International Network for Sustainable Financial Policy Insights, Research and Exchange

Climate Change and Sovereign Risk

Ulrich Volz (SOAS Centre of Sustainable Finance; German Development Institute; INSPIRE), John Beirne (Asian Development Bank Institute; INSPIRE) and Emilie Mazzacurati (Four Twenty Seven; INSPIRE) present their INSPIRE supported research with responses from Shamshad Akhtar (Karandaaz Pakistan), Ekhosuehi Iyahen (Insurance Development Forum), Nick Robins (Grantham Research Institute, LSE), Ahmed M. Saeed (Asian Development Bank), and Mark Thomas (World Bank).

Conference on Climate Risk and Sovereign Risk in Southeast Asia

Recent research on the relationship between climate vulnerability, sovereign credit profiles, and the cost of capital in climate-vulnerable developing countries shows that these countries incur a risk premium on their sovereign debt, reducing their fiscal capacity for investments into climate adaptation and resilience. This raises serious questions about the impacts of climate risk on the sustainability of public finances for climate-vulnerable countries whose fiscal health is also threatened by output losses related to climate hazards and disaster recovery costs, as well as transition risks that may hit specific sectors or the economy at large.

This workshop will examine the nexus between climate risk and sovereign risk in Southeast Asia, a dynamic that is an increasing focus of rating agencies but has been little studied compared to the macroeconomic impacts of climate change. It will also explore how the climate-sovereign risk nexus may be integrated into the operational frameworks of central banks and supervisors to help them maintain price and financial stability, thus contributing to broader macroeconomic stability.

The workshop will mark the start of a research project co-funded by ADBI, the Climate Works Foundation, and the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE). The project is co-organized by ADBI, the SOAS Centre for Sustainable Development, World Wildlife Fund’s Asia Sustainable Finance team, and Four Twenty Seven.

Objectives
To identify the channels through which climate-related risks affect sovereign risk as well as the scale of the impacts in Southeast Asia.
To examine the monetary policy, regulatory and supervisory implications for financial supervisors and central banks in the region.

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.

Feeling the heat: Climate risks and the cost of sovereign borrowing

This paper empirically examines the link between the cost of sovereign borrowing and climate risk for 40 advanced and emerging economies. We find that vulnerability to the direct effects of climate change matters substantially more for sovereign borrowing costs than climate risk resilience. Moreover, the magnitude of the effect on bond yields is progressively higher for countries deemed highly vulnerable to climate change. Finally, a set of panel structural VAR models indicate that the reaction of bond yields to climate risk shocks become permanent after around 18 quarters, with high risk economies experiencing the largest permanent effects on yields.

Bracing for the Typhoon: Climate Change and Sovereign Risk in Southeast Asia

Southeast Asian countries are among those most heavily affected by climate change. The number and intensity of extreme weather events in the region have been increasing markedly, causing severe social and economic damage. Southeast Asian economies are also exposed to gradual effects of global warming as well as transition risks stemming from policies aimed at mitigating climate change. To empirically examine the effect of climate change on the sovereign risk of Southeast Asian countries, we employ indices for vulnerability and resilience to climate change and estimate country-specific OLS models for six countries and a fixed-effects panel using monthly data for the period 2002–2018. Both the country-specific and the panel results show that greater climate vulnerability appears to have a sizable positive effect on sovereign bond yields, while greater resilience to climate change has an offsetting effect, albeit to a lesser extent. A higher cost of debt holds back much-needed investment in public infrastructure and climate adaptation, increases the risk of debt sustainability problems, and diminishes the development prospects of Southeast Asian countries.

Climate Change and Sovereign risk

Climate Change and Sovereign Risk provides a comprehensive analysis of the ways in which climate risks affect sovereign risk. New empirical evidence demonstrates how climate risk and resilience influence the cost of sovereign borrowing, with econometric analysis showing that higher climate risk vulnerability leads to significant rises in sovereign bond yields. The report provides a closer look at Southeast Asia, a region with significant exposure to climate hazards such as storms, floods, sea level rise, heat waves, and water stress. It explains that the implications of climate change for macrofinancial stability and sovereign risk are likely to be material for most, if not all, countries in Southeast Asia.

The report also stresses the need for governments to climate-proof their economies and public finances or potentially face an ever-worsening spiral of climate vulnerability and unsustainable debt burdens. It urges financial authorities to integrate climate risk into their risk management processes. It also encourages governments to prioritize comprehensive climate vulnerability assessments and work with the financial sector to promote investment in climate adaptation.

The report was co-published by SOAS University of London, ADBI, the World Wide Fund for Nature, and Four Twenty Seven.

Feeling the Heat: Climate Risks and the Cost of Sovereign Borrowing

This paper empirically examines the link between the cost of sovereign borrowing and climate risk for 40 advanced and emerging economies. Controlling for a large set of domestic and global factors, the paper shows that both vulnerability and resilience to climate risk are important factors driving the cost of sovereign borrowing at the global level. Overall, we find that vulnerability to the direct effects of climate change matter substantially more than climate risk resilience in terms of the implications for sovereign borrowing costs. Moreover, the magnitude of the effect on bond yields is progressively higher for countries deemed highly vulnerable to climate change. Impulse response analysis from a set of panel structural VAR models indicates that the reaction of bond yields to shocks imposed on climate vulnerability and resilience become permanent after around 12 quarters, with high risk economies experiencing larger permanent effects on yields than other country groups.