ARX Series 28 March 2021
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.
Part 1: Insights on the Macroeconomic Impacts (0.5 PL)Download PDF
Part 2: Insights on the Financial ImpactsDownload PDF
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.
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