGFS means that CWR has achieved a key milestone in embedding water risks in finance. Debra Tan and Dharisha Mirando expand on these game-changing moves by the central banks. The credit evolution has started
  • Capital Threats Remain Post COVID – There is no vaccine for climate & water risks, yet some in the financial sector are still burying their heads. CWR’s Dharisho Mirando reminds us how our capital is at risk & steps we can take to reduce them while going green

More on Latest

Dr. Patrycja Klusak
Author: Dr. Patrycja Klusak
Patrycja Klusak is a lecturer 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 relationship between firms’ financial flexibility and their ratings, 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. Dr Klusak holds a PhD in Accounting and Finance and a BA in Banking and Finance from Bangor University, and an MPhil in Real Estate Finance at Cambridge University.
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Dr. Matthew Agarwala
Author: Dr. Matthew Agarwala
Matthew Agarwala is an economist interested in wealth-based approaches to measuring and delivering sustainability, wellbeing, and productivity. His research is motivated by the belief that 20th century statistics can’t capture 21st century progress. Matthew leads the Bennett Institute’s Wealth Economy project, which seeks to transform economic measurement to better reflect sustainability, inequality, and human wellbeing. Matthew regularly consults for governments and scientific organizations on topics of natural capital, ecosystem services, wellbeing, and sustainability. He enjoys working across sectors and disciplines, and his co-authors include ecologists, economists, conservation scientists and practitioners, social anthropologists, civil servants, members of UK Parliament, and Nobel Laureates in peace, medicine, physics, and chemistry. Beyond Cambridge, Matthew enjoys affiliations at the LSE, University of East Anglia (Centre for Social & Economic Research on the Global Environment), the University of Exeter and maintains active research networks in Canada, Hong Kong, Germany, USA, Japan, and throughout the UK.
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Matt Burke
Author: Matt Burke
Matt Burke is a Research Assistant at the Bennett Institute for Public Policy and Doctoral Candidate at the University of East Anglia. His main areas of interest are in the application of computational techniques to contemporary problems in finance and economics.
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Dr. Moritz Kraemer
Author: Dr. Moritz Kraemer
Moritz Kraemer is an international economist and expert in credit analysis and economic policy. Moritz is Chief Economist at CreditRisk.io and a Senior Fellow at SOAS Centre for Sustainable Finance. Until 2018 Moritz was Global Chief Ratings Officer for Sovereigns at S&P Global Ratings. Before joining S&P in 2001 Moritz worked as an Economist at the Inter-American Development Bank in Washington, D.C. Moritz holds a Ph.D. in Economics from the University of Göttingen (Germany). He studied Economics, Latin American Studies and Literature in Frankfurt, Southampton and San Diego. He teaches graduate courses at Goethe-University Frankfurt and the Centre International de Formation Européene (Nice).
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Dr. Kamiar Mohaddes
Author: Dr. Kamiar Mohaddes
Kamiar Mohaddes is a macroeconomist at the Judge Business School at the University of Cambridge and a Fellow in Economics at King’s College, Cambridge. His main areas of research are applied macroeconomics, global and national macroeconometric modelling, energy economics, and climate change. His articles have been published in a number of edited volumes as well as in leading journals, and have been covered in major international news outlets. He is currently a consultant at the Asian Development Bank and has previously served as a Departmental Special Advisor at the Bank of Canada, a consultant at the United Nations ESCWA, and a regular visiting scholar at the International Monetary Fund.
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