March 17, 2021

Anticipating climate change risks on sovereign bonds

Part one

The deep economic changes necessary to achieve the Paris Agreement objectives require a consistent reallocation of resources. This gives the financial sector a key role in tackling climate change. Risk analysis is important in that perspective.

Due to the nature of climate change, with unprecedented and non-linear dynamics, relying on historical data is not sufficient to anticipate climate change risks. This paper proposes a methodology for a forward-looking assessment of climate risks as recommended by regulating international institutions.

Read part 1 of the research paper

Part two

Regulators and international institutions require financial risks assessment of climate change, however the practical methodology frameworks available are lacking. This paper provides an innovative and practical methodology that measures the financial impact of climate change risks on sovereign fixed-income assets. 

Learn more about the climate change risks assessed:

  • What's the difference between physical and transition risks, and what scenarios are used to assess them?
  • What is a "hot house" world scenario? What is a "disorderly transition" scenario? How are these scenarios calculated?

Find out how climate change impacts translate into financial risks:

  • Our methodology estimates the impact of climate change on sovereign credit risk spread, and therefore on bond yields and returns
  • Find out how our proprietary default-probability and financial models simulate the potential fallout of climate change on sovereign bonds

Dive into the details of our main findings.

  • Physical risks will mainly affect emerging market economies based in areas that are most impacted by climate change, while advanced economies that emit more greenhouse gases and are more carbon-dependent will be mostly affected by transition risks
  • The probability of sovereign defaults is likely to increase over time and could undermine the creditworthiness of economies with weak fiscal capacity
Read part 2 of the research paper

Part three

In this paper, we illustrate how climate change could materialize should no further mitigation efforts be implemented. We focus on two specific climate hazards: (i) the average temperature and (ii) the frequency of very hot days. Then, building on the methodologies developed in the first two papers in this series, we continue our exploration of quantifying financial risk from climate change for sovereign issuers. This analysis provides more detailed results, in terms of time horizons, countries and climate scenarios, compared to our previous studies.

Read this paper for a deeper understanding of our three main findings:

  • Learn which countries are most vulnerable to climate change, and which countries have a high default risk due particularly to their lower fiscal capacities
  • Find out how soon financial instability in the sovereign market from unmitigated climate change might be seen
  • Understand how even a Paris-aligned scenario will lead certain regions and countries to still be exposed to significant physical risks
Read part 3 of the research paper