Climate threatens government debt: analysts fear a collapse of the government bond market due to unaccounted environmental risks

Existing credit ratings of countries do not reflect climate risks and risks associated with the upcoming energy transition, analysts fear. This, in their opinion, poses a danger to the government bond market and can lead to a sudden and chaotic collapse of assets. On the other hand, the revision of the ratings threatens with problems in attracting capital to those countries that already have insufficient funds to combat climate change.

What is the problem?

A growing number of investors, scientists, politicians and regulators are wondering if existing credit ratings take into account the risks associated with climate change and the actions of the authorities on the energy transition, writes Bloomberg. This is especially true for the risks of government bonds with a long maturity - 50 years or more. “They are assigned the same rating as two-year bonds. I think this is inappropriate,” says Moritz Kremer, who headed sovereign debt ratings at S&P until 2018.

The major rating agencies — Moody's, S&P and Fitch — say they take climate-related factors into account when evaluating government borrowers and call their methodologies sound. But investors remember the 2008 crisis, when countries and companies with the highest ratings from these agencies suffered significant losses, Bloomberg notes.

Rating agencies were “catastrophically wrong about the risks to corporations and financial institutions during the financial crisis,” says Matthew Agarwala, an environmental economist at the Bennett Public Policy Institute in Cambridge. “And now they are lining up on the defensive to be just as disastrously wrong when it comes to climate risks.”

The problem also has a reverse side: if the ratings are revised in accordance with environmental risks, then in the first place they will decrease in countries that are least prepared for climate change. This will make it even more difficult for them to raise the capital they need to solve environmental problems.

What does it threaten?

If climate risks not accounted for in credit ratings materialize, it will provoke a sudden and chaotic asset collapse, analysts say. The consequences of this collapse will be reflected in pension funds and the balance sheets of central and commercial banks.

A study by London Stock Exchange subsidiary FTSE Russell notes that 10 of the 26 members of the FTSE World Government Bond Index, including Japan, Mexico, South Africa and Spain, will default on their sovereign debt by 2050 in the event of a "disorderly energy transition" that is, if government attempts to reduce their carbon footprint are belated, abrupt, and economically harmful.

In another study, a team of scientists used artificial intelligence to model how a rise in the Earth's temperature would affect sovereign credit ratings. Modeling has shown that 63 of 108 countries, including Canada, Germany, Sweden and the US, will have their ratings downgraded by 2030 due to climate change if emission reductions are not in line with global targets. As a result, states will lose from $137 billion to $205 billion.

As for Russia, Australia and Canada — countries whose economies are tied to fossil fuels and other natural resources — they will all face challenges even under a planet-friendly climate scenario. If emissions are reduced too slowly, Australia's credit rating, for example, will drop by about one notch by 2030 and four notches by 2100. Now the country has the highest rating from all the Big Three agencies.

What's next?

European regulators began to think about the problem of credit ratings. The European Central Bank said in July it would check whether rating agencies provide sufficient information about how they account for climate risks. If the ECB is not satisfied with the Big Three methodology, it could introduce its own rating requirements.

The European Securities and Markets Authority plans to analyze and report on how environmental, social and governance (ESG) factors are taken into account in credit ratings. Based on this report, the European Commission intends to "take action".

Some large investment funds are trying to predict climate risks on their own. For example, Jens Nistedt, a New York-based fund manager at Emso Asset Management, pays ESG data providers to get a complete picture of risk. Dutch asset management firm Robeco uses a ranking tool that includes ESG data. Swiss banking group Lombard Odier has developed its own “portfolio temperature equalization tool,” which it uses to determine asset exposure to climate risks.

However, as analysts point out, there are types of climate-related risks that are almost impossible to account for. "It's very difficult to be precise about the physical impact of weather on credit," says Peter Kernan, S&P's global benchmarks specialist. The risks associated with the energy transition are easier to predict, he says.

Investors should now be concerned if they have bonds in their portfolios that mature in several decades. In the short term, climate risks are unlikely to be fully realized. “If I have a bond that matures in the next five years, do climate change considerations really affect the likelihood of the security being redeemed? Most likely no. If I have 50-year bonds, then yes, it is,” concluded Naistedt of Emso.