Weekly round-up: March 15-19

The top five climate risk stories this week

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1) Climate-induced sovereign downgrades possible by 2030, research shows

Without action to curb global emissions, over 60 countries could see their credit ratings drop by a notch or more by the end of this decade, economists at the University of Cambridge say.

Using data from S&P and a purpose-built sovereign ratings model, the researchers studied the impact of three different climate scenarios on the credit scores of 108 countries for the years 2030, 2050, 2070 and 2100.

Under a ‘no action’ scenario, 63 countries were projected to be downgraded by around one notch by 2030. Germany, India, Sweden and the Netherlands would all fall three notches, the US and Canada two, and the UK one.

Eighty countries face drops of over two notches by 2100 under this scenario. India and Canada could fall over five notches, and China eight.

The additional costs associated with issuing debt due to these climate-induced downgrades was estimated at $137-205 billion.

However, the economists found that a low-carbon transition could eliminate much of this downgrade risk. Under a 2°C scenario, the reduction in sovereign ratings would average 0.65 notches, with additional issuing costs increasing by a more modest $22-33 billion.

The researchers said the findings supported extending the time horizons used to gauge sovereign credit risk.

“Rating agencies’ sovereign forecasts rarely extend beyond three years,” said co-author Dr Moritz Kraemer. “Investors are holding government bonds with ever-longer maturities. The agencies’ short time horizon increasingly leaves investors without a reliable yardstick for credit exposures that can extend up to a hundred years”.

2) ‘Hot house world’ scenario most destructive, early ECB climate stress test results show

Projected losses to firms and their lenders under a low-carbon transition are lower than those estimated if no transition were taken at all, preliminary results from the European Central Bank’s (ECB) inaugural climate stress tests show.

On Thursday, vice-president of the agency Luis de Guindos laid out the early findings of the economy-wide exercise, which covers four million companies worldwide and 2,000 banks. The ECB subjected these to three different climate simulations using the physical and transition risk trajectories from the Network for Greening the Financial System’s (NGFS) scenarios. The NGFS is a club of climate-conscious central banks and supervisors, of which the ECB is a member. Each scenario was applied over a 30-year horizon.

Under the ‘hot house world’ scenario, which assumes no climate policies are taken, the chaos unleashed by more frequent and damaging natural disasters incurs losses on companies that exceed the costs of moving to a low-carbon economy under both the ‘orderly’ and ‘disorderly’ transition scenarios.

In addition, companies’ probability of default (PD) are much higher under the ‘hot house world’ scenario than under the ‘orderly’ transition simulation. Firms in the mining, transport and agriculture sectors were projected to see their PDs increase the most under this scenario.

Source: ECB

The ECB also found that the scenario impacts varied widely across sectors, with the most polluting firms up to four times more exposed to climate risk as the average company over the next 30 years. Under the ‘hot house world’ scenario, the physical risks faced by firms in certain geographical areas vulnerable to natural hazards would also surge.

The ECB says the full results of the exercise will be available from mid-2021.

3) Methodological issues frustrate use of forward-looking metrics — TCFD

Unease with the methods used to create forward-looking portfolio metrics were shared by three in four financial institution respondents to a recent consultation run by the Task Force on Climate-related Financial Disclosures (TCFD).

Asked what challenges their organisations faced using metrics like portfolio warming potential and climate value-and-risk, 77% of respondents in the financial services industry said “concerns around reliance on assumptions required to derive future company-level emissions” and 74% “concerns around reliance on assumptions and future uncertainty”.

Seventy-two percent said “difficult to understand or opaque metric calculation methodologies” were a barrier, and 61% “distrust in the reliability of outcomes”. Sixty-five percent also said “resource constraints” were an obstacle. 

As for the top challenges facing the disclosure of forward-looking metrics, 55% of financial institution respondents said that they are ill-suited to public reporting. Fifty-three percent said “distrust in the reliability of outcomes” was making them reticent. The TCFD received 96 responses to its consultation from financial institutions. Overall, over 200 institutions responded.

Of total respondents, roughly half said forward-looking metrics could be useful if their methodological issues were ironed out. The TCFD did not disclose how many said they are useful in their current state, though.

In addition, 53% of finance companies and 44% of investment managers say the benefits of disclosure will outweigh the challenges if there is a further standardisation of metrics.

4) ‘Green funds’ more resilient to climate shocks — ESMA

Investment funds holding the debt and equity of low-carbon companies may better withstand climate-related market panics than those loaded with ‘polluting’ assets, a study by the European Securities and Markets Authority (Esma) finds.

Not only do those funds brimming with carbon-intensive securities face bigger losses than their ‘green’ counterparts, their distress would also incur more system-wide damage because they are more interconnected.

Esma’s research, included in its latest ‘Report on Trends, Risks and Vulnerabilities’, assessed the impacts of four climate shock scenarios on 23,965 funds in the European Union, representing €10.7 trillion of assets under management. Projected losses incurred by the shocks ranged from €500 billion to €1.3 trillion, or between 6.8% and 19.4% of fund portfolio assets.

However, losses were uneven across fund types. Most of what Esma called ‘brown funds’ — those heavily invested in carbon-intensive securities — were projected to take losses of 8% to 19% on affected assets, whereas for ‘green funds’, holding climate-friendly assets, the range was between 3% and 7%.

Source: Esma

The systemic impact of ‘brown fund’ losses was found to be greater than that of ‘green funds’ because of portfolio overlap. Put simply, more funds invest in each ‘polluting’ firm than in each ‘green’ firm — about four times more on average — and therefore ‘brown funds’ are often more similar than their ‘green’ counterparts. On the flip side, this means that ‘green funds’ are more exposed to idiosyncratic risks than ‘brown funds’.

To better “balance” the fund network, the Esma study said ‘brown funds’ could diversify their portfolio holdings away from the same assets and ‘green funds’ could co-invest more, which would “provide lower-emission firms with more broad-based and stable funding”.

5) CFTC launches ‘Climate Risk Unit’

US derivatives regulator the Commodity Futures Trading Commission (CFTC) has formed a cross-agency team to focus on the role financial instruments like futures, swaps and options could play in addressing climate-related risks. 

The new Climate Risk Unit (CRU), announced by Acting CFTC Chairman Rostin Behnam on Wednesday, will “accelerate” the agency’s engagement in industry-led climate and ESG initiatives. It will also take the lead on educating the agency on how derivatives and similar products could hedge institutions’ climate risks and smooth the transition to a net zero economy.

“Climate change poses a major threat to U.S. financial stability,” said Behnam, “and I believe we must move urgently and assertively in utilizing our wide-ranging and flexible authorities to address emerging risks. The CFTC’s unique mission focused on risk mitigation and price discovery puts us on the front lines of this effort. Leveraging the CFTC’s personnel and expertise demonstrates our commitment to taking thoughtful and deliberate next steps toward building a climate-resilient financial system”.

Behnam pioneered the CFTC’s engagement on climate risk in 2019 by setting up the agency’s climate-related market risk subcommittee, which published an almost 200-page report last year on how the US financial system could manage global warming threats.

The launch of the CRU follows the establishment of a Climate and ESG Task Force at the Securities and Exchange Commission, which oversees issuers of debt and equity. This group is pledged to hunt out “material gaps or misstatements in issuers’ disclosure of climate risks under existing rules” and stamp out ‘greenwashing’.

Please send questions, feedback and more to louie.woodall@climateriskreview.com

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The views and opinions expressed in this article are those of the author alone

Fifth image: Daniel Macy / Shutterstock