Investment Research

Towards a new way of assessing sovereign risk

Part 1: Where will the current path take us?
Credit Analyst
Louis Landeman
llan@danskebank.com
+46 8 568 80524

February 2024

This document is intended for institutional investors and is not subject to all the independence and disclosure standards applicable to debt research reports prepared for retail investors

www.danskebank.com/CI Important disclosures and certifications are contained from page 15 of this report
Towards a new way of assessing sovereign risk
Risks related to climate change is not captured by traditional economic indicators

▪ Traditional economic indicators such as GDP do not capture a variety of material credit risk factors. Although
this relates to many different areas of the economy, in this series of reports we look more closely on the effects of
climate change and how that could impact sovereign credit quality.

▪ In Part 1, “Where will the current path take us?”, we take a closer look at where the current path, with a
rising emissions gap and large inequalities with regards to current and historical emissions, may take us.
Absent of mitigating actions, climate change will increasingly disrupt economic activity, with likely non-linear
impact as climate hazards interact and as tipping points are reached. If average global temperature rises are
to stabilise at 1.5-2.0 degrees Celsius, carbon emission prices will need to increase further. In turn, this could
have a major impact on economic growth, inflation, and asset prices.

▪ In Part 2, “An alternative mindset”, we examine the rating agencies and the ESG rating providers and how
they assess ESG-related risks for sovereigns. We also present some alternative ways of assessing ESG-
related risks for sovereigns, using the Nordic countries as an example. Both traditional credit rating agencies
and ESG rating providers have a strong income bias, with a risk of underestimating sovereign related climate
risks and costs. In order to be more forward-looking and proactive, we believe that a complementary
analytical framework is needed.

▪ In Part 3, The Nordic transition opportunity”, we look closer at the forthcoming Nordic transition including
green and sustainable financing trends. The sustainability transition will require large investments, both
globally and across the Nordic region. Generally, the debt capacity among the Nordic countries is strong,
with good potential to support the decarbonisation process. Due to both the decarbonisation process and
company “reshoring”, new green value chains will emerge. Considering the large commodity resources that
are spread out across the countries, the Nordic region will be important for the whole European transition.
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Global greenhouse gas emissions continue to rise
Collectively, the G20 currently accounts for 76% of global emissions

Total GHG emissions 1990 – 2022 (GtCO2e/yr)

• Global GHG emissions and atmospheric
concentrations of CO2 set new records
in 2022 with a 1.2% y/y increase.

• Emissions from fossil fuel combustion

and industrial processes account for
around two-thirds of the total.

• Emissions across the G20 countries

also increased by 1.2% y/y in 2022.
China, India, Indonesia, and the US
increased their emissions while Brazil,
the EU, and Russia decreased their
emissions.

• While renewable energy sources

showed good growth, investments in
fossil fuel extraction and use have also
continued in most regions.

• Planned production of fossil fuels in

2030 is more than double than what is
consistent with the Paris agreement.

Source: UN environment programme: Emissions Gap Report 2023 3

Action is needed this decade to bridge the emissions gap in 2030 and 2035
There is a significant emissions gap in 2030 and 2035 to reach the Paris agreement targets

Global GHG emissions under different scenarios and the emissions gap in 2030 and 2035 (GtCO2e)

• The world is witnessing a disturbing

acceleration in the number, speed, and scale
of broken climate records.

• Assuming that current published national

emission reduction targets are fully
implemented, this would reduce global
emissions by 2% by 2030, excluding
conditional targets, and by 9% when
including the conditional targets.

• Action in this decade will determine the

ambition that will be required in the next
round of national emission reduction
targets for 2035, and if it will be possible to
achieve the temperature goal of the Paris
agreement.

• To achieve the Paris agreement target of

limiting global warming to 1.5-2 degrees
Celsius, global emissions would need to be
reduced by 28-42% by 2030.

Source: UN environment programme: Emissions Gap Report 2023. Unconditional NDC: Intended Nationally Determined Contribution is a submission from a country describing the national actions intended to reach the Paris agreement.
Conditional NDC: Referring to an NDC that is contingent on a range of possible conditions (financing etc.)
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Contributions to climate change are unequal
A minority of countries have contributed most of the historical emissions and global warming

Current and historical contributions to climate change (% share by countries or regions)

• Current and historical emissions are unevenly
distributed both within and across countries.

• Nearly 80% of historical emissions have

come from the G20 countries. The largest
contributors are China, the SA, and the EU.
The least developed countries account for
around 4%.

• The US accounts for 4% of the global

population but contributed 17% of global
warming from 1850-2021.

• In contrast, India accounts for 18% of the

global population but has to date only
contributed 5% of global warming.

• Continued global population growth will make

emission reduction targets in absolute
numbers more challenging.

• Consequently, all countries need to accelerate

the low-carbon transformations of their
economies in order for the Paris agreement
targets to be achieved.
Source: UN environment programme: Emissions Gap Report 2023 5
Large inequality in current consumption-based emissions
Globally, the 10% of the population with the highest income accounts for nearly half of emissions

Per capita GHG emissions in 2021 and trend since 2000, including inventory-based LULUCF CO2 (tCO2e/capita)

• Households with the

highest income or wealth
contribute a
disproportionate amount of
global emissions.

• The global top 10% of

individuals contribute 45-
49% of total global
emissions.

• In contrast, the global

bottom 50% of individuals
emitted 7-13% of the total.

• Climate policy instruments

have not always been
successful in reducing
emissions-intensive
consumption or
investments.

Source: UN environment programme: Emissions Gap Report 2023. LULUCF – land use, land-use change and forestry.
Territorial emissions per capita. 6
Consumption-based emissions will only decline marginally up to 2030
For five G20 countries, per capita emissions will increase between 2015 and 2030

Per capita GHG emissions G20 member per capita emissions implied by current policies and unconditional transition plans

• The average per capita emissions in 2030 of

G20 members are projected to be only
marginally lower than under the current
policies scenario, according to the UN.

• These emissions (6.8-7.1 tons CO2 per

capita) are still far from the median
estimates implied by the 1.5-2 degrees
scenario by 2050 (1.0-2.2 tons CO2 per
capita).

• Australia, the EU, the UK, and the US are

projected to reduce their per capita
emissions by more than one-third between
2015 to 2030 under current policies and by
40-50% under their national plans.

• In contrast, China, India, Mexico, Russia, and

Turkey are all expected to increase their per
capita emissions between 2015 and 2030.

• For several G20 members the per capita

emissions are projected to stay above 10
tons per capita in 2030.
Source: UN environment programme: Emissions Gap Report 2023. Current policies scenario reflects all policies adopted and implemented up to specific cut-off dates.
Territorial emissions per capita. 7
 Nordic transition plans
Overall ambitious plans across the Nordics, but none that include consumption-based emissions

▪ Denmark: Climate law from 2020 mandating a reduction in annual territorial CO2 emissions by 70% in 2030 relative
to 1990 levels and with a target for climate neutrality by 2050. The municipalities define their own goals and
ambitions, but most municipalities have signed up to the national targets.

▪ Finland: Climate Change Act from 2022 aiming for carbon neutrality by 2035 based on a territorial calculation. No
national goals have been set for consumption-based emissions. More than 70 municipalities (out of 309) have made
their own municipal climate plan.

▪ Norway: Target to reduce territorial emissions by 55% by 2030 relative to 1990. This obligation can be partly fulfilled
by buying emission quotas. Norwegian Climate Law sets a target of reducing territorial emissions by 90-95% by 2050
relative to 1990. Norway does not have a target for consumption-based emissions. Most municipalities in Norway
have some sort of climate budget for direct (Scope 1) emissions.

▪ Sweden: Climate Policy Framework that targets net zero GHG emissions by 2045 and negative net emissions after
2050. No parliamentary decision yet regarding consumption-based emissions, even though an indicator for this is
monitored and reported annually by Statistics Sweden. A large number of Swedish municipalities have established
carbon budgets for their territorial emissions, and some have set their own consumption-based targets.

▪ Consumption-based emissions: Denmark 11 tons CO2e/pc (2020), Finland 10.5 tons CO2e/pc (2015), Norway 11.1
tons CO2e/pc (2017), Sweden 8.4 tons CO2e/pc (2021).

Source: Consumption-based emission inventories in Nordic municipalities – a quest to develop support for local climate action.
Frontiers in Climate, January 2024.
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Summarising the transition challenge for the Nordic countries
Significant reduction in consumption-based emissions needed to reach long-term sustainable levels

Per capita GHG emissions vs global average levels needed for Paris agreement Scenarios for Sweden until 2045 excluding and including behavioural changes

• National emission targets

under the Paris agreement
have a territorial focus.
12
• Consumption-based
10 climate targets
demonstrate the need for
8 new demand-side climate
policies together with the
6 focus on supply chains.
4
• In fact, a focus on
behavioural changes are
2
needed if Nordic residents
0
are to approach global
Denmark Finland Norway Sweden Global avg Global avg Global avg sustainable levels of CO2
2030 2040 2050 emissions by 2045.
Tons CO2e per capita

Source: Left graph - IPCC scenario AR6 for 1.5 degrees, as reported in Sveriges Globala klimatavtryck, Miljömålsberedningen 2022. 2020 levels for Denmark and Sweden, 2015 level for Finland, 2017 level for Norway.
Right graph from the article “Emission pathways and mitigating options for achieving consumption-based climate targets in Sweden”, Morfeldt, Larsson, Andersson et al 2023. Consumption-based emission pathways for scenarios including
behavioural changes in comparison with the proposed trajectory (dashed: main trajectory; dotted: alternative trajectory). The lower level represents a global climate transition in line with the Paris agreement.
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Carbon prices not yet impacting the economy in a meaningful manner, but…
While a moderate increase of the carbon price will not severely hurt the Euro economy, it will not reduce emissions in line with the EU’s own emission targets either

Impact on Euro area real GDP by CO2 price increase to EUR140/tCO2 in 2030 Impact on Euro area carbon emission by CO2 price to EUR140/tCO2

• The ECB has studied the impact

of a potential increase in carbon
emission prices from
EUR85/tCO2 in 2021 to
EUR140/tCO2 in 2030.

• According to the models, the

overall impact of the carbon tax
scenario on real GDP and
inflation is rather contained.

• At the same time, the models

suggest that the adjustments to
CO2 prices alone will not be
enough to reduce emissions in
line with EU’s own targets
(median estimate 11%
reduction until 2030 vs 2021
vs needed 46%).

Source: The macroeconomic implications of the transition to a low-carbon economy, ECB Economic bulletin no 5/2023. Assumed impact of the increase in carbon price from EUR85/tCO2 in 2021 to EUR140/tCO2 in 2030
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…the longer the actions are delayed, the more radical the measures need to be
In order for the green transition to be successful, carbon prices need to be much higher - and combined with other measures

Rising “shadow” carbon prices reflect need for tougher climate policies* Global GDP losses due to climate change: current policies and Net Zero 2050**
• The Network for Greening
the Financial System (NGFS)
has created a toolkit to
estimate the effects of
different climate scenarios.

• The main policy lever in the

models is a “shadow” carbon
price that seeks to estimate
the price needed to achieve
carbon neutrality by 2050.

• The 2023 edition of the

NGFS highlights the
increasing transition risk
towards net-zero vs 2022.

• The estimated impact on

GDP also highlights the risk
of delaying further policy
actions.
Source: Both graphs – IIASA NGFS Climate Scenarios Database. From the ECB blog ”Climate scenarios: procrastination comes at a high cost”. December 2023. *A shadow carbon price has been used as a proxy for
overall climate policy ambition **The losses are calculated relative to a hypothetic scenario without any climate change at all.
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The exact cost of the “hot house world” is uncertain – but most likely it is extremely high
Many climate models used in the financial industry exclude several costs and dynamic effects related to tipping points

• Estimating economic losses

from climate change is both
Comparison of GDP losses by 2100 with different methodologies Climate damage functions - % GDP loss vs temperature uncertain and complex.

• Many of the traditional

economic models to estimate
the economic losses from
climate change exclude many
of the expected risks,
including those from tipping
points.

• Using a different approach to

the damage function yields a
different outcome with much
higher expected losses.

• Given the large uncertainties

a more fruitful approach
could be to assume 80-100%
GDP loss at a certain level of
warming (4-6C) and then
work backward from this
starting point to estimate
losses at lower increases in
Source: Left graph - Piontek et al, ‘Integrated perspective on translating biophysical to economic impacts of climate change’, 2021. From the report “The Emperor’s new climate scenarios, July 2023. temperatures.
Right graph – Carbon Tracker, Keen et al. IFaA analysis. From the report “The Emperor’s new climate scenarios, July 2023.
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The current economic development is unsustainable
The gap between demand and supply for biosphere services has widened

The impact inequality*

▪ Our ecological footprint is currently larger than the
biosphere’s ability to supply goods and services to
meet that demand at a sustainable rate.

▪ There are basically four different ways for humanity to

reach a balance between demand and supply for
biosphere services:

▪ Reduce per capita global consumption.

▪ Lower future global population from what it is

today.

▪ Increase the efficiency of how the biosphere’s

supply of goods and services are turned into
global output and returned as waste.

▪ Invest in nature through conservation and

restoration in order to increase nature capital
and improve its regenerative rate.

Source: The Dasgupta Review, Abridged version. *The gap between the ecological footprint and the biosphere’s regenerative ability
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Where will the current path take us?
Rising emissions gap with larger inequalities

▪ With regards to climate risk, most countries are yet to present credible “net-zero” transition pathways for their
economies. There is currently a large gap between communicated emission reduction policies from most
countries and the estimated needed levels to limit global warming to specific levels. Furthermore, both current
and historical emissions are unequally distributed both within and across countries.

▪ Absent of mitigating actions, climate change will increasingly disrupt economic activity, with likely non-linear
impact as climate hazards interact and as tipping points are reached.

▪ If average global temperature rises are to stabilise at 1.5-2.0 degrees Celsius, carbon emission prices will need
to increase further. In turn, this could have a major impact on economic growth, inflation, and asset prices.

▪ Furthermore, when analysing the territorial CO2 emissions in individual countries, the full negative environmental
impact of the economy is seldom recognised. The country’s full consumption-based emissions are not accounted
for as part of the negativity is “exported” to the producing countries.

▪ All the Nordic countries have ambitious decarbonisation targets. However, none of the plans include targets for
consumption-based emissions.

▪ In Part 2 of this publication series, we will examine the rating agencies and the ESG rating providers and how
they assess ESG-related risks for sovereigns. We will also present some alternative ways of assessing ESG-
related risks for sovereigns, using the Nordic countries as an example.

14
 Danske Bank Credit Research team
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Industrials & Transportation
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Financials
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Credit Portfolios
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mradm@danskebank.com
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Norwegian HY
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Rasmus Justesen Louis Landeman Mark Elving Naur
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Report completed: 21 February 2024 at 16:00 CET

Report disseminated: 21 February 2024 at 16:10 CET
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