Nature of risk

Natural catastrophes can damage sovereign credit ratings, especially as a result of climate change.
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Natural disasters could weaken sovereign ratings, potentially contributing to governments’ funding challenges, with the biggest impact coming from earthquakes and tropical storms.

Conditions are conducive to human life in most inhabited areas much of the time, but nature can strike at almost any moment. When severe natural catastrophes hit densely populated and economically developed areas, these rare events bring large economic costs. They can also hurt a sovereign credit rating, a reflection of a national government’s ability and willingness to honor its financial obligations on time and in full.

S&P Global Ratings has – in cooperation with SwissRe – simulated the economic and ratings impact of natural catastrophes so severe that they are expected to hit a nation only once every 250 years. Based on a sample of 48 countries, the simulations indicate that such natural disasters could weaken sovereign ratings, potentially contributing to governments’ funding challenges, with the biggest ratings impact coming from earthquakes and tropical storms. On average, tropical cyclones are more damaging than floods.

The most severe natural catastrophes could by themselves lead to downgrades of several notches for the sovereigns affected. This is significant: the complete credit rating scale reaches some 20 notches from the top ‘AAA’ to the near-default ‘CCC’ category. One way to mitigate the economic and ratings impact of natural disasters is catastrophe insurance, which could reduce the negative rating impact of severe catastrophes by half if 50 per cent of the damage were insured.
Between 2001 and 2010, according to the World Meteorological Organization, more than 370,000 people died in extreme weather incidents – a 20 per cent rise over the previous decade. Extreme precipitation events have increased significantly at high and middle latitudes in the second half of the 20th century, while tropical cyclones are becoming stronger around the globe. Climate change is expected to continue to make our planet even more lethal, given future trends in coastal urbanization, as rising sea temperatures and levels result in more frequent and more devastating storms and floods, particularly in the tropics. As the planet gets warmer, natural catastrophes are likely to become yet more frequent and severe. The detrimental impact on credit ratings will be ratcheted up as well. But by how much?

Poor countries are already significantly more at risk than rich ones. This can be due either to existing economic and financial vulnerabilities or to the underdevelopment of an insurance market. Latin America and Caribbean sovereigns in this report had the highest average rating decline, followed by Asia-Pacific, where the ratings could also come under pressure. The average impact for European and North American sovereigns, however, was negligible at present and did not point to outright downgrades in sovereign ratings.

The impact of climate change is also most harmful for emerging and developing sovereigns, and much less so for advanced economies. The most notable ratings risks due to climate change will be from cyclones in the Caribbean and Vietnam and floods in Thailand, where the impact of climate change doubles potential flood damage.

Some countries will be able to adapt to the challengesassociated with climate change. But the speed of change could be so rapid as to make this all but impossible for the most vulnerable nations in Asia, Africa, the Caribbean, and elsewhere in the developing world. Even advanced sovereigns are likely to see significantly raised potential direct damage from climate change. Tropical cyclones in the US, New Zealand or Japan would raise it by between one half and two-thirds, albeit from a lower base than for Caribbean economies. The rising impact of floods in Europe, however, appears quite small.

The chart demonstrates how global warming exacerbates the risk to sovereign ratings from tropical cyclones. The light green bars show the likely number of notches a sovereign would be downgraded if a once -in-250-years storm hit national territory under current climate conditions. The added dark green bars show the additional effect of such a storm under the climate conditions expected in 2050. The risks to governments’ solvency rises hand in hand with the planet’s temperature. Again, the most impacted sovereigns are in the developing world, especially in small, geographically undiversified and densely populated tropical nations. The additional damage caused by climate change in richer countries is, on average, more moderate. Their higher level of preparedness, including insurance coverage, further reduces economic and rating impacts there.

Drought and some other hazards related to climate change, including social upheaval and migration, have been excluded due to limited data. But they too can affect lives and economic activity, especially in low-income developing sovereigns with important agricultural sectors. The results presented here should therefore be understood as merely a partial analysis of how climate change would affect sovereign ratings, and the negative effects may turn out in practice to be even more significant. ▲