(Bloomberg Markets) – For years, climate scientists have been warning of the violent forest fires and hurricanes that are now overwhelming many communities. Today the alarms are ringing about an associated financial threat: risk lurks in government bonds, the largest part of the global debt market.
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A growing number of investors, academics, policymakers, and regulators are wondering whether credit ratings – the ubiquitous assessments that underlie much of the financial system – explain the impact of extreme weather events and policy changes related to global warming on borrowers. As soon as these risks materialize, they threaten to trigger a sudden, chaotic asset collapse, described by the late economist Hyman Minsky. The repercussions would hit pension funds and the balance sheets of central and commercial banks.
“A lot looks like it is years and decades in the future, but when you look at the financial implications, you risk Minsky-esque moments and quick devaluations,” said Steven Feit, attorney at the Center for International Environmental Law in Washington focusing on environmental liability and finance. âThe climate timescale is decades or a century long. The financial schedule is now. “
The Big Three rating firms – Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings – all state that they consider climate-related factors when rating government borrowers and defend their methodology as robust. However, investors recall the 2008 credit crunch when AAA-rated structured products suffered significant losses. Now studies are showing potential long-term risks to public debt that aren’t featured in today’s ratings.
For example, 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 if there is a âdisorderly transitionâ – that is, if governments try to reduce carbon emissions. Reducing emissions is late, abrupt and economically damaging. This is based on research by FTSE Russell, an index provider owned by the London Stock Exchange Group Plc.
“We have these really well-understood structural challenges over the time horizon of two, three, four decades ahead of us, and that is in no way reflected in the credit ratings,” says Moritz Kraemer, who was responsible for the sovereign debt ratings at S&P until 2018. “Some countries issue bonds with much longer maturities – 50- or 100-year bonds – and they all have the same rating as a two-year bond. And I think that’s not appropriate. “
Earlier this year, Kraemer, who is now CountryRisk.io’s chief economist, and a team of academics used artificial intelligence to simulate the impact of rising temperatures on states’ creditworthiness in research for the University of Cambridge. They found that 63 out of 108 government bond issuers, including Canada, Germany, Sweden and the US, would experience climate-related downgrades by 2030 if emissions reductions did not meet global targets. Research showed that climate-related downgrades could cost the national treasury from $ 137 billion to $ 205 billion.
National debt is âthe backstop. It’s what everyone withdraws to in a time of misfortune, conflict and turmoil, âsays Matthew Agarwala, environmental economist at the Bennett Institute for Public Policy in Cambridge and one of the study’s authors. Rating companies “were catastrophically wrong about corporate and financial institution risks for the financial crisis,” he says, “and now they’re just as catastrophically wrong when it comes to climate and national risks.”
Consider Australia, Canada, and Russia, countries with economies tied to fossil fuels and other natural resources. All would face challenges for the planet, even at best, if the transition to a lower carbon economy were done in an orderly fashion, says Lee Clements, head of sustainable investment solutions at FTSE Russell. In a high-issuance scenario, Australia’s credit, currently the top rated of all the Big Three, would likely decrease by one notch by 2030 and four notches by 2100, according to a study by Cambridge.
âGiven the high CO2 emissions and the lack of a decline in these emissions, Australian government bonds are rated more critically despite their AAA rating,â says Rikkert Scholten, Global Fixed Income Portfolio Manager at Robeco Asset Management. He does not invest in Australian bonds as part of the company’s climate bond strategy, a portfolio aligned with the United Nations Paris Agreement on Climate Change, a 2015 international agreement to reduce harmful emissions.
In Europe, policymakers and regulators are starting to get involved. The European Central Bank said in July it would look to see if rating companies provide enough information on how they incorporate climate-related credit risk into ratings. The central bank, which uses Morningstar Inc.’s ratings of the Big Three and DBRS to value assets, could introduce its own climate requirements if it believes the rating companies are not doing enough, says Irene Heemskerk, chief executive officer the ECB Center for Climate Change. The European Securities and Markets Authority, the region’s financial market regulator, plans to report on how environmental, social and governance (ESG) factors are incorporated into credit ratings and the European Commission can take action based on the results.
Emerging market government bonds like Jens Nystedt, fund manager in New York at Emso Asset Management, pay specialized ESG data providers to get a better picture of the risks. Robeco uses a ranking tool that contains ESG data including climate-related factors. Lombard Odier Group has its own Portfolio Temperature Alignment Tool, one of the key resources it uses to assist credit ratings in determining the vulnerability of assets to climate risk.
âWe still have to do our own work,â says Christopher Kaminker, Head of Sustainable Investment Research and Strategy at Lombard Odier. âEveryone understood that in the financial crisis – they [the rating companies] not always right. âRead more: Rating companies reacted slowly to the Covid crisis, as research shows
The Big Three have quickly grown the ESG side of their business. Fitch and Moody’s have developed ESG scores to show the impact of climate risk on ratings. S&P says the company “includes the impact of ESG credit factors such as climate change risks related to carbon dioxide and other greenhouse gas emissions costs when our analysts consider them material to our creditworthiness analysis and when we have enough transparency about what those factors are” will evolve or manifest. “
David McNeil, Director of Sustainable Finance at Fitch, says that the company’s ESG relevance scores are a key rating product and that climate issues are fully integrated into the credit research process.
The strategy at Moody’s is similar. Swami Venkataraman, senior vice president of ESG for the company, says his Environmental Issuer Profile Scores – which indicate exposure to environmental risks – feed directly into the ratings and that “climate considerations have always played a role.”
Half of the government bonds examined by Moody’s are valued differently today than without ESG considerations, says Venkataraman. The recent forest fires in Greece highlight the credit risk of climate change, the company said in a study published in August.
Critics say these efforts don’t go far enough. Rating firms use comments and ESG ratings to avoid potentially unpopular downgrades, says Bill Harrington, a former senior vice president at Moody’s who is now a senior fellow at the Croatan Institute in Durham, NC, and straight to the Big Three.
“This proliferation of non-credit-rating measures is one of the ways credit rating agencies are avoiding their work,” says Harrington. âInstead of taking creditworthiness actions, they make comments that say, ‘We’re watching these things.’ â
Agarwala, the Cambridge economist, says: “Credit rating companies simply offer the same old rating plus an ESG guarantee of ‘scientific’ indicators of varying relevance and credibility.”
âWe need them to incorporate climate economic projections into today’s mainstream rating,â continues Agarwala. “It’s the difference between a prior diagnosis by a doctor or a coroner at an autopsy.”
However, some types of climate-related risks are easier to include in ratings than others, according to Peter Kernan, Global Criteria Officer at S&P. “It is inherently very difficult to pinpoint the physical effects of weather on credit,” he says. The transition risk is simpler, says Kernan, because it affects “public policy decisions by global decision-makers – for example on carbon taxes.”
The Big Three have taken steps to address growing climate risks in some sectors and regions. Fitch has adjusted its rating model for Jamaica due to the increasing likelihood of natural disasters on the Caribbean island nation. S&P says it has lowered its ratings on Caribbean countries’ debts because of growing natural disaster risk. Roberto Sifon-Arevalo, chief analytics officer for government bonds at S&P, also points out that a country’s vulnerability to physical climate risks alone does not always result in downgrades. Japan, for example, experiences natural disasters frequently, but can withstand them better because it’s a more prosperous country, he says.
According to the International Monetary Fund, the financial risks emanating from climate change are most felt by developing countries, especially those that are poorly prepared for climate-related shocks. Downgrading countries that are least prepared for climate change will only make it more expensive for them to raise the capital needed to transition to a lower carbon economy. This issue is already playing out in green bond markets, where emerging market companies and countries are finding it increasingly difficult to attract funding, according to a report from London’s Imperial College Business School.
Kraemer, former head of the government bond rating agency at S&P, says the rating company’s business models create a conflict of interest. Since they are paid by the companies they review, he says, they may be reluctant to downgrade an important customer. The companies say commercial considerations don’t affect their ratings.
For some investors, the solution might be to provide ratings that change for different maturities.
âIf I have a bond that matures in the next five years, will climate considerations really affect the likelihood of the security being repaid? Probably not. If I have a 50-year bond, then yes, âsays Nystedt von Emso, the emerging market bond company that manages around $ 7 billion. Rating companies “don’t usually break it down by maturity – I think that’s ultimately the revolution that is going to happen.”
Ward covers currency and rates markets for Bloomberg News in London.
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