Published on 18 March 2021
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Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness

Using artificial intelligence, economists construct the world’s first ‘climate smart’ sovereign credit rating and warn of climate-driven downgrades as early as 2030.

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.

This research was selected as a runner-up for the Financial Times Responsible Business Education Awards.

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This research is supported by LetterOne and by the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE). INSPIRE is a global research stakeholder of the Network for Greening the Financial System (NGFS); it is philanthropically funded through the ClimateWorks Foundation and co-hosted by ClimateWorks and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics

Authors

Patrycja Klusak

Dr Patrycja Klusak

Affiliated Researcher

Dr Patrycja Klusak is an Associate Professor at Norwich Business School at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of...

Matthew Agarwala

Dr Matthew Agarwala

Project Leader: The Wealth Economy

Matthew Agarwala, Economist, Bennett Institute for Public Policy, Cambridge. Matthew Agarwala is an economist interested in wealth-based approaches to measuring and delivering sustainability, wellbeing, and productivity. His research is motivated...

Dr Moritz Kraemer

Dr Moritz Kraemer is an international economist and expert in credit analysis and economic policy. Moritz is Chief Economic Advisor of Acreditus, a UAE-based risk consultancy firm, and Independent Non-Executive...

Dr Kamiar Mohaddes

Kamiar Mohaddes is an Associate Professor in Economics & Policy at the Judge Business School at the University of Cambridge and a Fellow in Economics at King’s College, Cambridge, where...

Matt Burke

Matt Burke is a Senior Lecturer at Sheffield Hallam University, former Research Associate at the Bennett Institute for Public Policy and Doctoral Candidate at the University of East Anglia. His...

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