Climate Change and Sovereign Risk

This special feature for the European Central Bank (ECB) considers the relationship between climate and sovereign risk and contributes to the understanding of the climate-debt sustainability nexus in advanced economies. The results show that an “accelerated transition” and action to reduce the insurance protection gap are key to containing systemic risks.

The feature was published as part of the ECB’s financial stability review and explores the impact of an untimely or disorderly transition and increasingly severe or frequent natural catastrophes. It finds that both will adversely impact sovereign credit quality and debt refinancing rates if they materialise.

The authors state that central banks should incorporate such contingent risks in their prudential policy and risk management. They also emphasise that banks ought to be sufficiently capitalised for climate losses, including transition risks that will materialise in the short term.

Additionally, they stress that explicit and implicit contingent liabilities must be reflected in European debt sustainability analyses. If liabilities occur alongside debt sustainability issues, they can create feedback loops of higher interest and falling credit ratings, amplifying effects on financial stability.

Explicit liabilities can arise from damage to infrastructure and property, natural disaster recovery costs, and calls for government compensation. Sovereigns may also face implicit liabilities through the financial sector, due to credit losses and explicit or implicit sovereign guarantees.

Disaster losses and reconstruction costs also imply an indirect effect on sovereign risk through reduced growth and tax revenues. The authors cite European Commission research which simulates the fiscal shocks of natural disasters in 13 EU countries, and projects debt-to-GDP ratios to be between 2.3 and 2.7% higher by 2032 in 1.5°C and 2°C scenarios respectively.

Sovereign exposures are particularly pronounced in countries with high risk and low insurance of losses, say the authors. Given that only 25% of losses are currently insured in the EU, the insurance protection gap represents a substantial credit risk.

The pace of transition may also be a source of sovereign risks, say the authors, especially if it is untimely or disorderly. Overall, the authors find that an accelerated and orderly transition would best contain systemic risk and would not pose financial stability concerns.

Transition is vital to limit the most “catastrophic” climate impacts but banks should make provisions for inevitable transition costs, say the authors. Every transition scenario investigated – accelerated, “late push” and delayed –  saw increased probabilities of defaults and expected bank losses.

The authors use a refined model that distinguishes two routes to meeting 2030 emissions targets: an accelerated scenario, which assumes an immediate and optimal start, and a late-push scenario in which transition efforts do not intensify until 2026.

Both successfully contain systemic physical risks but result in short term losses. In the accelerated scenario, annual expected losses for the median bank will be 25% higher in 2030 than in 2022 under a baseline scenario without transition risk, and 53% in the late-push scenario.