A growing number of investors, academics, policymakers, and regulators are expressing concern that credit ratings, which are fundamental to the financial system, are not adequately accounting for the impact of extreme weather events and policy shifts related to global warming on government borrowers. Critics point to the 2008 credit crisis, where highly rated structured products experienced substantial losses, as a precedent for rating agencies potentially underestimating systemic risks. Studies suggest that current ratings may not reflect long-term risks to government debt from climate change.
Research indicates severe financial consequences. For example, FTSE Russell projects that 10 of the 26 members of the FTSE World Government Bond Index, including Japan, Mexico, South Africa, and Spain, could default on their sovereign debt by 2050 under a "disorderly transition" scenario. Additionally, a University of Cambridge study using AI found that 63 out of 108 sovereign debt issuers, such as Canada, Germany, Sweden, and the US, could face climate-induced downgrades by 2030 if emissions reduction targets are not met, potentially costing national treasuries from $137 billion to $205 billion.
The impact on credit ratings could be substantial for individual countries. For instance, Australia's credit rating, currently AAA from the Big Three agencies, could drop one notch by 2030 and four notches by 2100 under a high-emissions scenario, according to the Cambridge research. Robeco Asset Management's global fixed-income portfolio manager, Rikkert Scholten, notes that Australian government bonds will be evaluated more critically due to high and persistent CO2 emissions, despite the current AAA rating. European regulators, including the European Central Bank, are beginning to scrutinize how rating companies integrate climate-related credit risks.
The financial risks are disproportionately felt by developing economies, particularly those unprepared for climate shocks, as highlighted by the International Monetary Fund. Downgrading these countries would increase their borrowing costs, making it harder to secure the capital needed for a transition to lower-carbon economies. This trend is already evident in green bond markets, where emerging-market companies and nations struggle to attract funding. While short-term bonds might be less affected, long-term bonds (e.g., 50-year bonds) are significantly exposed to climate change considerations regarding repayment probability.
Climate change is expected to lower economic growth and increase disaster frequency, straining public finances through both reduced revenue and increased expenditure. This could lead to fears of defaults and higher government borrowing costs, creating a feedback loop. Studies suggest that if climate impacts are large, global GDP losses could average about -28% from 2030 to 2100, making debt unsustainable for some countries like Brazil, India, and Italy. While adaptation measures can help, they are not a complete solution, and governments may only be able to finance a portion of the adaptation costs.
