Climate change could slash credit rating of 63 countries, raise cost of debt

The sovereign credit ratings of many countries could be downgraded as early as the next ten years if current levels of carbon emissions continue, increasing the cost of government and corporate debt globally, recent research led by the University of Cambridge revealed.

Using Standard and Poor’s (S&P) data and climate-adjusted macroeconomic indicators, the researchers found that under a “business-as-usual” scenario with no action in curbing carbon emissions, the sovereign ratings of 63 countries will be downgraded by an average of one notch by 2030. Germany, India, Sweden, and the Netherlands would all fall three notches; the US and Canada would be downgraded by two notches and the UK by one.

COVID-19 has spotlighted the importance of environmental, social, and governance (ESG) and long-term sustainability issues for governments and companies. Despite the rapid increase in climate risk disclosures and sustainability reports by companies, businesses operate in macro environments often beyond their control.

“Most disclosures present companies as if they are independent of their physical … and macroeconomic surroundings. But climate change does not just affect firms individually, it affects countries and economies systemically,” the researchers wrote. “No corporate climate risk assessment is complete without also considering the effect of climate on sovereign bonds.”

The researchers simulated climate change’s effect on sovereign ratings (creditworthiness of countries) for 108 economies under three warming scenarios. By 2100, the countries would face a more significant downgrade where creditworthiness for 80 countries could fall an average of 2.5 notches, if carbon emissions continue to rise.

Sovereign ratings are reported according to a 20-notch scale, where AAA is “prime high grade”, while anything below BBB is considered “speculative” or noninvestment grade.

The impact of climate change on countries’ ability to repay debts will be more severe compared to what countries are facing now due to COVID-19. Over the past year, pandemic-induced economic shocks have led to sovereign rating downgrades for 48 countries, a smaller number compared to what could be on the horizon if nothing is done to reduce carbon emissions.

“Rating agencies’ sovereign forecasts rarely extend beyond three years,” Moritz Kraemer, a co-author of the study, said in a news release. “Investors are holding government bonds with ever-longer maturities. The agencies’ short time horizon increasingly leaves investors without a reliable yardstick for credit exposures that can extend up to a hundred years. … [T]he latest climate science is essential to doing this.”

Countries with downgraded credit ratings would face increases in annual interest payments. An estimated rise of between $137 billion and $205 billion in interest payments is expected if carbon emissions continue to increase, the report noted. Corporate debt could also be more expensive. Businesses could see additional cost of debt up to $62 billion globally by 2100.

— Alexis See Tho (Alexis.SeeTho@aicpa-cima.com) is an FM magazine associate editor.