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No increased risk of sovereign default from credible transition, KfW study finds

Analysis from bank’s risk department shows credible transition leads to raised GDP from 2060 onwards.

A credible net-zero transition does not lead to increased sovereign default risk and will result in higher prosperity from 2060 onwards, according to new analysis from German promotional bank KfW.

In Germany alone, KfW estimates that €5 trillion will be needed for climate neutrality, while UN Environment Programme estimates put the yearly sums needed for the transition in developed markets as high as $300 billion, on top of the additional finance given to emerging markets countries to assist their transition.

“In view of the immense sums involved, many investors may be concerned that the creditworthiness of the recipient countries could suffer as a result of this challenge, that investments could become unprofitable or that debtors’ probability of default may rise,” said Marcel Hastermann, a credit risk analyst at KfW.

However, KfW analysis of 96 sovereigns found that “no real GDP decline” would result up to 2050 due to climate change mitigation measures and that transition investment will lead to increased prosperity from 2060 onwards, especially for emerging markets.

In contrast, Hastermann said that a disorderly transition, where a country does “too little for too long”, could lead to a deep recession, which would increase the pressure on some sovereign ratings. However, even in this scenario the adverse effects would be outweighed in the long run, as the worst effects of climate change would be mitigated.

“The costs of limiting the global temperature increase to 1.5C or 2C rise with every missed opportunity to shape the transition in a well-considered and planned manner,” Hastermann said.

The analysis also looked at the historical impact of physical climate events and found that 95 percent of events caused damage equivalent to less than 1 percent of a country’s GDP, losses of more than 10 percent of GDP occurring in fewer than 1 percent of cases. For most sovereigns, damages are not large enough to have an adverse effect on credit ratings on their own, Hastermann said.

He added that, while acute physical climate risks have a small impact on credit ratings, the impact is unlikely to change in size until 2035, regardless of climate path. However, from 2035 up to 2050, the world’s trajectory “will be highly relevant for the creditworthiness of several countries”. A weak response to climate change could lead to the damage caused by physical climate events more than doubling, the analysis found. “A large number of ratings will suffer if climate change is not adequately addressed,” Hastermann said.

KfW’s analysis comes after a paper published by the Network for Greening the Financial System last week warned that there was a lack of transparency around the methodologies used by rating agencies for incorporating climate risk into their ratings.

While transparency has improved in recent years, the paper said that disclosures “diverge significantly” across agencies, and mainly focus on ESG factors as a whole instead of specific climate-related risk. The network’s central bank members “may need to consider additional tools or apply their own analysis to complement the information contained in [rating agencies’] traditional ratings” while standards improve, the paper continued.

Find out more about this topic from industry leaders at the Responsible Investor Europe 2022 conference, taking place in person in London on 14-15 June.