The economic effects of climate change and biodiversity loss threaten sovereigns’ ability to service their debt. Markets need credible, digestible information on how these threats translate into material financial risks. Countries’ access to finance is mediated by sovereign credit ratings. Yet methodologies published by leading credit rating agencies do not explicitly incorporate biodiversity and nature-related risks. Omitting them may ultimately undermine market stability.Matthew Agarwala, Matt Burke, Patrycja Klusak, Moritz Kraemer and Ulrich Volz (2022), in “Nature Loss and Sovereign Credit Ratings” estimate how credit ratings may develop under three increasingly devastating scenarios of nature loss. Under the most severe scenario, 58% of the sampled sovereigns would face a downgrade of one notch or more in their credit ratings by 2030. Additional annual interest payments of $28-$53 billion would have to be borne by these downgraded governments.The methodology is based on earlier climate-related work by Patrycja Klusak et al. (2021), “Rising temperatures, falling ratings: The effect of climate change on sovereign creditworthiness,” which follows three steps (see figure). First, the authors train a random forest model on historical data to replicate sovereign ratings issued by S&P for more than 100 countries between 2000 and 2020. Their model of credit ratings is then further adjusted for climate change using the outputs from a climate-economy model run for multiple warming scenarios (Kahn et al. 2021, see below).Finally, the authors calculate the increase in corporate and sovereign interest payments which can be attributed to climate-induced sovereign downgrades. E.g., under the worst-case scenario (RCP 8.5), climate change could increase the annual interest payments on sovereign debt by $137-$205 billion and on corporate debt by $35.8-$62.6 billion. Stringent climate policy consistent with limiting warming to below 2°C could nearly eliminate the effect of climate change on ratings.
