Why and how to integrate climate risks in the sovereign asset class

As the timeline for impacts shortens, many countries will become increasingly exposed to climate change-related risks.

Today, many countries are torn between the need to set increasingly ambitious climate goals and the powerful allure of Business As Usual (BAU). This often leads to contradictory signals for sovereign investors and requires them to “think outside of the box”.

For example, it is relatively well-recognised in international negotiations that global warming should be limited to 2°C or less. Yet the sum of country commitments (the “NDCs”, Nationally Determined Contributions) following the 2015 Paris Agreement would lead to 3°C global warming or more. Based on BAU scenarios, global warming is expected to go beyond 4°C or even 5°C by 2100. A good example of the world’s paradoxical situation is in greenhouse gas emissions: while energy-related CO2 emissions should have already been decreasing for a long time, they rose by 1.4% worldwide in 2017 and by 1.7% last year.

As the timeline for impacts shortens, many countries will become increasingly exposed to climate change-related risks. Climate change represents both risks and opportunities for investors. Much could be done to not only better manage sovereign risk, but also to shift investment to the areas where it is most needed.

Physical risks, transition risks and resilience

At Beyond Ratings (now part of the London Stock Exchange Group), we identify two key categories of investment risks. First, climate change involves direct physical impacts that can have major economic, social, and human consequences. For example, the World Bank estimates the cost of natural disasters already at around USD 520 bn, a number that is expected to grow with climate change bringing potential increases (both in terms of frequency or intensity) in tropical cyclones, heat waves, water stress, forest fires, floods, etc. There are also indirect risks to consider: for example, the impacts of agricultural yields falling for countries in which the sector is key, or the possibility of extreme weather events disrupting key supply chains.

In a 5°C scenario, 80% of the world GDP output would be lost, based on the Dietz and Stern climate damage function. While other damage functions assess risks at lower levels, global warming will have very material impacts. Damage functions standing at the lowest levels tend to neglect the non-linear impacts that are however key to understand climate risks, as illustrated by the examples above.

The second type of risks to which sovereign assets will be increasingly exposed are transition risks. The climate transition requires huge investment in the energy sector, building renovations, transportation, and worldwide industry. Many financial assets are at risk as the outlook of some conventional businesses may be put under growing stress. For example, drastically reducing fossil fuel consumption to limit climate change will have implications for many economic sectors, but also for some countries more than for others (80% of global fossil fuel reserves are owned by Sovereigns).

Climate-related sovereign risks could, thus, materialise in several ways: international negotiation pressure and regulatory developments, carbon border tax adjustments impacting country competitiveness depending on the carbon intensity of exports, lower demand for fossil energy, socio-economic benefits of energy transition investments in terms of economic resilience and jobs creation, climate liability litigation risks, etc. However, it should be noted that risk is not simply a question of exposure. A country can be highly exposed to physical and transition risks but deploy significant efforts to mitigate them, so that risk assessment must also be adjusted by resilience factors.To conclude, we recommend assessing risk based on the three following pillars:

Climate Risk = Physical Risk + Transition Risk – Resilience

Creating a climate risk-adjusted sovereign index

So, what can be done and how? Shifting trillions of financial investments towards the energy transition will not be done overnight, but some essential steps must be taken quickly. The first is to start gathering and analysing data. It is key to understand climate issues and your investments before considering changes in their allocation: what are their climate characteristics, carbon footprints, trends, alignment levels with low-carbon trajectories, physical climate risks, adaptive capacities, etc.?

A second step is to use relevant climate data to develop adjusted financial products and tools. For example, a newly launched index brought to market by Beyond Ratings and FTSE Russell combines climate data models with a fixed income index. The result is a climate risk-adjusted version of the well-known sovereign bond index, the FTSE World Government Bond Index (WGBI). This innovative index, the FTSE Climate Risk-Adjusted World Government Bond Index (Climate WGBI) has been built using three climate measures corresponding to the three key areas of climate risk assessment: i.e. physical risk, transition risk and resilience.

We believe our approach to transition risk can bring notable added value to risk assessment. It is based on an innovative methodology to assess the carbon reduction needed on a country-by-country basis to limit warming to 2°C by 2050. It relies on the BR CLAIM Model, a stochastic process to determine the most likely allocation of future emissions across countries. This method of optimising emissions reductions ensures that the 2°C-aligned carbon budgets estimated for each country are as realistic as possible and based on a neutral statistical approach rather than on ex ante criteria. The Climate WGBI weights are tilted based on both the current distance of each country to a 2°C emissions target, and their forecasted distance to target corresponding to their recent 5-year trends.

What appears is that it is possible to reduce the exposure to climate risk whilst keeping index characteristics in line with those of the traditional WGBI: 10 bps of tracking error, limited index turnover, similar duration, country weights changes not going beyond a -5 to +5 percentage points range, etc.

Of course, achieving full 2°C alignment would require much more significant shifts, such as strengthening the earmarking of financing towards relevant infrastructure and low-carbon project investments. The effort to be provided is so massive and urgent that it will require thinking even further “outside of the box”!

However, sovereign indexes can send a “carbon price-signal” on the cost of debt for sovereign assets, in order to encourage governments to take more ambitious climate action. Climate change will have significant costs that will not be fully internalised overnight. It is therefore urgent to start better integrating these risks not just in reporting and data analysis, but also in investment management.

Guillaume Emin is an Analyst at Beyond Ratings, part of the London Stock Exchange Group.

This article was sponsored by Beyond Ratings and RI editorial staff were not involved in the creation of this content.