John Beirne, Declan Magee, Agnes Surry and Ulrich Volz
Climate change poses a serious threat to the development of countries and can have material impacts on sovereign risk. Sovereign risk refers to the probability that a country may not be able to pay its debts. However, since the global financial crisis, interactions between fiscal balances, public and private debt, and the financial sector have proven to be very complex. Sovereign risk reflects this complexity.
For example, the devastating floods in Pakistan in 2022 were caused by heavier-than-usual monsoon rains and faster melting of glaciers. They killed more than 1,700 people, left half a million homeless, and cost around $30 billion. The events led to Moody’s revising downward Pakistan’s sovereign credit rating by one notch, citing amplified liquidity and debt sustainability risks alongside falling foreign exchange reserves.
Today, countries face two main climate-related risks. The first is physical risk, as the increasing number and intensity of extreme weather events have significant social and economic adverse effects. The second is transition risk, as the magnitude of the transition required to respond to climate emergencies is high. Implementing mitigation policies and developing more climate-friendly technologies create enormous challenges that can threaten a country’s social, political, economic, and financial stability.
Sovereign risk transmission channels
Climate-related risks adversely affect sovereign risk through seven transmission channels (Volz et al. 2020):
Depletion of natural capital: Nature and the environment provide the foundation for societies and economies through ecosystem services, such as flood control, recreation, and tourism. With human activity, natural capital is declining, and climate change is amplifying this trend. Extreme weather events or global warming can destroy an entire ecosystem, slowing down economic growth, eroding incomes, and undermining the government’s ability to repay debt, exacerbating sovereign risk.
Adverse fiscal impact of disasters: Climate-related disasters can disrupt economic activity, which may adversely affect tax income and other public revenues, increasing social transfer payments. The disaster-related destruction of physical government assets and public infrastructure, and financial support for households and firms, add to the challenge and drive up public debt.
Mitigation and adaptation policies: Mitigation and adaptation policies are key for responding to climate change but are costly. For instance, adaptation finance needs in developing countries are 10 times greater than current international public adaptation finance flows. According to the International Energy Agency (2023), the global investment required to achieve net zero by 2050 is estimated at $4.7 trillion per year, or around 5% of current global GDP.
Macroeconomic impact: Physical and transition risks can cause supply and demand shocks that impact economic output and the ability to repay debt. On the supply side, climate hazards and heat can worsen labor productivity. On the demand side, disasters damage household and corporate balance sheets, undermining consumption and investment.
Financial sector effects: Extreme weather events and chronic physical risks, such as sea-level rise, can damage operating assets and reduce borrowers’ capacity to service their debt, increasing non-performing loans and banking sector risks. Transition risks related to technology and structural change can also have a negative impact on borrowers’ credit profiles, triggering credit downgrades and losses. Overall, amplified financial sector vulnerabilities can also transmit to the real economy, potentially worsening the productive capacity of the economy.
Impact on trade and international capital flows: Physical and transition risks also affect trade patterns, trade volumes, and financial flows. Disasters can halt economic activity and disrupt trade flows, and climate transition requires new products, services, and investments. Severe trade disruptions affect countries’ current account and balance of payments positions and, ultimately, sovereign risk. This could also trigger net capital outflows and even exclude climate-vulnerable countries from international capital markets.
Impact on political stability: The economic and social effects of climate change may accentuate social tensions within society and fuel political instability. Moreover, climate change can lead to large-scale migration movements and conflict. Political instability can undermine the ability or willingness of a government to repay its debt.
Understanding these transmission channels and mitigating the related risks are critical to containing sovereign risk and countries’ cost of borrowing. This is important for countries that are highly exposed to climate change, as they are the ones most in need of climate finance climate to build resilience but face the highest climate-related premia on their sovereign bond yields (Kling et al. 2018; Beirne et al. 2021).
The options ahead
Against this background, policy makers have a range of available policy options to mitigate climate-related sovereign risk. One key recommendation would be the preparation of climate vulnerability assessments to underpin the development of their national adaptation plans to climate-proof their economies and public finances. Once the assessments and plans are ready, it is suggested that policy makers mainstream climate risk analysis in public financial management, which includes budgeting processes, debt instruments, and revenue source diversification, among others.
Central banks and financial supervisors also have an important role to play in analyzing the macro financial risks arising from climate change. They also need to assess the impact of climate-related risks in their monetary and prudential frameworks through the development of ambitious climate disclosure standards, the implementation of climate stress tests to ensure the financial institutions’ health, and the integration of climate risks into financial supervision.
At the same time, governments and financial authorities should implement financial sector policies to scale-up investment in climate adaptation and resilience. It is also important to identify insurance solutions through local currency bond markets and further develop insurance markets, including fintech-based insurance solutions. In this regard, international financial institutions, such as the Asian Development Bank, have a special role to play in supporting climate-vulnerable countries by strengthening adaptive capacity and macro financial resilience. For instance, the Asian Development Bank offers a range of innovative instruments, such as green and blue finance bonds and projects to support countries in mitigating the adverse impact of climate risks on sovereign risk.