Sovereigns Face Long Term Climate Shocks, Modeled Catastrophe Risks a Wildcard

Government bond issuers, including the US, will pay more to investors to buy their climate crippled debt, but models don’t even take into account extreme weather scenarios.

Sovereigns Face Long Term Climate Shocks, Modeled Catastrophe Risks a Wildcard
Photo by PiggyBank / Unsplash

Sovereign bonds face significant “transition risk” as climate change puts pressure on underlying economies and forces governments pay investors more to purchase future debt.

For example, U.S. five-year yields risk could rise by almost 100 basis points in the short term under the best case “Net-Zero 2050” scenario, according to benchmarking firm MSCI.

MSCI issued a report last week that attempted to model the “transition risk” that sovereign issues face when moving towards a low-carbon economy.

MSCI’s said that modeled climate transition risk might not only affect sovereign bonds through their market choices, but also through the bonds’ maturity.

“Shocks to the front end of the yield curve (e.g., five-year yields) are larger in the more orderly Net-Zero 2050 scenario, whereas the largest shocks at the back end of the curve (e.g., 20-year yields) arise from more disorderly scenarios, such as “Divergent Net-Zero,” the report states. “Thus, our results caution against downplaying or generalizing transition risk as simply a distant issue relevant only for longer-maturity portfolios.

The report points out, however, that MSCI’s modeling does not take into account the physical risks sovereign issuers face as a result of climate filed extreme weather losses and that costs to government issuers could be underestimated.

“The story is not complete from our results alone, as the inputs cover only transition risk and chronic physical risks, not acute physical risks,” the report states. “The addition of this into our framework in the future could quite substantially affect the overall results for yields.”

In fact, catastrophes caused by climate induces extreme weather could produce the perverse result of pushing sovereign yields lower as governments curtail interest rate hikes to offset GDP losses.

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