The impact of climate change on sovereign ratings

In a guest blog for ICC, Marko Mrsnik of Standard & Poor’s Ratings Services, and Dr David Niklaus Bresch of Swiss Re. warn that sovereign ratings could become more at risk as evidence of the economic implications of climate change and extreme weather events becomes more concrete.

Climate change: The impact on sovereign ratings and the role of insurance in mitigating its economic impact

As the planet as a whole gets hotter, what are the potential consequences of climate change on sovereign creditworthiness?

At Standard & Poor’s Ratings Services, we have made our first-ever informed estimates on climate change’s impact on economic and individual sovereign ratings factors.

While our sovereign credit rating methodology doesn’t specifically refer to risk of climate change impact, it does reference natural peril as an “event risk” and a situation where a sovereign would be subject to “constant exposure to natural disasters or adverse weather conditions.” In general, however, the most likely effect of climate change via natural catastrophes on sovereign ratings would be indirect rather than direct, through a weakening of the fundamental factors that determine a sovereign’s rating.

Using direct damage data provided by Swiss Re, we’ve focused on two perils: tropical cyclones, and associated storm surges and floods. This simulation follows on from a report earlier in the year that for the first time simulated the ratings impact of 1-in-250-year natural catastrophes without the effect of climate change.

For both reports, using the direct damage data provided by Swiss Re, we constructed a simplified sovereign rating tool, based on Standard & Poor’s sovereign rating criteria. The hypothetical rating changes generated by the model are not to be misunderstood as Standard & Poor’s definitive view on likely future ratings trajectories.

Our analysis showed that climate change will exacerbate the negative sovereign rating impact arising from 1-in-250-year natural catastrophes by 20% on average. For example, tropical cyclones and floods on average lead to a rating downgrade of about one notch. When accounting for the impact of climate change, sovereign ratings would on average decline by 1.2 notches.

Our analysis showed that climate change will exacerbate the negative sovereign rating impact arising from 1-in-250-year natural catastrophes by 20% on average.

Geographically, ratings of sovereigns in the Caribbean and Southeast Asia appear to be most at risk, while in terms of income, emerging and low income sovereigns seem the most vulnerable. In contrast, the climate change risks to sovereign ratings of advanced economies appear on average relatively small. The additional climate change damage caused in richer countries is on average more moderate. Their higher level of preparedness, including insurance coverage, further reduces the economic and rating impacts for that prosperous group.

Our analysis highlighted that larger insurance coverage of the assets damaged or destroyed by a natural catastrophe can, to some extent, mitigate the medium-term economic impact.

Insurance coverage cushions the negative effect on the private sector, and insurance payouts help accelerate the restoration of damaged productive assets of the private sector. This boosts economic growth and raises the tax base.

As a result, higher insurance coverage will also mitigate the ratings impact of natural catastrophes. This holds true if we account for changes in magnitude of disasters due to climate change.

We caution that insurance can’t offset all of the economic and ratings impact of a natural disaster.

The extent to which this can be effective, however, depends to a large degree on the strength of the fundamentals that support the rating, especially when the damage caused by the disaster is large.

We caution that insurance can’t offset all of the economic and ratings impact of a natural disaster. Even with insurance coverage at 100%, it will take time to rebuild infrastructure and other capital. During that time, government spending is likely to be at least as high as in the absence of a natural disaster while tax receipts will fall comparatively short, leading to a deterioration of the fiscal position. It is worth noting that smaller sovereigns and regionally close sovereigns with similar natural disaster exposure have been effectively sharing and hence diversifying risk through multilateral risk-pooling institutions.

The 2015 U.N. Climate Change Conference in Paris aims to achieve a legally binding and universal agreement to limit global warming. It’s too early to say whether the conference will produce a clear-cut consensus on global policy or significant changes to emissions targets. Either way, if insufficiently addressed, we expect the significance of the climate change megatrend in assessing sovereign risk to only increase over coming decades. As evidence of the economic implications of climate change and extreme weather events becomes ever more concrete, sovereign ratings could gradually become more at risk as well.

The report ‘The Heat Is On: How Climate Change Can Impact Sovereign Ratings’ is available on the Standard & Poor’s Rating Services website.

See more on S&P’s website dedicated to The Long Term Effects of Climate Change