Decoding climate-related risks in sovereign bond pricing: a global perspective

Summary

Focus

Sovereign yields are often the strongest reference for corporate debt markets and investment decisions in each country. Shocks impacting sovereign solvency therefore pose great concerns for the economy and financial stability. Weather disasters are especially relevant shocks because their timing is unpredictable and imply significant damage to infrastructure, economic activity and humanitarian losses. This work shows how sovereign yields across the globe react to transition risks and physical climate risks.

Contribution

We study the reaction of sovereign yields to climate risks from 2000 to 2023 for 52 countries, including both advanced and developing economies. Our analysis considers both transition risks, as measured by carbon dioxide emissions per capita, and physical risks from rising temperatures and weather disasters, such as droughts, extreme temperature waves, floods, storms and wildfires.

Findings

We show that transition risk is associated with higher sovereign yields, with the effect more pronounced for developing economies and countries with high carbon emissions, especially after the Paris Agreement. However, temperature changes are not related to sovereign borrowing costs because they are a chronic physical climate risk that is not yet fully priced in by investors. Finally, we find that borrowing costs increase substantially after weather disasters, especially for poorer economies and highly indebted governments. This shows that countries with greater exposure to natural disasters should give more attention to fiscal solvency as the frequency and intensity of weather shocks increase over time.

Abstract

Climate change poses a significant risk to financial stability by impacting sovereign credit risk. Quantifying the exact impact is difficult as climate risk encompasses different components – transition risk and physical risk – with some of these, as well as the policies to address them, playing out over a long time horizon. In this paper, we use a large panel of 52 developed and developing economies over two decades to empirically investigate the extent to which climate risks influence sovereign yields. The results of a panel regression analysis show that transition risk is associated with higher sovereign yields, with the effect more pronounced for developing economies and for high-emitting countries after the Paris agreement. In contrast, high-temperature anomalies do not appear to be priced-in sovereign borrowing costs. At the same time, countries with high levels of debt tend to record higher sovereign yields as acute physical risk increases. In the medium term, using local projections, we find that sovereign yields respond significantly but also differently to different types of disaster caused by climate change. We also explore the nonlinear effects of weather-related natural disasters on sovereign yields and find a striking contrast in the impact of climate shocks on sovereign borrowing costs according to income level and fiscal space when the shock hits.

JEL classification: C23, E62, H63, Q54

Keywords: climate risk, sovereign risk, transition risk, temperature change, natural disasters