Climate threats to sovereigns’ creditworthiness are on the rise. Are financial institutions on top of their exposures?
Pakistan. China. Kenya. Each country is grappling with the devastating impacts of different physical climate risks — from titanic floods to blistering heat waves. Each nation also provides a drastic example of how climate change can disrupt national economies and foist unexpected financial burdens on governments.
In the extreme, physical and transition climate risks may even undermine a country’s ability to finance itself in the USD$29trn sovereign bond market. The results could be catastrophic. For issuing governments, sovereign bonds are a way to make up the shortfall between incoming tax revenues and outgoing public spending. For institutional investors, sovereign bonds are the ultimate safe assets. They’re not only used to ballast investment portfolios relied on by millions of individuals and businesses — they also collateralize derivatives trades and short-term cash loans between banks, asset owners, and other financial firms.
If a country is shut out of the sovereign bond market because of climate risks, it may struggle to raise the necessary funds to build resilience and keep its economy ticking. On the flip side, an institution holding the sovereign bonds of a country struggling with climate risks may see its portfolio sink in value, which could imperil its own solvency.
Understanding climate-related sovereign risk
Given the stakes, it’s no wonder that financial services companies are looking into how climate risks could impact sovereign bonds.
A recent analysis by financial data vendor MSCI estimated the transition risk impacts on sovereign bond yields by using its proprietary Climate Value-at-Risk model. The assessment found the macroeconomic choices made by governments could catalyze a variety of yield shocks. For example, a country that spends heavily on decarbonization could spur “greenflation,” which may force its central bank to hike interest rates, pushing short-dated sovereign bond yields higher. On the other hand, a country that delays climate investments until later this century may avoid short-term yield shocks but could amplify transition risks to its economy over the medium to long term. The market may respond to this dynamic by pricing the potential loss in GDP in longer-dated bonds.
A separate study from credit ratings agency S&P Global looked at how physical risks could degrade countries’ economies over time and explored the implications for sovereign debt. The study found that up to 4.5% of world GDP could be lost to extreme weather and chronic physical hazards by 2050, with the lion’s share of impacts shared among low-income countries that lack the resources to withstand or recover from these disasters.
How central banks identify climate-related sovereign risks
Increased evidence of the climate threat to sovereign bonds is driving financial institutions to measure and manage their exposures. Central banks are particularly sensitive to the looming dangers. Why? Because sovereign bonds make up a hefty chunk of their asset portfolios. For example, UK sovereign bonds make up around 98% of the Bank of England’s (BoE) Asset Purchase Facility — the portfolio it uses to conduct quantitative easing — and 82% of its own securities holdings, which are used to fund its day-to-day monetary policy and other operations. Without good climate risk management, central banks’ sovereign portfolios could steadily lose value over time, making it harder for them to do their jobs.
Some central banks are starting to get to grips with climate-related sovereign risks, according to a report published by the Bank for International Settlements (BIS). The document includes answers to a set of questions asked of the BIS’s Consultative Group on Risk Management (CGRM), which is made up of central banks. When asked what asset classes will or could be monitored for climate-related risks, most of the respondents cited sovereign bonds.
This shows central banks understand the need to track climate risks in their sovereign portfolios. But what matters more is how they measure these risks. The answers to other questions in the report suggest they aren’t using the right tools for the job. When asked what kind of metrics they use to monitor climate risks to their portfolios, the CGRM members cited environmental, social, and governance (ESG) scores, portfolio carbon intensity metrics, and traditional credit ratings from credit rating agencies (CRAs).
There are well-known problems with each of these metrics when it comes to sovereign bonds. The main issue with ESG scores is that they are highly subjective. Using the same data, two providers could assign wildly different ESG scores to the same sovereign bond. Furthermore, there is mixed empirical evidence linking ESG factors and sovereign credit risk — the risk that a government may not make good on its debt. Put simply, current ESG score calculations may not be good indicators of sovereigns’ climate-related default risks.
As for portfolio carbon intensity metrics, what makes them ill-suited to gauging climate-related risks is that they look backward, not forward. These metrics do not account for governments’ planned decarbonization measures or adaptation policies, both of which can impact the climate risk exposure of the bonds they issue. Intensity metrics also don’t provide information to contextualize their fluctuations. For example, the BoE says the UK sovereign bonds in its Asset Purchase Facility had a weighted carbon intensity of 208 metric tons of carbon dioxide equivalent (CO2e) per million pounds of GDP in 2022. This was down by 8% from 2020 levels. Does this mean the BoE’s climate-related sovereign risk dropped 8% over the last two years? No, because the metric has nothing to say about why the carbon intensity of the portfolio fell. Did GDP and emissions both grow over the period, but GDP at a faster pace? Or did emissions fall in absolute terms? If the answer is that both GDP and emissions grew, then the portfolios’ transition risk arguably increased over the time frame. On top of all this, intensity metrics have nothing to say about how physical risks could impact sovereign bonds.
What about traditional credit ratings? It’s certainly true that the leading agencies — Fitch, Moody’s, and S&P Global — all incorporate physical and transition climate factors into their sovereign rating assessments. But only to a certain extent. Fitch — for example — says that some transition and physical impacts, like the increased frequency and intensity of natural disasters or reduced tax revenues from fossil fuels, are partially captured by its in-house sovereign risk model. But it also says it is “far from clear” that climate risks can be “adequately captured in sovereign ratings through simple quantitative ranking and scoring.” This suggests there are limits to its methodology.
Then there are the time horizons used to calculate sovereigns’ creditworthiness. Generally, CRAs’ ratings are based on a 3-5 year time horizon. This is a problem because most climate-related sovereign risks are expected to unfold over longer timescales. Fitch says it expects climate risk to trigger more ratings changes “as and when the effects become clearer, closer and more material.” Of course, the risk could be so high by that point that it’ll be too late for central banks or other financial institutions to adjust their portfolios. A World Bank paper also found that sovereign credit rating assessments generally ignore that portion of a country’s wealth based on its natural assets — those most susceptible to physical climate risks — and typically do not reflect a country’s exposure to a low-carbon transition.
Green bonds: a solution to sovereign risk?
If central banks are using flawed metrics to gauge their climate-related sovereign risks, it’s hard to see how they can make their sovereign bond portfolios climate resilient. The BIS survey suggests their favored approach is rudimentary at best. When asked how they consider or plan to consider climate-related risks, the top answer was “green bond investments.”
This is a beguilingly simple solution, but it’s unlikely to be a cure-all. For one thing, green sovereign bonds are in short supply. The Climate Bonds Initiative says USD$27.4bn of new green bonds were issued in the first half of 2022 — a big number but still just 13% of total green bonds issued over that period. Furthermore, not every country has issued green sovereign debt. A central bank cannot simply sell the non-green sovereign debt of its host country and buy the green sovereign debt of another country. Doing so would hobble its monetary and foreign exchange policy capabilities.
More importantly, a sovereign bond is not impermeable to climate risk just because it is green. After all, the tax base of issuing countries could still be ravaged by physical climate risks no matter how much governments invest in cutting emissions. A country’s low-carbon transition also depends on more than the odd green investment. For instance, a government can’t be said to have reduced its transition risk if it issues a green bond while simultaneously cutting taxes for fossil fuel producers.
A smarter approach
If the metrics used to assess climate-related sovereign risks and the approaches to manage them are not up to scratch, how could they be improved?
On the metrics front, a closer relationship between traditional CRA methodologies and ESG scores may yield more decision-useful information. The World Bank paper says CRAs should produce more detailed ratings that allow investors to distinguish between sovereigns with the same credit ratings that are doing better or worse on climate-related issues. CRAs could also explicitly incorporate countries’ natural capital and the factors that drive their long-term sustainability in their methodologies. Of course, this would require them to use longer time horizons to produce assessments and forward-looking metrics they may not be familiar with.
Initial CRA assessments of climate-related sovereign risks could also be more granular. Greater focus should be given to the makeup of countries’ tax revenues by sector and their relative vulnerability to physical and transition risks. Using geospatial data, it should be possible to identify the economic hubs most threatened by sea-level rise and flood risks, while sector-level emissions data could be used to identify the portion of countries’ GDP most exposed to transition risk.
CRAs could also more strongly consider how politics influence countries’ climate risk profiles. Take the US as an example. With the Democrats controlling Congress and the White House, climate action has advanced rapidly. In fact, the passage of the Inflation Reduction Act — and its USD$369bn in climate spending — arguably lowered the US’s transition risk at a single stroke. This risk could rise again, however, if a Republican takeover leads to an increase in fossil fuel production and a slowdown in clean energy growth.
As for climate-related sovereign risk management, increased green bond investments can’t be the only answer. What financial institutions have to understand is how the countries they’re invested in are likely to weather future physical and transition shocks and how their resilience — or lack thereof — will feed through to their respective sovereign yield curves. They can then adjust their sovereign allocations to match their risk appetites accordingly.
These kinds of insights can be gleaned using forward-looking climate scenarios. Though these are by no means infallible, and many include flaws or oversights, they can at least provide a sense of which countries are more or less likely to struggle with upcoming climate challenges. Last week, the Network for Greening the Financial System, the club of climate-focused central banks and supervisors, published a third set of climate scenarios to help financial institutions with this exact task. Significantly, the scenarios include countries’ latest climate commitments — important for projecting sovereign issuers’ transition risks — as well as projections for potential losses from extreme weather events and specific impacts from chronic risks.
Though the details are unclear, it is guaranteed that climate change will impact sovereign creditworthiness and transform the risk/reward calculus of holding sovereign bonds over time. Financial institutions, including central banks, should work on sharpening their climate-related sovereign risk management strategies today to avoid being cut by losses tomorrow.
