Researchers call for regulatory climate crackdown on sovereign credit ratings

Regulators such as the EU’s ESMA and the US SEC should require credit ratings agencies (CRAs) to demonstrate how they are incorporating climate change within sovereign ratings, according to academics from the University of East Anglia and the University of Cambridge.

Research published today found that 63 sovereigns could experience climate-induced downgrades by 2030, with an average reduction of 1.02 notches, in a worst-case scenario where no new climate policies have been introduced. This rises to 80 sovereigns facing an average downgrade of 2.48 notches by 2100.

Canada, China, India, Mexico and four other nations are expected to be the most affected, and could see their ratings slashed by more than five notches in the same 2100 scenario. The US, UK and Japan would see rating downgrades of over four, three and two notches respectively.

Researchers estimated that downgrades would cause annual interest payments on sovereign debt to balloon by $137 billion to 205 billion worldwide as a result, with additional costs to corporates reaching $36 billion to 62 billion.

They also described the “up to 10-year” horizon cited by ratings agencies as “not credible”, noting that credit reports typically include forecasts that only reach three years into the future, at most, and exceptionally to five. In addition, current assessments of sovereign creditworthiness do not account for “ultra-long-risks” such as climate change and aging societies, they said.

“Currently CRAs apply the same ‘long-term’ rating to a two-year bond as they do to a 50-year or century bond,” they added. “This equalisation of risk is clearly implausible.

“A transparent and scientifically grounded truly long-term rating will help support better investment decisions today, expose stranded assets earlier and create incentives for public policies and investments that contribute to containing and mitigating climate change.”

The researchers said regulators could start by “insisting” that ratings agencies document how they how they fulfil their current claim of a five to 10-year time horizon, and subsequently work on a methodology to incorporate longer-dated challenges such as climate change.

Researchers involved in the project include Cambridge environmental economist Matthew Agarwala, University of East Anglia credit ratings expert Patrycja Klusak, and former S&P chief sovereign ratings officer Moritz Kraemer.

The study was billed as the first to simulate the effect of future climate change on sovereign credit ratings.

Separate research by FTSE Russell has found that nearly half the constituents of the FTSE World Government Bond Index – including Australia, Japan, South Africa and Spain – could default on their sovereign debt by 2050, if climate policies are not implemented in earnest before 2030.

ESMA, which regulates European credit ratings, previously called for greater transparency and disclosure around ESG factors in 2019 following a consultation on the topic. The regulator has refrained from introducing formal requirements.