By Nicolas Lancesseur, Ph.D, head of global climate research and Julien Moussavi, Ph.D, sustainable investment sovereign research
With ever-increasing focus on climate risks, government bond market participants are attempting to quantify two main climate risks for the asset class. namely physical impacts and transition costs to a carbon-neutral economy.
With this in mind, we have been estimating the economic (cf. Part 1) and financial (cf. Part 2) impacts of transition and physical risks in the 25 countries of the World Government Bond Index (WGBI). This methodological framework enables a country-level assessment of the physical risk through the lens of a hot house world scenario, and the transition risk via a disorderly transition scenario.
The hot house world scenario considers physical damage ratcheting the debt-to-GDP ratio as it lowers fiscal revenues as losses affecting infrastructure, employment, manufactured products and services, reducing the tax base. The disorderly transition scenario envisages abatement costs are assumed to be fully funded by the government because investment in backstop technologies is mainly a matter of public policy. It would, therefore, add to the budget balance and increase the debt-to-GDP ratio.
Potential GDP losses in both scenarios are evaluated for the 25 constituent economies of the FTSE WGBI in comparison to a baseline (i.e., no climate change impact in the case of the hot house world scenario and no mitigation efforts in the disorderly transition scenario). These estimated GDP losses then inform a proprietary model based on an empirical calibration of default threshold, which allows us to model the default probability and impact on sovereign bond yields and returns.
The magnitude of the estimated economic impacts is very high, with tens of GDP percentage points at risk from both transition and physical risks by 2050 in the most vulnerable economies. Economically, significant impact could become evident as early as 2030.
The hot house word scenario has a strongly negative effect on GDP, and equatorial and southern European countries are particularly hard hit.
This would increase debt and default probability in the hot house world scenario by 2050, with Malaysia, South Africa, Mexico, Portugal, Italy, Greece and Spain all expected to default by 2050 in this scenario. The impact of transition risk is also stark: the number of defaulting economies is higher than under a hot house world scenario. Overall, up to 10 economies of the WGBI could experience episodes of financial stress (i.e., South Africa, Australia, Poland, Japan, Italy, Portugal, Greece, Spain, Mexico and Israel). While some countries with lower debt-to-GDP ratio would still have enough fiscal capacity due to their large default threshold estimates, others—Italy, for example—would experience episodes of high sovereign credit stress within just a few decades.
These are sobering long—and medium term outcomes. But these risks—and the disproportionate impact on more indebted, and equatorial countries—will be a fascinating backdrop to COP 26, and beyond, as competing national agendas shape the response to the global climate crisis, and a clear understanding of these risks is important to reallocate financial resources in a manner that is consistent with the Paris Agreement objectives.
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