Anticipating the Climate Change Risks for Sovereign Bonds

The deep economic changes necessary to achieve the Paris Agreement objectives require a consistent reallocation of resources. This gives the financial sector a key role in tackling climate change. Risk analysis is important in that perspective.

Overview

PART 1:  Insights on the Macroeconomic Impacts

Due to the nature of climate change, with unprecedented and non-linear, dynamics, relying on historical data is not sufficient to anticipate climate change risks. This paper proposes a methodology for a forward-looking assessment of climate risks as recommended by regulating international institutions.

It is the first of a two-part study whose objective is to explore how sovereign bonds could be affected by climate change risks. This first part focuses on assessing the macroeconomic impacts related to climate change. Two “worst case” scenarios (similar to current trends, though) are explored, leading to the following conclusions:

• The magnitude of the estimated impacts is very high, with tens of GDP percentage points at risk in 2050 in the most vulnerable countries, from both transition and physical risks.
• Economically significant impacts could appear from 2030 onward.
• Accordingly, investors should take climate change consequences very seriously in their investment decisions.Overall, the results underline clear benefits of an orderly transition that would enable the development of sustainable economic activities.

PART 2: Insights on the Financial Impacts

The huge economic transformation to achieve the Paris Agreement objectives is requiring a sizeable reallocation of assets. This assigns the financial sector a key role in tackling climate change. Forward-looking analysis in a scenario-based framework is crucial to assess the financial risks of climate change.

This paper, which is the second of a two-part study, explores the effects of climate change risks on sovereign bond returns and proposes an innovative and practical methodology that measures the anticipated costs from climate change. The results from the first study have been used in this research. The findings are as follows:

• The impact from indebtedness varies considerably, which may be highly significant for some economies, particularly in relation to transition risks. 
• Because the default probabilities are heterogenous, the large residual fiscal capacity in some economies will reduce their likelihood of default, especially with regard to transition risks.
• At the index level, the financial impact of physical risks could be evident as early as 2030, followed by a few years later for transition risks. The potential decline in returns is comparable in both types of risks by 2050.
• Overall, the results underline the benefits of an orderly transition to the development of sustainable economic and financial activities.
  

PART 3: Insights on the Physical Risks

In this paper, we illustrate the possible effects of climate change depending on the level of mitigation efforts within the next years, and decades. We focus on two specific climate hazards: (i) the average temperature and (ii) the frequency of very hot days. Then, building on the methodologies developed in the first two parts of the series, we continue our exploration of quantifying financial risk from climate change for sovereign issuers.

Compared to our previous studies, this analysis provides more detailed results, in terms of time horizons, countries and climate scenarios. We highlight our three main findings: 

• almost all countries might experience adverse effects from climate change. Emerging markets are the most highly vulnerable to climate change, with a high default risk due particularly to their lower fiscal capacities;
• The first evidence of financial instability in the sovereign market from unmitigated climate change could be seen as early as 2030;
• Contrary to common belief, our results show that even a Paris-aligned scenario will lead to significant physical risks for many countries,
  especially in Latin America, Africa and Southeast Asia.