By Nicolas Lancesseur, head of global climate research
Sovereign bonds investors need to consider risks from the impact of climate change into their allocation decisions. Climate change implies two main categories of risks for financial stakeholders: the risks from physical impacts and transitioning to a carbon-neutral economy. A clear understanding of these risks is important to reallocate financial resources in a manner that is consistent with the Paris Agreement objectives. The latter seek to limit the likelihood of capital being destroyed by climate damages and investments turning into “stranded assets.”
Our study is a first step in the wider project of investigating forward-looking analyses. There is a broad consensus among regulating international institutions about the specific nature of the climate change risks and the need to make projections in the framework of climate and economic scenarios to estimate these risks. Relying only on past data would be imprudent when dealing with the unprecedented, non-linear and interacting dynamics of climate change. Recent changes in thinking by the main financial regulators in favour of forward-looking approaches to assess climate risks can be interpreted as a paradigm shift in a sector used to relying on empirical studies.
Building on the NGFS (Network for Greening the Financial System) approach, our study explores two independent “worst-case” scenarios. The 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.
Physical risk of climate change in a hot house world
The differing effects on countries of temperature increases (see Chart 1) are driven by one main factor: the heterogeneity in their starting climate conditions. The higher current average temperature around the equator leads to greater estimated damages from global warming in that region.
Overall, most of the FTSE World Government Bond Index (WGBI) countries would suffer a negative impact from unmitigated global warming. Only Norway and Finland could slightly benefit from a temperature increase, according to the damage function calibrated on Burke and Tanutama (2019) estimations. These positive impacts should however be interpreted very cautiously. Beyond the effects of extreme events and sea level rise that are not captured, the very high damages that most countries are likely to suffer in such a scenario would have negative repercussions on foreign trade or political stability for instance.
Costs to disorderly reach a carbon-neutral economy
Chart 2 shows the total abatement costs (in percent of GDP) associated to the residual emissions after depletion of the carbon budgets—comparable to the “disorderly transition” NGFS scenario. The total abatement costs of a country are incurred from the depletion year and would continue to be sustained, as long as residual emissions remain at the same level.
With the highest abatement costs-to-GDP ratio, South Africa, Mexico, Poland, the US, Australia and Canada are among the countries in the FTSE World Government Bond Index that are most exposed to transition risks. The situation appears all the more worrying for countries where the depletion year of their carbon budget is very close, especially Australia, the US and Canada (respectively 2025, 2026 and 2026, compared to 2031 for Poland and 2036 for South Africa as examples).
*Note: the level of the impact represented by each histogram bar is calculated with a technology cost of 200$/tCO2 (reference) although the lower and the upper ends of the sensitivity bar are calculated respectively with a cost of 100$/tCO2 and 300$/tCO2. This cost range is given by the IPCC in the SR 1.5 for the DACCS technology, used here as proxy for the last resort technology (please refer to the paper for methodology details).
In general, the magnitude of the estimated impacts from climate change is high, with strong geographic differences observed: for both transition and physical risks, tens of GDP points are at risk in the most vulnerable countries by 2050. These results show that investment decisions should consider climate change consequences very seriously in the sovereign bonds asset class.
 See for instance:
- TCFD (2017) Technical Supplement: The Use of Scenario Analysis in Disclosure of Climate-related Risks and Opportunities and TCFD (2019), 2019 Status Report.
- NGFS, (2019), First comprehensive report - A call for action Climate change as a source of financial risk.
- Grippa et al. (2019), Climate Change and Financial Risk, Finance & Development. [IMF journal]
- European Commission (2019), Guidelines on non-financial reporting: Supplement on reporting climate-related information, 2019/C 209/01.
- Bank of England (2019), Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, Bank of England Prudential Regulation Authority, Supervisory Statement SS3/19.
- Bank for International Settlements (2020), Green Swan 2 – Climate change and Covid-19: reflections on efficiency versus resilience, BIS Speech by Luiz A Pereira da Silva, May 13.
 The NGFS is a network of 87 central banks (ECB, BoJ, BoE, Fed, etc.) and 13 supervisors (IMF, WBG, BIS, etc.), launched at the One Planet Summit in 2017 in Paris, aiming at strengthening the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage climate change-related risks.
 World Government Bond Index (WGBI) managed by FTSE Russell, comprising investment-grade sovereign debt from over 20 countries.
Burke, M., & Tanutama, V. (2019). Climatic constraints on aggregate economic output (No. w25779). National Bureau of Economic Research.
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