How will climate change affect public finances and sovereign risk?

Enthusiasm for ‘greening’ the financial system is welcome, but a central challenge remains: decision-makers lack some basic information. It’s not enough to know that climate change is a threat, markets need credible sources on how global warming translates into material risks.

Climate change will affect every element of the global financial system. With Covid-19 pushing global public debt to a record $92 trillion globally by the end of 2021, a key concern is how climate change will affect the fiscal triangle – taxes, borrowing and spending – and the ability of nations to respond to future shocks.

But translating climate risk into material financial risk remains a substantial challenge. Early research shows that climate change has already increased the cost of public borrowing for 25 of the most climate-vulnerable countries – including Bangladesh, Costa Rica, the Maldives, the Philippines and Vietnam – by 1.17 percentage points (Kling et al, 2018). It has also added over $40 billion to the debt interest paid by the 40 most vulnerable nations between 2007 and 2016 (Buhr et al, 2018).

A recent study shows that 63 sovereigns may see their credit ratings downgraded by 2030 due to climate change, which could add over $200 billion to the annual interest payments on public debt in the G7 plus China by 2100 (Klusak et al, 2021).

Figure 1: G7 government debt, % of GDP

Source: IMF World Economic Outlook, 2021

Although much of the scientific and media attention focuses on extreme weather events, sea level rise and mass extinction, there are many channels through which climate change can affect the public finances and sovereign risk (see Figure 2). Many of the biggest economic and financial risks may fall in the realm of social and political stability, and there are numerous opportunities for driving innovation, green jobs, productivity gains and improved human and planetary health.

Some of the most significant near-term economic consequences, especially in developed countries, will derive from the transition towards net zero as much as the physical risks from climate change itself. Ultimately, the net effect of climate change on the national debt, fiscal sustainability and financial stability is a function of investment choices made today.

Figure 2: Translating climate risk into sovereign risk

Source: Agarwala et al, 2021 ; adapted from Volz et al, 2020

The most obvious path from climate change to fiscal risk is through environmental degradation. In addition to extreme weather events, research reveals complex interactions between the climate and other elements of nature, demonstrating that expanding protected areas and restoring sensitive ecosystems can be a cost-effective way of addressing multiple environmental goals (see Bastien-Olvera and Moore, 2020; Agarwala and Coyle, 2020). For example, restoring coastal mangroves will help to store more carbon while also providing habitat for fish and bird species, as well as dampening storm surges (see Hochard et al, 2019; Blankespoor et al, 2017).

The transition can also create risks and opportunities in the management of natural resources. For example, phasing out fossil fuels will also phase out the tax revenues that they generate. In the short term, the shortfall can be filled using carbon taxes. But in a net-zero economy, carbon taxes will not generate much revenue.

Ultimately, the macroeconomic risks from climate change will depend on how governments respond, particularly with changes in taxation, borrowing, and spending (the fiscal triangle).

On the downside, we can expect government spending on disaster relief, lost tax revenue due to reduced economic output and wasteful spending on fossil-fuel-based infrastructure that will soon be obsolete. But on the upside, the investments needed for a smooth and just transition can help to spur new markets and greater efficiency, including as a result of lower-cost energy.

In addition, if innovators act early enough, they can carve out a competitive advantage. They can benefit from learning-by-doing, capturing market share in new products and industries and from economies of scale.

The consensus among economists is that low-carbon, climate-resilient investments offer among the highest returns on investment (both public and private). Further, these returns are higher the sooner we get started and any delay only increases costs, decreases returns and threatens stability (Hepburn et al, 2020).

How should governments think about the costs of climate change?

The most important message for governments and investors is that there are two types of climate costs. The first are investment costs, which provide beneficial returns long into the future. Reducing costs and increasing efficiency, decarbonising buildings, energy, transport and the food system will free up resources – that we currently spend on fossil fuels – for more productive endeavours.

By lowering emissions and enhancing resilience, these investments offer the best available hedge against the worst effects of climate change. Crucially, they can also help to increase productivity – a chief concern among developed nations – by improving health (due to better air quality and avoiding extreme temperatures).

The second kind of climate cost has no upside nor positive return. These include the loss of life, property and social stability that arises over the course of repeated climate catastrophes. They also encompass the permanent loss of globally unique ecosystems – from the Great Barrier Reef to the Arctic – as well as the stranding of assets and declines in productivity and production that temperature volatility and extreme weather brings.

Research shows that climate change could cost between 2% and 21% of global economic output by the end of the century (Kahn et al, 2019; Kalkhul and Wenz, 2020; Burke et al, 2015).

It is important not to confuse the two types of costs. Investments that generate beneficial returns are very different from wasteful losses due to climate inaction. The sums required are substantial, but well-designed public investment, combined with bold, clear policies can effectively encourage private investment.

For example, green investment banks can help to leverage private finance, while vehicle emissions standards – for example, banning new internal combustion engines – and building regulations can send clear signals to markets and ensure demand for greener products.

How will climate change affect public borrowing and why does it matter?

Sovereign debt is the money that central governments borrow, typically in the form of bonds (think Treasuries for the United States and gilts for the UK). According to the International Monetary Fund (IMF), public debt is ‘an important way for governments to finance investments in growth and development’ and it has been used extensively to respond to economic shocks including the global financial crisis of 2007-09 and the Covid-19 pandemic. Globally, public debt is expected to reach $92 trillion by the end of 2021 (Institute of International Finance (IIF), 2020).

Public debt is extremely important to growth and macroeconomic performance. It is the mechanism through which countries invest in themselves. Government borrowing is what fuelled Roosevelt’s New Deal, financed the UK through world wars and, if deployed strategically, will be a key tool in the drive to decarbonisation. It is also the safe ground to which investors flee in times of turmoil.

But public debt is no free lunch. Investors expect to be compensated for parking their money with the government. That compensation is determined by a range of factors, but it is higher when the government in question is deemed to be a high credit risk.

Sovereign credit ratings serve as independent assessments of the creditworthiness of nations – their ability and willingness to repay debt. Recent research shows that climate change is already increasing the cost of borrowing for the most climate vulnerable countries including Cambodia, Colombia, Madagascar and Sri Lanka (Kling et al, 2018; Buhr et al, 2018). Further, climate-driven sovereign downgrades could begin within the decade (Klusak et al, 2021).

These downgrades can be expected to increase the cost of public borrowing, making it harder and more expensive to make decarbonising investments in the future. But they will likely also spill over into other asset classes, increasing the cost of borrowing for corporations and financial institutions (Augustin et al, 2018; Baum et al, 2016).

What is the upshot?

The potential effects of climate change on sovereign risk are substantial. Climate economics can offer important insights into how this translates into sovereign creditworthiness and the cost of public and private debt. Despite considerable noise around green finance metrics, and especially, environmental, social and governance (ESG) indicators, most climate risk assessments and disclosures are ad hoc, unregulated and unreliable (Mathiesen, 2018).

Existing metrics have not factored climate risk adequately into sovereign credit assessments. This has important implications for financial stability, given the role that sovereign debt plays in portfolios from banks to pension funds.

Without credible, science-based risk metrics, even well intentioned investors lack the necessary information to price and manage risk in their portfolio. Research shows that climate is beginning to affect the cost of debt for some countries, but credit assessments that can only identify risks after the fact are of limited use.

Climate risk assessments need to be forward-looking, based on the best available climate and economic modelling. It is the difference between getting a diagnosis from the doctor, beforehand, or from the coroner, afterwards.

Where can I find out more?

Rising temperatures, melting ratings: Patrycja Klusak and co-authors discuss the world’s first ‘climate-smart’ sovereign credit rating and warn of climate-driven downgrades as early as 2030.

Climate change and sovereign risk: Report from the Asian Development Bank on the need to climate-proof economies and public finances to avoid vulnerability and unsustainable debt burdens.

Public debt, public wealth and economic dynamics: Investing in inclusive and resilient growth to address public sector debt and restore prosperity.

The first climate smart sovereign credit ratings: Discussion of sovereign credit ratings and the need to reduce emissions to avoid downgrades.

Climate change and fiscal sustainability: risks and opportunities: Matthew Agarwala and co-authors highlight the need for credible estimates of how climate change will affect debt sustainability, sovereign creditworthiness and the public finances of major economies.