Climate Change and Country Risk

By: Louis de Fauconval

A link between climate change and country risk exists and can no longer be ignored. For some years now, national and international regulators have been urging the financial sector to take this new risk factor into account when making assessments of country risk.

Nevertheless, because of a lack of historical data on climate risk and because both issues have different horizons, it is wise to keep them both on separate scales and to present climate change risks alongside of country and sovereign ratings. This methodology will help users of these ratings better understand the ongoing risks of climate change.

The Paris Agreement

Meeting in Paris in December 2015, the United Nations 21st Conference on Climate (COP21) agreed to decarbonize the global economy by 6.3% per year with the goal of limiting global warming to between 1.5°C and 2°C by 2100 (Figure 1).

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Each country published its “intended nationally determined contributions” (INDC) under different forms. Developed countries announced absolute goals by a given year (for example, by 2030, the EU will have reduced its emissions by 40% from its 1990 levels), the large emerging countries except Brazil determined intensity goals (for example, by 2030 China will reduce its emissions per unit of GDP by 60-65% from the 2005 level), and the middle-income countries announced engagements that reference a “business as usual” scenario.


For every country, complying with its own pledges implies huge infrastructure changes and, often, the need to transform sections of its economic model. In the medium term, such reforms are expected to modify country risk profiles and, hence, the country and sovereign ratings assessments.

As reported in the United Nations report “Climate: Get the Big Picture”:

“Overall, efforts under the Paris Agreement are guided by its aim of making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”1

G20 Task Force

In 2016, the G20 Financial Stability Board established a Task Force on Climate-Related Financial Disclosures (TCFD), led by the financial industry, and asked it to develop voluntary, consistent climate-related financial disclosures that would be useful to investors, lenders, and insurance underwriters seeking to understand the material risks linked to climate change.

In June 2017, the TCFD consequently published four recommendations, organized around four themes: governance, strategy, risk management, and metrics and targets2 (See table below).


The EU Level

At the end of 2016, a High-Level Expert Group (HLEG) on Sustainable Finance was mandated to advise the EU Commission on “how to steer the flow of public and private capital towards sustainable investments, identify the steps that financial institutions and supervisors should take to protect the stability of the financial system from risks related to the environment, [and] deploy these policies on a pan-European scale.”

In March 2018, the HLEG’s final report included a series of eight proposals ranging from “a classification system, or ‘taxonomy,’ to provide market clarity on what is ‘sustainable’” to “a European standard for green bonds.”3

In addition to these recommendations to the EU Commission, the HLEG also made sectoral recommendations—to banks, insurance companies, and pension funds, among others, but also to credit rating agencies (CRAs) and sustainability rating agencies (SRAs), which together help guide investment decisions.

In particular, since the HLEG “considers that credit ratings currently fail to incorporate adequate consideration of long horizon risks or to assess the influence of transformative ESG [environmental, social, governance] trends on issuers’ prospects or future creditworthiness,”4 the experts recommended that CRAs “systematically integrate relevant ESG factors and factors related to longer term sustainability into their credit risk analysis and credit ratings by 

  • Ensuring that their ratings methodologies are fit for purpose, publicly available, and fully integrate relevant ESG factors, for example, considerations of stranded assets, the secular shift to a low-carbon economy, as well as robust disclosures, including alignment with the TCFD recommendations.
  • Ensuring that credit ratings staff are sufficiently trained to conduct analysis of ESG factors relevant for assessing creditworthiness, and that the current governance principles of CRAs are effectively applied with respect to ESG matters.”5

The National Level

Adopted in August 2015, Article 173 of the French Energy Transition for Green Growth Law came into force on January 1, 2016. It is designed as a “consistent package of measures affecting a wide range of entities regarding climate change issues.”6

  • “Provision III requires listed companies and/or large non-listed firms (non-financial and financial alike) to report on the financial risks in relation with the consequences of climate change as well as the measures taken to reduce them.
  • Provision IV extends existing carbon disclosure requirements on direct emissions (those that are generated by the manufacturing process) and indirect ones (those that are generated through energy consumption).”7

Country Risk Assessment and Climate Change

The risk factors usually taken into account when assessing country risk and counterparties’ ability and willingness to pay their debt can be classified into three groups:

  • Sociopolitical risk factors, including the level of human development, political stability, respect for the rule of law, and the quality of the business environment.
  • Macroeconomic risk factors, linked to inflation, GDP growth, current account balance, and public debt.
  • Banking-sector risk factors, which concern assets, liabilities, and credit-related data.

Physical Risks of Climate Change

The TCFD has reported the following:

“Physical risks resulting from climate change can be event driven (acute) or longer-term shifts (chronic) in climate patterns. Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption. Organizations’ financial performance may also be affected by changes in water availability, sourcing, and quality; food security; and extreme temperature changes affecting organizations’ premises, operations, supply chain, transport needs, and employee safety.

  • Acute risks refer to those that are event-driven, including increased severity of extreme weather events, such as cyclones, hurricanes, or floods.
  • Chronic risks refer to longer-term shifts in climate patterns (e.g., sustained higher temperatures) that may cause sea level rise or chronic heat waves.”8

According to the TCFD, these physical risks faced by financial institutions also apply at the country level. Direct risks include human health deterioration, air and water pollution, land pollution, and desertification—inducing costs for countries according to their exposure. Meanwhile, indirect risks include population displacements, internal or cross-borders tensions or conflicts, and reputation damage.

Materializing of these risks can therefore alter the conditions within which counterparties operate. For example, some kind of economic expansion can result in air, ground, and water pollution and lead to disruptions of some supply chains. Mitigation measures can lead to factory closures and relocations, job losses, and population displacement—all potential seeds of sociopolitical risks and economic slowdowns. But at the end of the day, country risk factors might change the final ratings (Figure 2).

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To assess a country’s exposure to physical risks, we looked at numerous criteria, including the following:

  • The share of the population living in areas where elevation is below five meters (source: World Bank).
  • The agriculture sector’s share in GDP (source: World Bank).
  • Indicators related to food, water, and health (source: Food and Agriculture Organisation).

Not surprisingly, countries that rank the lowest according to these criteria are often those that suffer the heaviest pollution and are granted the poorest ratings (commonly, sovereign) by the rating agencies (Figure 3).

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Transition Risks of Climate Change 

The only way for a country to get out of the vicious circle and lower its exposure to physical risk is to enter the energy transition process (Figure 4).

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Whatever its INDC, transforming an economy into a low-carbon model is not a risk-free proposition:

  • Unforeseen fiscal expenditure will undoubtedly occur.
  • Current account imbalances may appear or grow with capital goods imports and/or lower exports.
  • Higher prices of fossil energy and of CO2 emissions may feed inflation.
  • GDP growth may accelerate on higher investments, but may slow on higher imports.
  • Fossil-fuel assets today that are highly valued will become stranded.
  • Opposing economic interests may lead to sociopolitical instability.

Clearly, the journey to the COP21 goal will not be hurdle-free.

It might also bring benefits earlier than expected. A country can transform itself from fossil energy importer to climate-friendly energy exporter, bringing positive effects on growth, employment, investment, and inflation.

But assessing the real cost of a country’s INDC is a hazardous and perilous exercise, for several reasons. As stated above, countries’ engagements take different forms. And there are as many pathways to the COP21 goal as there are institutes producing climate scenarios.

Depending on technological developments, fossil fuel prices, geopolitical evolutions, international carbon prices, and uncertain strategic decisions, countries clearly face difficult decisions: Should they develop additional carbon storage capabilities, which would enable further fossil fuel consumption, or should they reduce the demand for the most polluting sources, risking effects on political stability? On an infinite list of additional factors impossible to foresee, the transition costs will undoubtedly vary over the years.

Last but not least, a strong and reliable long-term GDP growth scenario is needed—one that extends beyond the usual economic forecasting horizons. In some cases, the benefits of energy transition might be rapid and great, possibly surpassing the costs linked to the process. But most of the time, the investments needed to transform a country’s energy profile are huge, and financing needs can be met through long-term external debt, where the maturity often exceeds the five-year horizon attached to country ratings. In addition, the benefits may be visible only beyond that horizon and percolate slowly among the country risk factors.

Nevertheless, one way to assess a country’s exposure to transition risks is to observe a series of environment-linked indicators: 1) the fossil energy used and CO2 emissions per unit of GDP; 2) fossil fuel in the form of coal, oil, and gas rents of the state; and 3) the credibility of pledges made by governments.9

Compiling this data, several institutes have created free indexes measuring physical risk, transition risk, or both. Among them are the Notre Dame Global Adaptation Initiative (ND-GAIN), the German Watch Global Climate Risk Index (CRI) and Climate Change Performance Index (CCPI), and the World Economic Forum Energy Transition Index.



Based on 45 sub-indicators, this index measures both physical risk (vulnerability) and transition risk (readiness) in 191 countries. A general index aggregates these two components for each year, starting in 1997.

This index is by far the most comprehensive, as it takes into account the largest sample of countries, has historical data, and provides an aggregated indicator of both physical and transition risks (Figure 5).

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German Watch has two different indexes relating to climate risk: the Global Climate Risk Index (CRI), which measures the physical risk, and the Climate Change Performance Index (CCPI), which measures the transition risk (Figure 6).

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For both indicators, the methodology is very different from that of ND-GAIN:

•  The CRI (physical risk) is based on the damages and casualties that occurred in the last 10 years.

    Score CRI:  1/6 * casualties + 1/3 deaths/100,000 people + 1/6 damages (USD, PPA) + 1/3 damages (% of GDP)

•  The CCPI (transition risk) is largely based on energy consumption (while the ND-Gain is based on investments needed to achieve energy transition).

    Score CPPI: 0.4*GHG emissions + 0.2*share of renewable energy+ 0.2*energy consumption + 0.2*climate policy

However, there is no aggregated index that combines these two sub-indexes. One reason is that the CRI takes into account 181 countries, whereas the CCPI includes only 57.

Energy Transition Index

This index measures the transition risk of 114 countries through two indicators: the performance of the current system and its readiness to transition. These two components are themselves based on 40 sub-indicators, some being very specific—such as fossil fuel subsidies, carbon intensity, access to capital, rule of law, trade logistics, and energy mix.

Physical risk is not measured. But because each component and sub-indicator can be taken separately, the transition risk index can still be very useful (Figure 7).

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Work by Other Institutions

Other noteworthy institutions publish similar studies and indexes, including the Paris-based Beyond Ratings, Four Twenty Seven, the NewClimate Institute, the PBL Netherlands Environmental Assessment Agency, Principles for Responsible Investment (PRI), and others.

Most interesting is the Environmental Risk Integration in Sovereign Credit Analysis (E-RISC) initiative, launched in 2012 by the UNEPFI and the Global Footprint Network. The first phase of their project led to the construction of four new dimensions of country risk profiles, potentially integrated into existing sovereign ratings (as an add-on) or in each of the traditional risk factors. Convincing tests on Brazil, France, India, Japan, and Turkey were made by the authors, who concluded the following:

  • A 10% variation in commodity prices can lead to changes (within five years) in a country’s trade balance equivalent to between 0.2% and 0.5% of GDP.
  • A 10% reduction in the productive capacity of renewable, biological resources could lead, assuming that consumption levels remain the same, to a reduction in the trade balance equivalent to between 1% and over 4% of a nation’s GDP (within five to 10 years).

Ended in 2016, the second phase of the E-RISC project consisted of building a stress-test model to calculate the impact of a rapid doubling in global food commodity prices for 110 countries.

All these indicators provide useful information; however, their direct integration into internally determined country and sovereign ratings cannot be done immediately because they cannot be compared with each other. Even rankings between different approaches often differ. Taking any of these three methodologies (or any other) into account to reconcile country risk and climate risk will take time and, similarly to the UNEPFI and the Global Footprint Network, require some broad-based stress tests.


Risks related to climate change are of two types: physical and transition. Both risks can alter the ability and willingness of counterparties to service their debt, not only because their assets, suppliers, or customers are exposed to these risks, but also because the characteristics of the countries in which they do business can be affected.

Because climate change will continue to have huge economic and political implications, regulators are pushing financial institutions to take into account climate risk issues in their analyses of country risk and sovereign ratings.

The views expressed in this article are those of the author, and do not necessarily represent the views of BNP Paribas.


1. “Climate: Get the Big Picture,” United Nations Framework Convention on Climate Change. Available at

2. TCFD, “Final Report: Recommendations of the Task Force on Climate-Related Financial Disclosures,” June 2017, p. 22.

3. See the following two EC publications dated January 31, 2018: “Sustainable Finance: High-Level Expert Group Delivers Roadmap for Greener and Cleaner Economy,” press release, available at, and “Final Report of the High-Level Expert Group on Sustainable Finance,” available at

4. EU High-Level Expert Group on Sustainable Finance, “Financing a Sustainable European Economy: Final Report 2018,” p. 76.

5. Ibid., p. 78.

6.   French Treasury, “The Financial Sector Facing the Transition to a Low-Carbon Climate-Resilient Economy,” in Trésor-Economics, no. 185, November 2016, p. 7.

7.  Ibid.

8.  TCFD, “Final Report,” June 2017, p. 14.

9.  The first two series are provided by the World Bank and the third by the London School of Economics.

LOUIS de FAUCONVAL is senior country risk analyst at BNP Paribas. He can be reached at or at