It's time for ‘adaptation smart’ credit ratings that account for climate change

09 September 2024

Portrait of Dr Nicola Ranger

Dr Nicola Ranger
Director, Global Finance and Economy Group, ECI and Senior Research Fellow

Nicola Ranger is the Director of the Global Finance and Economy Group at the ECI and the Resilient Planet Finance Lab. She is also Executive Director of the Oxford Martin Systemic Resilience Initiative.

Portrait of Dr Mark Bernhofen

Dr Mark Bernhofen
Research Associate

Mark Bernhofen is a Research Associate at the Global Finance and Economy Group at the Environmental Change Institute and the Lead on Risk Analytics for Adaptation Finance in the Resilient Planet Finance Lab. As part of the Oxford Martin Systemic Resilience Initiative, he conducts research on sovereign climate financial risk.

Pakistan floods
© Adobe Stock
Climate change isn’t just an environmental issue — it’s a financial one too. For financial institutions, but also for governments.

As global temperatures rise, and extreme weather events become more frequent and severe, the economic costs of climate impacts, as well as the costs of adapting to these impacts, are putting serious strain on government (or sovereign) finances.

This is particularly true in emerging and developing economies, which are often the most vulnerable to climate change and already face high levels of debt. These countries risk facing a 'climate investment trap', where the rising costs of climate disasters increase indebtedness and make it much harder for countries to invest in adaptation and resilience, in turn putting them at even higher risks. A vicious cycle.

Sovereign climate risks can also have knock-on impacts for financial institutions, including banks, insurers and pensions funds, and can even threaten financial stability, as financial institutions are large holders of government debt and are therefore exposed to losses if a government were to default on their debt. This is known as the ‘sovereign-bank nexus’ and creates another vicious cycle that puts countries at even higher risk.

Despite these risks, sovereign credit ratings — one of the most widely used metrics of sovereign financial risk —do not fully account for climate risks in their methodologies. Recent academic research has shown that if the long-run economic impacts of rising temperatures are incorporated into ratings, over 80 countries could see climate-induced credit downgrades by the end of the century.

Sovereign credit ratings are a vital driver of how ‘investable’ a country is and so a downgrade can have a big effect on an economy’s ability to invest, both in adaptation but also in other vital areas like schools, hospitals and new jobs. Their study was a great first step to reveal this challenge faced by many countries, but we know it likely underestimated the risks, as it did factor in extreme weather events – arguably, the key driver of economic and social damages from climate change.

The clear message is that it is time for credit ratings agencies to get adaptation smart.

New research that we have published today aims to address this issue, but also goes a step further in demonstrating how investment in adaptation can alleviate the impact on sovereign credit ratings and break the cycle of the climate investment trap.

Using detailed insurance catastrophe modelling, we show that climate impacts on sovereign credit ratings could be far worse than previously thought, but with significant investments in adaptation, these effects can be mitigated. Taking the case of one middle-income country at risk from flooding, we find that climate change could lead to a significant downgrade in credit ratings.

Not accounting for these risks in credit ratings means that today we are underestimating and so mispricing the risks. This itself can have big implications. It can mean that financial institutions – and so the whole economy – are more exposed than they are prepared for, increasing the potential for financial crises. For our case study middle-income country, we estimate that the scale of the financial risk (conservatively) represents around 10% of their portfolios. That is a greater risk than the risks associated with an event like COVID-19. Incorporating these risks into financial stress tests is therefore vital for banks to prepare for the future.

Importantly, the research also illustrates why it is important that credit ratings account for adaptation. Indeed, not doing so reduces the incentives to invest. Right now, credit ratings are blind to adaptation and so investment by countries is not positively reflected in their credit ratings, meaning they lose a big part of the benefit. By reflecting a country’s adaptation efforts in its credit rating, we can encourage smarter investments that help protect both governments and the wider economy.

Ultimately, 'adaptation-smart' credit ratings could drive more climate investment, especially in regions most vulnerable to climate change.

The clear message is that it is time for credit ratings agencies to get adaptation smart. Our analysis underscores why credit rating agencies should factor in climate risks and adaptation efforts when evaluating sovereign creditworthiness. Doing so would provide not just a more accurate picture of risk but also incentivise both governments and the financial sector to invest more in climate adaptation.

This research was conducted in collaboration with co-authors Matt Burke, Akaraseth Puranasamriddhi, and Gireesh Shrimali.

This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.