Sovereign risk and climate change

We investigate how climate risks impact sovereign credit risk and debt sustainability and assess the implications from a financial regulation and central banking perspective. We address the following two sub-questions:

  • Through which channels can climate-related risks affect sovereign risk and how important are their respective impacts?
  • What are the regulatory and supervisory implications for financial supervisors and central banks?

First, we develop a conceptual framework that characterises the transmission channels between climate risk and sovereign risk, stressing the importance for financial regulators and central banks to integrate these risks into their operational frameworks in achieving their mandated objectives. Second, building on this conceptual work, we assess the climate-sovereign risk nexus for the 10 member countries of the Association of Southeast Asian Nations (ASEAN), a group that includes four NGFS members (Indonesia, Malaysia, Singapore, Thailand).

We find climate change can have a material impact on sovereign risk through direct and indirect effects on public finances. Furthermore, it raises the cost of capital of climate-vulnerable countries and threatens debt sustainability. All branches of government will have to address climate-related risks and must climate-proof their economies and public finances or potentially face an ever-worsening spiral of climate vulnerability and unsustainable debt burdens. Monetary and financial authorities will have to play crucial roles in analysing and mitigating macrofinancial risks. Our research provides insights into policy coordination between the central bank and government in order to optimise public debt management.