With sea levels continuing to rise, coastal flooding is already a considerable – and growing – economic threat to low-lying regions. A recent academic study – presented at the latest conference of the Global Research Alliance for Sustainable Investment and Finance (GRASFI) – looks into whether investors account for and hedge this hazard by exploiting country exposure to such floods.
This article is part of our series on current academic research into a range of sustainability-related investment topics. The papers discussed were presented at the latest annual GRASFI conference. We believe in science-led sustainable investment. Partnering with academic researchers can add value since thorough research helps us to grasp the scope of climate change and biodiversity loss, to quantify risk, and to develop fit-for-purpose solutions. This is why we sponsor GRASFI’s annual conference and share relevant scientific findings with investors, clients and the wider asset management industry on our websites.
Using sovereign credit default swap (CDS) spreads as premiums that incorporate information on credit quality and insurance demand, the author of the study “Surging sovereign spreads: The impact of coastal flooding on sovereign risk” concludes that severe coastal surge disasters increase the credit risk of affected countries across contract maturities.
Examining the countries most vulnerable to coastal flooding in the short term, the study shows a positive and significant relationship of sovereign credit risk to global and local attention toward physical and adaptation risks.
In contrast, investors do not account for adverse future trends of flooding under climate model projections of sea levels, land subsidence or population growth.
Countries that have built protection against one-in-100-year floods experience no increase in sovereign risk during periods of increased attention to adaptation risk, according to the study. Additional tests demonstrate a positive and significant relationship between sovereign CDS trading and attention, clearly showing that investors buy insurance against countries with existing flood exposure.
The results suggest that sovereign credit risk will rise with the perception of coastal flooding, leading to increased financial pressures for exposed countries. Coastal flooding disasters have dire effects on human life and countries’ economies, one example being the 2011 floods in Thailand, in which more than 800 people died and which caused economic losses totalling USD 40 billion.
Various factors heighten the likelihood of severe damage from future coastal surge events, including:
- The rise in global mean sea levels; this is expected to be 1.3 metres by 2100
- The number of people living in low-lying coastal zones; this is projected to increase from 625 million in 2000 to 1.4 billion in 2060
- Coastal land subsidence.
While such factors could increase the severity and frequency of disastrous coastal surge events experienced by coastal countries, there is substantial variation across regions.
Stock and trend risk
When the author looks at populations as a measure of economic activity, a country’s vulnerability to coastal flooding can be assessed as a function of two components: stock and trend risk.1
Stock exposure represents the current vulnerability of a country’s population to shore flooding.
This has remained largely static in modern history. The driver of recent historical changes to stock exposure has primarily been the movement of people as climate change has begun to increase the rate of sea level rise only in the last two decades.
In contrast, trend risk is the future rate at which a country will experience coastal population growth, land subsidence, and sea level rise. These three factors compound on one another to exacerbate stock risk, intensifying future calamitous coastal disasters.
The study investigates whether investors account for stock and trend coastal flooding risk by buying sovereign insurance as protection against disastrous events. The author focuses on sovereign credit default swap spreads as they are seen as an efficient gauge of a country’s credit health, are useful instruments to insure against risk, and are available over multiple time horizons.
Coastal surge can drive CDS price surge
It appears that investors will demand more insurance when they are particularly attentive to climate threats. Specifically, investors who worry natural disasters affect credit worthiness may buy insurance against default risk for the most exposed countries. This, in turn, will increase the equilibrium price of sovereign CDS spreads, particularly for longer-term tenors.
Where coastal surges pose a systemic threat to particularly vulnerable countries, sovereign insurance becomes more valuable and rises in price when investors are attentive to the current and future severity of coastal flooding and sea level rise.
The author gathers historical data on surges from international environmental disasters and conducts panel regressions to examine shocks to a country’s credit risk. The results indicate that severe surge events are associated with a sharp decrease in the creditworthiness of the country.
To test whether investors are accounting for trend risks, the study samples improving and worsening countries based on historical and future sea level rise trends, focusing solely on the growth of the 10-year CDS spread.
The results indicate that neither historical nor future trends are accounted for. Explicitly, investors are not incorporating SLR trends when buying insurance against future catastrophic surge events.
The findings suggest that investors are not pricing more the complex information of trend vulnerability, but rather focus on stock exposure, which is simpler to quantify.
Implications for policymakers
The study finds evidence of increased sovereign CDS trading activity where more attention is paid to climate risks. The percentage growth of weekly trades and gross notional amounts of sovereign CDS is found to be positively associated with adaptation and global warming risks. The findings support evidence that investors hedge against sovereign risk using CDS contracts.
The author claims its results have substantial implications for policymakers. Countries exposed to sea level rise will be driven to build resilient infrastructure using public finance such as government bonds.
However, as sovereign risk increases with the perception of coastal flooding, government debt will also become more expensive to issue. Both factors will pressure the finances of highly affected countries.
“This interesting study takes a sample of 13 countries most vulnerable to short-term coastal flooding and finds a positive and significant relationship of sovereign credit risk to global and local attention toward physical and adaptation risks. More frequent and severe flooding threatens costal economies, infrastructure, and real estate sector values, therefore rising sea levels pose increasing credit risks for many coastal countries and governments. So, we should see more studies such as this one that reiterate the importance of physical climate risk such as rising sea levels for sovereigns. However, I would not agree with the author, who claims that investors do not account for adverse future trends of flooding under climate model projections of sea levels, land subsidence and population growth, because at BNPP AM we do incorporate physical climate risk forward-looking view data including severe weather events and hazards into our Sovereign ESG Assessment Model and believe it is a vital part of our environmental assessment of sovereigns. Otherwise, I fully agree with the results and findings that sovereign risk will rise with the perception of coastal flooding, leading to increased financial pressures for exposed countries.”
Malika Takhtayeva, Sustainable Fixed Income Lead – EMEA
 Atreya Dey, University of Edinburgh Business School. Atreya.Dey@ed.ac.uk
 “Thai flood 2011: Rapid assessment for resilient recovery and reconstruction
planning.” World Bank, 2012.