Bernhofen, M., Burke, M., Puranasamriddhi, A., Ranger, N., Shrimali, G. (2024). Integrating Physical Climate Risks and Adaptation into Sovereign Credit Ratings.

Climate change poses significant risks to financial stability, particularly through its impact on sovereign credit ratings, which determine borrowing costs and influence investor confidence. This discussion paper explores the sovereign-bank nexus, showing how physical climate-related financial risks and adaptation measures are currently undervalued by credit rating agencies. Using a more granular risk assessment approach, incorporating insurance catastrophe models, the paper demonstrates that the potential impacts of climate change on sovereign credit ratings are greater than previously estimated. However, these impacts can be significantly mitigated through investment in adaptation, as demonstrated in a case study on flood risks in Thailand. By incorporating acute climate risks and adaptation into credit rating methodologies, governments and financial institutions can reduce fiscal risk and improve capital costs. The paper advocates for the integration of "adaptation smart" ratings to incentivise adaptation investments and improve global financial stability.