At a time when interest rates are already high, there’s some scary writing on the wall that we dare not miss.
The relationship between climate risk and the cost of capital is becoming glaringly evident at sovereign and firm levels. There’s a decision to be made: become climate friendly or say goodbye to affordable (and accessible) borrowing.
Governments and businesses are in the same ship. High climate risk is leading to a repricing of sovereign assets, reduces creditworthiness and increases borrowing costs. In 2020, Fitch announced that water risks would become a stronger consideration in sovereign credit ratings over the medium to long term, against a backdrop of escalating climate change consequences.
Water risks can shape public finances through several avenues, including a slowdown in economic activity, particularly in agriculture-intensive economies, forcing an increase in spending and opening up sovereign contingent liabilities.
Fitch said that African countries are especially exposed to flood risks, particularly Benin, Rwanda and Mozambique. Countries where droughts or floods have been explicitly mentioned as hindrances to growth, external finance and/or inflation in the context of a downgrade in recent years include Morocco, Namibia, Sri Lanka, Thailand, Uruguay and Zambia.
The cost of capital is also going up for firms. Many are choosing avoidance in a bid to delay the impact. As part of a new host of measures introduced by the UK government, it announced that it would consult on developing transition plans for all large companies, whereby firms have to announce how they will cut emissions and how much it will cost.
Freshly published research from Ernst & Young holds that although 80% of companies in the Financial Times Stock Exchange 100 Index (FTSE 100) have already made some disclosure on how they will achieve net-zero emissions by 2050, only 5% are credible and in compliance with the level of disclosure required in the Transition Plan Taskforce’s (TPT’s) draft disclosure framework. The TPT was initially established to fulfil the UK government’s COP26 commitment to require businesses to publish decarbonisation plans by 2023.
A key concern for many companies is that disclosing the cost of decarbonisation publicly would adversely affect their access to capital. In essence, being transparent on the cost of reducing emissions would make the whole business model riskier and reduce overall creditworthiness. It makes sense. If I was a financial institution and saw how much it may cost to make Shell or BP net zero, I’d probably run in the opposite direction (or, more likely, inflict terribly high interest rates, given the high cost of emissions reductions and high risks amid decarbonisation).
But the question for governments and firms is whether anything can be done to manage the cost of capital amid climate change. The short answer is yes, but it requires some short-term losses before reaping the benefits. In its commentary, Fitch said the effect of water risk on ratings will continue to increase, but strengthening resilience could counteract this. With strong institutional and policymaking capacity, countries could adopt policies to minimise the fallout.
Cape Town is one such example at a municipal level. In 2018, during the devastating “Day Zero” drought, credit ratings agency Moody’s noted that the water crisis would drive up the city’s borrowing costs sharply as its operating revenue shrank due to overreliance on water charges, economic activity slowed, and spending increased.
Cape Town has bitten the bullet to strengthen its resilience in coming years. The recently tabled budget included R8.6bn for wastewater treatment works upgrades and R2.2bn for a new water plan to enhance water security. Cape Town’s heightened economic, financial and physical resilience compared with six years ago has supported the city’s credit rating.
On a company level, higher borrowing costs are reflective of two dynamics. First, a higher default risk on loan portfolios, which is particularly true for businesses in high-risk areas. The Wall Street Journal identified California’s largest utility, Pacific Gas & Electric, as the first “climate-change bankruptcy”.
And second, the transparency required to meet the UK’s level of disclosure reporting can lower asset valuations. For instance, for a company that is emissions-intensive and for which the cost of decarbonising is high, disclosure will reduce asset valuation and make borrowing costlier.
Companies can best manage this by actively engaging in emissions reductions processes rather than procrastinating. Spend the money now and be transparent about it. Delaying action will slow business, force unethical greenwashing, lower asset valuations, and make borrowing more expensive.
Financing resilience now will yield high returns for decades to come. Otherwise, today’s interest rate woes will pale in comparison.
• Dr Baskaran (@gracebaskaran), a development economist, is a bye-fellow in economics at the University of Cambridge.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.