Feeling the Heat

Fiscal health is “under threat”, says this 2020 report published by the Asian Development Bank Institute. The report’s macroeconomic analysis shows that climate change has material effects on the cost of sovereign borrowing globally. Policymakers must “ramp up” investment in climate change resilience, the authors say, to avoid substantial effects on economic growth and financial stability.

According to the authors, climate hazards and natural disaster recovery costs contribute to unsustainable national debt and central banks should prepare to become a “climate rescuer of last resort” as temperatures rise. The paper’s findings highlight the need for central banks to include climate risk in their core financial stability operations and facilitate international investment in climate mitigation and adaptation.

Considering a panel of 40 countries, the authors – John Beirne, Nuobu Renzhi and Ulrich Volz – employ both fixed panel and structural panel vector autoregressive models to conduct impulse response analysis, examining the relationship between climate vulnerability and resilience and sovereign bond yields.

The results show a consistent link between sovereign borrowing costs and climate risk. Controlling for a large set of global and domestic factors, high climate vulnerability and low climate resilience were shown to have significant and sustained upward pressure on the cost of borrowing. Permanent effects emerge on average after 12 quarters.

The largest effects were seen in countries with high climate risk exposures, including Singapore, Japan, the Netherlands and Korea. The results also show that emerging and developing economies experience a substantially higher, and disproportionate, risk premium.

The authors call for a precautionary approach which facilitates investment in climate adaptation and creates a more proportionate distribution of climate risk. This is especially important as credit rating agencies increasingly include climate risk in sovereign ratings.

The paper makes an essential contribution to understanding the nexus between climate risk and sovereign debt sustainability.