Risks From Climate Change To Sovereign Debt In Europe

The exposure of European Union sovereigns to climate risks can be acute, from extreme weather, or chronic, from the productivity effects of gradual temperature increase, increased sea levels and the transition to a low-carbon economy that results in repricing of assets. Climate-related innovations can also spur growth. These risks are priced by investors and can affect sovereign credit ratings. Governments and fiscal stability authorities have an interest in the sovereign-debt implications of climate change being transparent. To this end, we look at the exposure of EU sovereigns to climate risks, study international best practices, and describe the transmission channels from climate change to public finance. European union institutions and national fiscal authorities should mainstream climate risk analysis in public finance. Stress testing of debt dynamic requires a link between regional climate scenarios and country debt dynamics. We argue for the adoption of an architecture of narrative climate scenarios, to guide national policymaking. Narrative Scenarios can be generated using integrated assessment models. As an illustration, we apply two prominent models to generate rough bounds on the extent of the risk for Italian debt from climate change. This raises issues about the models used. Coordination by EU institutions to develop regional scenarios will ensure acceptability, raise ambitions in dealing with climate risks and encourage the fiscal authorities to think of solutions. A network for climate-proofing public finance will bring together EU and member-state institutions. We also recommend budgeting for climate expenditures and contingent liabilities, and using risk-sharing instruments, with disclosure of the risks to public finance from climate change.

Climate change is already a systemic risk to the global economy. While there is a large body of literature documenting potential economic consequences, there is scarce research on the link between climate change and sovereign risk. This paper therefore investigates the impact of climate change vulnerability and resilience on sovereign bond yields and spreads in 98 advanced and developing countries over the period 1995–2017. We find that the vulnerability and resilience to climate change have a significant impact on the cost government borrowing, after controlling for conventional determinants of sovereign risk. That is, countries that are more resilient to climate change have lower bond yields and spreads relative to countries with greater vulnerability to risks associated with climate change. Furthermore, partitioning the sample into country groups reveals that the magnitude and statistical significance of these effects are much greater in developing countries with weaker capacity to adapt to and mitigate the consequences of climate change.

Aging populations. Weather shocks. Scarce water. Globalization. Security threats. Policymakers today confront a number of developments that threaten to burden public budgets for decades to come, or bankrupt some entirely. This book argues that governments need to make policy changes now to take account of the potential fiscal consequences of these developments. After describing how, if at all, analysts, national governments, and international organizations currently address these long-term issues, the book stresses the vital need for a multipronged approach, involving strengthened analyses, greater attention to long-term issues and risk factors in budgeting, and institutional reforms that address the myopic biases of politicians and the public.

The European Sovereign Debt Crisis: Breaking the Vicious Circle between Sovereigns and Banks explains why the euro area’s progress towards reining in the risks arising from the well-documented bi-directional financial contagion transmission mechanism that links sovereigns to commercial banks has been more prominent compared to the channel of contagion moving from banks to sovereigns. Providing an analysis of the legal and regulatory measures that Europe and the euro area have taken to mitigate the exposure of sovereigns to financial crises generated by commercial banks, this book draws attention to areas where improvements to the arsenal of tools hitherto introduced are either desirable or necessary. Chapters further explain – with recourse to economic and legal arguments – why the channel of contagion moving from sovereigns to commercial banks has proven harder to close, and explores ways in which progress could be made in the direction of closing it so as to avert the risk of future banking sector crises. This work provides essential reading for students, researchers and practitioners with an interest in sovereign debt crises and the euro-area banking system.

Recent events have shown that sovereigns, just like banks, can be subject to runs, highlighting the importance of the investor base for their liabilities. This paper proposes a methodology for compiling internationally comparable estimates of investor holdings of sovereign debt. Based on this methodology, it introduces a dataset for 24 major advanced economies that can be used to track US$42 trillion of sovereign debt holdings on a quarterly basis over 2004-11. While recent outflows from euro periphery countries have received wide attention, most sovereign borrowers have continued to increase reliance on foreign investors. This may have helped reduce borrowing costs, but it can imply higher refinancing risks going forward. Meanwhile, advanced economy banks’ exposure to their own government debt has begun to increase across the board after the global financial crisis, strengthening sovereign-bank linkages. In light of these risks, the paper proposes a framework—sovereign funding shock scenarios (FSS)—to conduct forward-looking analysis to assess sovereigns’ vulnerability to sudden investor outflows, which can be used along with standard debt sustainability analyses (DSA). It also introduces two risk indices—investor base risk index (IRI) and foreign investor position index (FIPI)—to assess sovereigns’ vulnerability to shifts in investor behavior.

This publication serves as a roadmap for exploring and managing climate risk in the U.S. financial system. It is the first major climate publication by a U.S. financial regulator. The central message is that U.S. financial regulators must recognize that climate change poses serious emerging risks to the U.S. financial system, and they should move urgently and decisively to measure, understand, and address these risks. Achieving this goal calls for strengthening regulators’ capabilities, expertise, and data and tools to better monitor, analyze, and quantify climate risks. It calls for working closely with the private sector to ensure that financial institutions and market participants do the same. And it calls for policy and regulatory choices that are flexible, open-ended, and adaptable to new information about climate change and its risks, based on close and iterative dialogue with the private sector. At the same time, the financial community should not simply be reactive—it should provide solutions. Regulators should recognize that the financial system can itself be a catalyst for investments that accelerate economic resilience and the transition to a net-zero emissions economy. Financial innovations, in the form of new financial products, services, and technologies, can help the U.S. economy better manage climate risk and help channel more capital into technologies essential for the transition. https://doi.org/10.5281/zenodo.5247742

This paper takes stock of Seychelles’ plans to manage climate change, from the perspective of its macroeconomic implications. It suggests macro-relevant reforms that could strengthen the plans’ likelihood of success. It highlights high public awareness and a body of existing sustainable development planning, which puts Seychelles several steps ahead toward preparedness. Next steps would be to ensure that climate change planning is integrated with the forthcoming National Development Plan. Disaster preparedness is a relatively strong point, but there is much still to be done—from improving warning systems to resilience building to contingency financing.

Climate change poses an existential threat to the global economy. While there is a growing body of literature on the economic consequences of climate change, research on the link between climate change and sovereign default risk is nonexistent. We aim to fill this gap in the literature by estimating the impact of climate change vulnerability and resilience on the probability of sovereign debt default. Using a sample of 116 countries over the period 1995–2017, we find that climate change vulnerability and resilience have significant effects on the probability of sovereign debt default, especially among low-income countries. That is, countries with greater vulnerability to climate change face a higher likelihood of debt default compared to more climate resilient countries. These findings remain robust to a battery of sensitivity checks, including alternative measures of sovereign debt default, model specifications, and estimation methodologies.