Article

Sovereigns to default as temperatures rise

sovereigns to default as temperatures rise
Undaunted by the ESG challenge
Introducing the series
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This is the first article in our new series, which looks at environmental, social and governance issues in the fixed income space.
Our unfixed approach
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In the spirit of (un)fixed income – bold, innovative and flexible – we start each piece with an ESG challenge before flipping it on its head.
Answering the big questions
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The aim of this series? To explore how investors can successfully navigate some of the greatest issues of our age.

In 2014, George Osborne made headlines as he announced the UK government’s intention to redeem bonds stretching back as far as the eighteenth century. This included First World War debt, as well as bonds issued during the South Sea Bubble crisis (1720) and the Napoleonic wars (1803-1815).1

The human interest element of the story is surely what caught the public’s attention. But it serves to emphasise two important, if somewhat elementary, points:

  • Governments can issue debt over long periods of time (these bonds were ‘perpetuals’, with no maturity date). 
  • The fate of a nation can change a lot during the lifetime of a bond.

Even if we meet the Paris target and keep global warming well below 2˚C – which is looking increasingly unlikely – it is hard to imagine a world where climate change doesn’t cause significant economic disruption. How different will sovereign creditworthiness look by 2050?

Temperature rises will negatively impact GDP

A recent report from the Intergovernmental Panel on Climate Change (IPCC) finds that ‘some vulnerable regions, including small islands and Least Developed Countries (LDCs), are projected to experience high multiple interrelated climate risks, even at global warming of 1.5°C'.2

Our first chart, based on projections from the Swiss Re Institute, suggests that global temperature rises will negatively impact GDP in all regions by 2050, with the losses increasing significantly as the temperature scenarios ramp up. 

Figure 1: Global temperature rises will negatively impact GDP in all regions by mid-century

Swiss Re Institute. Temperature increases are from pre-industrial times to mid-century and relate to increasing emissions and/or increasing climate sensitivity (reaction of temperatures to emissions), from left to right.

The implications for sovereign financial stability

The implications for sovereign financial stability could be extreme. However, no sovereign issuer has yet been downgraded on account of climate risk.3 In other words, ratings have some catch-up work to do.

A landmark report issued by the University of Cambridge in 2021 finds evidence that these downgrades will begin ‘as early as 2030, increasing in intensity and across more countries over the century’.4

Our next two charts are taken from this report. They highlight the regions that are likely to be worst affected by ratings changes.

Figure 2: Global climate-induced sovereign ratings changes by 2100 under a <2°C scenario*

Bennett Institute, University of Cambridge (2021). 

*Report refers to an RCP 2.6 scenario. RCPs are Representative Concentration Pathways and describe different potential scenarios under future emissions trends. RCP 2.6 is the ‘stringent climate policy’ scenario and is most consistent with limiting warming to below 2°C.

Figure 3: Global climate-induced sovereign ratings changes by 2100 under a 5°C scenario*

Source: Bennett Institute, University of Cambridge (2021).

*Report refers to an RCP 8.5 scenario. RCPs are Representative Concentration Pathways and describe different potential scenarios under future emissions trends. RCP 8.5 is the high emissions scenario and is most consistent with a 5°C warming world.

The evidence suggests that it is time for ratings to catch up. But Moritz Kraemer, a former Chief Ratings Officer at S&P Global, has argued that ratings methodologies aren’t currently compatible with long-term structural changes like global warming: 

The challenge for investors, then, is ensuring that their research and risk assessments take stock of the credit risk posed by climate disruption. They will have to go further than ratings providers if they want to build resilient portfolios.

Undaunted: how we’re responding

Invesco’s active fixed income teams carry out detailed credit analysis before investing, incorporating ESG considerations into their analysis. This allows them to form a comprehensive understanding of the issuer, its risks, and the potential opportunities.

Using data from organisations like the UN, the World Bank and the International Energy Agency, they score sovereign issuers on 23 indicators. Seven of these are environmental, with three focused on climate change specifically.

In this way, they aim to provide impartial insights on the key risks impacting sovereign debt securities today.

Discover (un)fixed income

We know investors are living through an unprecedented period of market disruption and volatility. As we face these new realities, we think taking an unfixed approach to fixed income is an advantage.

From active to passive, from mainstream to innovative, we have the expertise, the strategies and the flexibility needed to match your objectives as markets evolve.

Investment risks

  • The value of investments and any income will fluctuate. This may partly be the result of exchange rate fluctuations. Investors may not get back the full amount invested.

Important information

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