Climate Change and Default Risk: S&P’s Latest Report Connects the Dots
Credit to CGP Grey, CC BY 2.0
“Climate Change Is A Global Mega-Trend For Sovereign Risk.” That's not me talking. It’s the title of the latest report published by credit rating agency Standard & Poor's. While climate risk is not yet officially included in the agency’s credit rating model, it's the first time that a major rating agency has specifically recognized an environmental issue in its forecast of countries' economic health and their ability to honor their sovereign debt.
This report is a huge development as far as the financial sector is concerned. It is a clear signal that the message about the critical need for countries to incorporate environmental risk into their development strategies, economic plans and public policies is finally beginning to hit home. As such, it is great news.
S&P’s climate risk report is just the starting point of a much bigger conversation. The sovereign bond market has been a long overlooked portion of the financial system, even though it represents 41 trillion USD of total capital flows. Because a government's cost of borrowing is strongly related to its credit rating by agencies such as S&P, governments are powerfully motivated to manage issues that could harm their credit rating. Recent analysis has shown that environmental risks do impact national economic health, and by extension default risk, but are not currently incorporated into most country risk models. Incorporating environmental risks across the finance industry would undoubtedly cause nations to pay attention to ecological risk like never before, especially due to the potential for some governments to be downgraded (and others upgraded), thereby affecting their borrowing costs.
The S&P report looks at the economic impacts of climate change, such as changing rainfall patterns that could affect agricultural yields. But climate change isn’t the whole story. Our research has shown that resource constraints (limited supply of fossil fuels, metals and minerals, food and fiber) coupled with rising global demand also have a profound effect on the balance sheets of nations.
Taken together, the conclusion is clear: For countries to protect themselves from the erosion of economic performance due to climate change and growing resource scarcity they will need to redesign their economies in order to be ‘fit for the future.’ They will need to minimize their liabilities and optimize their opportunities. They will need to be resilient in the face of climate change but will also be compelled to view their natural resources as a source of wealth for their nations, rather than assets to liquidate on their way to economic growth.
Approximately 80 percent of the world’s population lives in countries that are in ecological deficit. In other words, their populations demand more resources and ecological services than can be supplied on a net basis by their own ecosystems. Deficit risks play out in three ways. Here goes, briefly:
1. Trade-related risks: countries that compensate for ecological deficits through imports are exposed to trade related risks such as commodity-price volatility and possible supply disruption.
2. Degradation of natural capital: soil, fisheries and forests that are overused or mismanaged can suffer from reduced yield, affecting production and possibly increasing countries’ reliance on imports.
3. Stranded assets risks: Many nations have invested in carbon-intensive infrastructure and industrial processes. Countries are unequally exposed in terms of the scale and impact of needed reforms as governments around the world respond to climate change.
Now, the good news is that governments do have options. The management of resources and fossil fuel dependence, to name but two aspects, belong in the realm of political choice.
We believe we're providing a very important lens for credit risk perspective. And so we're about to launch the second round of E-RISC (Environmental Risk Integration in Sovereign Risk Credit) research with seven partners from the financial industry: S&P, HSBC, European Investment Bank, Caisse des Dépôts in France, Colonial First State in Australia, KFW in Germany and Kempen in the Netherlands. Some 18 months after we launched the initiative, our focus is now on testing and refining the methodology to make it robust and useable in investment decisions.
Why is this important? Because getting the finance industry to incorporate environmental risks is one of the best ways to help governments pay attention. Ultimately, our goal is to see the implementation of policies at the national and regional level that address those risks.
The challenge is on.
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