Financial markets face increasing pressure to factor climate risks into decision-making. Enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: Investors lack the necessary information. This creates a potential conflict of interest and information asymmetry: Sovereigns want cheap access to capital and have an incentive to downplay climate risk, while investors want to manage climate exposure but do not know how much risk they face. Without a standardised framework and regulatory requirement for disclosing climate risk, organisations face little incentive to provide such information accurately to investors.
Existing climate risk disclosures are rare, ad hoc, voluntary, unregulated, and generally based on internal assessments rather than climate science. Credit ratings agencies are key intermediaries between investors and investment opportunities, serving an important role by rating the creditworthiness of potential investments. They use established and published methods to combine publicly available information with an ‘inside look’ to measure the ability of the issuer to repay its debt obligations. Ultimately, their role is to help reduce information asymmetries, overcome conflicts of interest, and provide investors with standardised information about risk.
We examine how well ratings agencies capture climate risks in ratings. We investigate how well the financial system factors in climate-related risk and makes such information available to investors. First, using historical evidence, we determine whether past ratings have factored in observed climate-related losses. Next, we combine forward-looking climate models with the ratings methodology from a major credit ratings agencies to compare sovereign creditworthiness in a world with climate change, versus a counterfactual world without warming (in which temperatures are held constant at their 1980-2010 average). Finally, we mobilise our extensive network in finance, climate science, and economics to develop a provocative position piece on the state of green finance and future priorities.