Governments around the world are struggling to avert a climate catastrophe. Regardless of whether they succeed, climate change threatens adverse consequences for government bonds, although market impacts are likely to vary.
The COP26 climate summit fell short of delivering the kind of unequivocal commitments many hoped for. Key text was watered down at the last minute to accommodate objections from India and China on ending coal use and fossil fuel subsidies.
The summit marked the first time coal or fossil fuels had been directly referenced in a COP agreement
Although the conference marked the first time coal or fossil fuels had been directly referenced in a COP agreement, a just and equitable settlement to prevent rising emissions triggering a dangerous rise in temperatures proved elusive.
In 2019, the UN Environment Programme estimated global greenhouse gas emissions needed to fall by 7.6 per cent every year until 2030 if global warming is to be limited to 1.5 degrees C (2.7 degrees F).1 While the latest report from the Intergovernmental Panel on Climate Change says that goal is still attainable, the pathways to achieving it are narrowing rapidly with the effects of climate change increasingly felt across the world.
There is a growing consensus that failure to keep the global temperature increase in check risks severe economic, as well as environmental and social, damage. For example, the Bank of Greece has estimated Greece’s annual GDP would be two per cent lower by 2050, without further global efforts to reduce greenhouse gas emissions. The cumulative cost would be over €700 billion by 2100, three times Greece’s current annual economic output.2
Agriculture, forestry, fisheries, tourism, transportation, coastal activities and the built environment in urban centres will all be affected by the rise in air temperature, drought, extreme weather events and the increase in sea level. According to the Greek central bank, this will lead to lower productivity, loss of capital and additional expenditure for damage repair, not to mention the negative effects on biodiversity, ecosystems and human health. Many countries face similarly bleak scenarios.
Repricing of financial assets
The adverse economic consequences of climate change are in turn likely to depress the value of various financial assets, including sovereign bonds. After all, coping with the effects of climate change threatens to further stretch governments’ finances. They have already been impaired by the pandemic and, in many cases, been deteriorating for a decade or more.
Climate change can be transmitted to sovereign debt markets through three main routes: via increased government spending on, for example, subsidies to renewable energy companies, the cost of weather-related damages and other social costs such as extra healthcare spending; via changes in economic growth as the shift to a low-carbon economy renders carbon-intensive production technologies obsolete; and via the repricing of sovereign risk.
Climate-induced downgrades could cost national treasuries between $137 billion and $205 billion
Earlier this year, a team of academics used artificial intelligence to simulate the effect of rising temperatures on sovereign credit ratings in research for the University of Cambridge. They found 63 out of 108 sovereign debt issuers, including Canada, Germany, Sweden, and the US, would experience climate-induced downgrades by 2030 under a scenario in which emissions reductions failed to meet global targets. The research showed climate-induced downgrades could cost national treasuries between $137 billion and $205 billion.3
The Organisation for Economic Cooperation and Development says while the low-carbon transition may have begun, with governments and markets taking steps to address the problem, the global economy is not on track to limit carbon dioxide emissions by nearly enough. It says abrupt policy changes would risk disorderly movements in asset markets.4
Research by FTSE Russell, an index provider owned by London Stock Exchange, reckoned ten of the 26 members of the FTSE World Government Bond Index, including Japan, Mexico, South Africa, and Spain, will default on their sovereign debt by 2050 in the event of a “disorderly transition” – that is, if governments’ attempts to reduce emissions are late, abrupt, and economically damaging.5
Since tackling climate change will not be cheap, that too has big potential implications for sovereign bond markets. A June 2021 report by the International Renewable Energy Association (IRENA) said funding the energy transition at the pace required to keep the world on a ‘climate-safe’ pathway will require a substantial increase in investments over their current level.6
A huge bill
Estimating the cost of keeping the rise in global temperatures to 1.5 or two degrees Celsius is problematic as there are multiple pathways towards net zero, each with a virtually infinite number of routes. That said, few would dispute huge sums will be required.
According to a 2021 report authored by a group including the World Resources Institute, a not-for-profit organisation focused on environmental research, far-reaching transformations across every sector – from power, buildings, industry and transport to agriculture – will be needed. For instance, to meet targets that align with limiting warming to 1.5 degrees, the world must, among other actions, phase out unabated coal-fired electricity generation five times faster than current trends, accelerate the increase of annual gross tree cover gain three times quicker, and boost crop productivity nearly twice as fast.7
Global annual investment in clean energy needs to more than triple by 2030 to reach net-zero emissions by 2050
The International Energy Agency estimates global annual investment in clean energy needs to more than triple by 2030 to around $4 trillion to reach net-zero emissions by 2050.8 As for IRENA, it says almost $98 trillion will have to be invested in energy systems over the next three decades if governments’ current energy plans are to be met. Meeting a ‘1.5°C Scenario’ would require an extra $33 trillion. All told, around $4.4 trillion a year will be needed over the next three decades.9
Given the huge sums involved, it seems inevitable governments will look to shift most of the cost of limiting global warming to the private sector. Nearly all economists believe establishing an effective carbon price, whereby polluters pay for the emissions they create, would be the most efficient and cheapest way to do this.
Unfortunately, around the world, carbon continues to be taxed at a woefully inadequate rate. Instead, governments seem to be pinning their hopes on preventive regulations: for example, prohibiting the burning of coal for electricity generation; phasing out the sale of cars with internal combustion engines; or requiring new buildings to be more energy efficient.
Nonetheless, to speed up the transition, tax breaks and other forms of subsidy are simultaneously being handed out to providers of renewable energy and other low-carbon technologies. In contrast to a carbon-pricing regime, that means governments are facing a sizeable bill.
There is a risk economic growth becomes depressed as fossil fuel assets are written off
Simultaneously, there is expected to be a sharp rise in the cost of dealing with the aftermath of extreme weather events and steps to mitigate the effects of climate change will be required. Worse still, there is a risk economic growth becomes depressed as fossil fuel assets are written off. Add these costs in and countries’ fiscal positions could be considerably weakened.
Take US President Joe Biden’s recent $1.2 trillion infrastructure bill. It included $73 billion of investment in clean energy transmission, $50 billion to make the economy more resilient to the effects of climate change and improve water supplies in the west of the country, $7.5 billion for electric vehicle charging points, and $2.5 billion for electric school buses.10 Biden’s draft ‘Build Back Better’ bill has a further $570 billion allotted to clean energy and tackling climate change.11
Bonds need to reflect a climate scenario
According to the International Capital Market Association, there was roughly $87.5 trillion of sovereign, supranational and agency debt outstanding as of August 2020.12 While most bonds mature within ten years, there is a significant amount with maturities of 30 years or more. Logically, these bonds ought to reflect a climate scenario, whether optimistic or catastrophic.
However, working out the climate implications for sovereign bond prices is fraught with difficulty. To date, no sovereign issuer’s debt has been downgraded because of the climate risks it faces, although rating agencies recognise the significance of climate shocks and anticipate climate trends will have implications for ratings in the coming decades.
The cost of facilitating the low-carbon transition can vary enormously depending on the character of the economy
Not only do huge uncertainties about climate change and its effects need to be factored in, the cost of facilitating the low-carbon transition can vary enormously depending on the character of the economy. Moreover, how much effort individual countries will make to tackle the problem over the next three decades or more is impossible to know with any certainty.
To date, few governments have given much, if any, indication of the expected impact on their financial position. One of the few to have begun doing so is the UK. In one of the first analyses of its kind, the UK Treasury published a report in October 2021 in which it looked at the fiscal consequences of transitioning the economy towards its 2050 net-zero objective.13
“The primary impact is a large and relatively rapid structural shrinking of the tax base as motorists move away from using petrol and diesel vehicles,” the report stated.
With revenues from fuel and road taxes amounting to £37 billion, or 1.7 per cent of GDP, in 2019-20, it estimated annual tax receipts would decline by up to the equivalent of 1.5 per cent of GDP by the 2040s were the current tax system to remain unchanged.
However, the report failed to mention other likely costs. Two years earlier, a parliamentary committee on public accounts said insufficient planning and provisions for the decommissioning of 320 fixed installations, 3,000 pipelines and 5,000 wells in the North Sea could cost the government as much as £24 billion. It pointed out the annual bill for tax relief on oil and gas decommissioning had averaged £1 billion since 2013.14
Figure 1: Reduction in tax revenues from decarbonisation (percentage share of GDP)
Source: HM Treasury, October 202115
“This is just the latest in a long list of issues likely to weigh on government finances. Right now, there is too much uncertainty to be making strong investment calls on the back of it. But it is yet another reason why central banks may struggle to tighten monetary policy by much, if at all, even over quite long horizons,” says Aviva Investors’ head of sovereign debt, Ed Hutchings.
Fossil fuel exporters could be hardest hit
Not all countries will be equally affected by efforts to tackle climate change. For instance, while the UK government rakes in large sums from taxing fossil fuels, many countries subsidise them. The impact of global efforts to limit climate change threatens to be especially harshly felt by those countries where fossil fuel exports account for a large slice of economic output.
Countries where fossil fuel exports account for a large slice of economic output will feel global efforts to limit climate change more harshly
Consider Australia, Canada, Russia and OPEC members such as Saudi Arabia. All would face challenges even in the best-case scenario for the planet, where the transition to lower-carbon economies is carried out in an orderly fashion, says Tom Dillion, Aviva Investors’ head of ESG - sovereign.
According to the Cambridge research, if this does not happen, Australia, which currently carries the top rating from each of the big three credit ratings agencies, would likely drop about one notch by 2030 and four notches by 2100.
Other countries with energy systems heavily reliant on fossil fuels, especially coal, could also be badly affected. China, for example, despite rapidly expanding its renewable energy capacity in recent years, still obtains as much as 65 per cent of its electricity from fossil fuels.
The country looks to be facing a huge bill if it is to meet its goal of carbon neutrality by 2060. In September, Zhang Shaogang, vice president of China's national foreign trade and investment promotion agency – the China Council for the Promotion of International Trade – said decarbonisation efforts will require $21.3 trillion of investment by 2060.16
While Zhang said much of the funding for the necessary investment will continue to come from financial institutions and carbon trading will also play a key role, government funding will also be needed. China Development Bank, the state-controlled lender, made loans worth up to 292.2 billion yuan ($45 billion) to green industries in the first half of 2021, pushing the balance of green loans to 2.3 trillion yuan.17
China’s focus on developing green infrastructure has been clear for some time
China’s focus on developing green infrastructure has been clear for some time. Longer term, the question is whether this marks a new format for economic stimulus that, over time, will replace more traditional policy measures such as cuts to reserve ratio requirements or reductions in interest rates.
“However, what we can say with some certainty is that green stimulus is currently playing a significant role for the Chinese authorities,” says Aviva Investors’ head of emerging market debt, Liam Spillane.
While this presents a challenge in terms of understanding the evolving policy framework, Spillane adds it also offers opportunities to embrace green and technology related investments.
Then again, although tackling climate change carries a sizeable upfront cost for a country like China, once a green electricity system is built running costs will be much lower than today. That means while fiscal burdens may rise in the near term, there could be a positive effect on economic growth in the long run. A green transition promises to have a big positive impact on China’s trade balance too since it is the world’s largest importer of oil and natural gas, and a big importer of coal, at the same time as being the world’s leading producer of electric vehicle batteries and solar panels.
More pressure for developing economies
Although climate change is being felt in every country on every continent, extreme weather and disruption from drought, flooding, and conflicts over natural resources are disproportionately affecting poorer nations. A July 2019 report by Moody’s said ‘small, agriculture-reliant sovereign credits’ were most susceptible to climate change.
Small, agriculture-reliant sovereign credits’ are most susceptible to climate change
Not only are poorer countries facing a bigger bill, fiscal constraints mean they have little headroom to respond. The challenge is being worsened by reduced access to external finance following a record number of credit rating downgrades in 2020. Some countries, such as Ghana, have been unable to access international capital.
Aviva Investors’ emerging market debt analyst Carmen Altenkirch says if developing countries are unable to implement fiscal packages for strong and sustainable recoveries, “it will not only be deeply damaging for their own growth prospects but will put the climate goals irrevocably beyond reach.
“A strong programme of support to tackle their debt and financing needs would be a win-win proposition for the global economy and for the climate,” she adds.
As with previous summits, the level of financial support rich countries give to developing countries to help them cope with climate change was arguably the most contentious battle of COP26. Not only has a 2009 pledge to provide $100 billion a year by 2020 not been met, it is clear it is not enough to help poorer nations build resilience and make their green transitions sufficiently quickly.
Indian Prime Minister Narendra Modi, who announced a net-neutral target of 2070 at the summit, is demanding richer countries make $1 trillion available for climate finance as soon as possible. “Justice would demand that those nations that have not kept their climate commitments should be pressured,” he said.18
Investment in climate adaptation for sub-Saharan Africa will cost an estimated $30 to $50 billion each year over the next decade
A United Nations report in October 2021 estimated investment in climate adaptation for sub-Saharan Africa will cost between $30 to $50 billion each year over the next decade, or roughly two to three per cent of GDP.19 According to a separate study by the United Nations Economic Commission for Africa, Cameroon and Zimbabwe are already spending close to nine per cent of GDP on climate adaptation, Ethiopia eight per cent, and Sierra Leone, Senegal and Ghana more than seven per cent.20 This suggests trouble for bond investors.
Then again, the scale of the challenge shows why so many countries will be reluctant to decarbonise their economies if support from richer nations is not forthcoming.
With African governments spending around $28 billion on energy subsidies annually, better targeted subsidies towards the poor could have the dual impact of freeing up cash for investment in the climate transition and improving energy efficiency.
If richer nations want poorer countries to go green and play a part in the battle to limit climate change, grants – not loans – will be needed
However, Altenkirch says while a reprioritisation of government spending can help at the margin, many poorer countries simply cannot afford to take on more debt, particularly costly market debt, to fund climate transition efforts.
A pledge by some G20 countries at COP, worth $8.5 billion, to help South Africa – the world’s fifteenth-largest carbon emitter with 87 per cent of its electricity derived from coal – made newspaper headlines. However, it remains to be seen what proportion of the money is in the form of grants, and how much is in loans.21
“If richer nations want poorer countries to go green and play a part in the battle to limit climate change, grants – not loans – will be needed,” Altenkirch says.