Climate Change

and Sovereign Risk

October 2020
This report was prepared by the SOAS Centre for Sustainable Finance at SOAS University of London; the Asian
Development Bank Institute; the World Wide Fund for Nature Singapore; and Four Twenty Seven.
This research has received partial financial support from the International Network for Sustainable Financial Policy
Insights, Research and Exchange (INSPIRE). INSPIRE is a global research stakeholder of the Central Banks and
Supervisors Network for Greening the Financial System (NGFS), and philanthropic support for INSPIRE is provided by
ClimateWorks. The authors thank INSPIRE as well as the NGFS Secretariat for their insightful input and suggestions.
The authors take full responsibility for any errors and omissions contained herein.
The views expressed in this publication are those of the authors and do not necessarily reflect the views and policies
of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Governors or the
governments they represent. ADBI does not guarantee the accuracy of the data included in this publication and
accepts no responsibility for any consequence of their use. The mention of specific companies or products of
manufacturers does not imply that they are endorsed or recommended by ADBI in preference to others of a similar
nature that are not mentioned. By making any designation of or reference to a particular territory or geographic area,
or by using the term “country” in this document, ADBI does not intend to make any judgments as to the legal or other
status of any territory or area. Terminology used may not necessarily be consistent with ADB official terms.
Four Twenty Seven did not contribute to the policy recommendations set forth in this report, and is not responsible
for errors or omissions in the report. Four Twenty Seven is a non-credit rating agency affiliate of Moody’s and is a
publisher and provider of data, market intelligence and analysis related to physical climate and environmental risks.
The views expressed in this report do not reflect the opinions of Moody’s Investors Service.

Contributors
Ulrich Volz (SOAS Centre for Sustainable Finance & German Development Institute)
John Beirne (Asian Development Bank Institute)
Natalie Ambrosio Preudhomme (Four Twenty Seven)
Adrian Fenton (WWF Singapore)
Emilie Mazzacurati (Four Twenty Seven)
Nuobu Renzhi (Asian Development Bank Institute)
Jeanne Stampe (SOAS Centre for Sustainable Finance)

Any correspondence relating to this report should be directed to:

Ulrich Volz
SOAS Centre for Sustainable Finance, SOAS University of London
Thornhaugh Street, Russell Square, London WC1H 0XG, UK
Email: uv1@[Link]

Acknowledgments
We gratefully acknowledge the support, assistance, and insights that we received from participants at workshops in
Singapore, Tokyo and London, as well as from the following individuals: Sara Ahmed, Rousseau Anai, Swisa
Ariyapruchya, Sylvain Augoyard, Anna Batenkova, Carter Brandon, Léonie Chatain, Wong Dan Chi, Marie Diron, Nigel
Foo, Isaam Hanif, David Harris, Irene Heemskerk, Gerhard Kling, Keith Lee, Peter Morgan, Julien Moussavi, Akiho
Nagano, Mary Nicola, Thomas Nielsen, Shanty Noviantie, Will Oulton, Samantha Power, Patrick Raleigh, Nick Robins,
Andre Roux, Anushka Shah, Viktoria Seifert, Fiona Stewart, KimEng Tan, Romain Svartzman, Joanna Woods, and
Naoyuki Yoshino. The views expressed in this report are those of the authors and should not be attributed to any of
the aforementioned or the organizations with which they are affiliated. Special thanks are due to Max Schmidt for
excellent research assistance and Adam Majoe for leading on the editing and layout. We thank Beyond Ratings/FTSE
Russell for providing the data that we have analyzed for this report and Aladdin Rillo for writing the foreword.
Suggested citation: Volz, U., J. Beirne, N. Ambrosio Preudhomme, A. Fenton, E. Mazzacurati, N. Renzhi and
J. Stampe. 2020. Climate Change and Sovereign Risk. London, Tokyo, Singapore, and Berkeley, CA: SOAS University of
London, Asian Development Bank Institute, World Wide Fund for Nature Singapore, and Four Twenty Seven.
To download the report, visit: [Link]
Contents
Figures, Tables, and Boxes v
Foreword vii
Acronyms viii
Executive Summary xi
1. Introduction 1
2. Rating Agencies and Climate Risk 4
2.1 Climate risks in the current methodologies of the “big three” rating agencies 4
2.2 Greater awareness of climate risks for sovereigns 8
3. Transmission Channels of Risk 10
3.1 Natural capital as the basis of economic prosperity 10
3.2 Fiscal impacts of climate-related disasters 17
3.3 Fiscal consequences of adaptation and mitigation policies 20
3.3.1 Fiscal implications of adaptation policies 21
3.3.2 Fiscal implications of mitigation policies 22
3.4 Macroeconomic impacts of climate change 24
3.4.1 Supply shocks 25
3.4.2 Demand shocks 27
3.4.3 Implications for long-run growth and sovereign risk 27
3.5 Climate-related risks and financial sector stability 31
3.5.1 Impact of climate risks on the financial sector 31
3.5.2 The negative feedback loop between financial sector instability and sovereign risk 35
3.6 Impacts of climate change on international trade and capital flows 41
3.6.1 Impacts of climate change on international trade 41
3.6.2 Impacts of climate change on international capital flows 44
3.7 Impacts of climate change on political stability 45
3.8 Summary 48
4. Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial
and Fiscal Stability 50
4.1 Climate risks in Southeast Asia 50
4.2 How can climate change affect sovereign risk in Southeast Asia? 56
4.2.1 Natural capital as the basis of economic prosperity 56
4.2.2 Fiscal impacts of climate-related disasters 58
4.2.3 Fiscal consequences of adaptation and mitigation policies 61
4.2.4 Macroeconomic impacts of climate change 65
4.2.5 Climate-related risks and financial sector stability 69
4.2.6 Impacts of climate change on international trade and capital flows 73
4.2.7 Impacts of climate change on political stability 81

iii
Contents

5. Climate Risk and Sovereign Bond Yields: An Econometric Analysis 85

5.1 Overview and main findings 85
5.2 Climate risk vulnerability, resilience to climate risk, and the cost of sovereign borrowing 85
5.3 Empirical results 87
6. What Are the Implications for Macrofinancial Governance? 90
6.1 Conduct a comprehensive vulnerability assessment and develop a national
adaptation plan 90
6.2 Mainstream climate risk analysis in public financial management 91
6.3 Adjust monetary and prudential frameworks to account for climate risks 94
6.4 Implement financial sector policies to scale-up investment in climate adaptation
and resilience and develop insurance solutions 98
6.5 Provide international support to mitigate and manage climate-related sovereign risk 99
6.6 Summary 100
7. Summary and Recommendations 102
References 105
Appendix to Chapter 5 130

iv
Figures, Tables, and Boxes
Figures
1 S&P’s sovereign issuer criteria framework 5
2 Moody’s primary transmission channels from physical climate change 6
3 Moody’s environmental considerations for sovereigns 6
4 Transmission channels of risk 10
5 Sustainable Development Goals wedding cake 12
6 Relative total GDP purchasing power parity per HydroSHEDS 16
7 Revenue from comprehensive carbon taxation in 2030, selected countries (% of GDP) 24
8 Economic impact of climate change on the world 29
9 Long-term impact of a temperature increase for a representative low-income
developing country 30
10 From physical risk to financial stability risks 31
11 From transition risk to financial stability risks 33
12 Number of relevant weather-related loss events worldwide and overall and insured
losses in US$ billion (in 2018 values), 1980–2018 35
13 Effects of inequality of disadvantaged groups 46
14 Conceptual framework of the direct and indirect effects of climate change on resource
availability and potential conflict and cooperation dynamics 48
15 Change in the number of days in a year where the daily temperature is projected
to exceed the local 90th percentile in 2030–2040 51
16 Change in the number of days in a year when the daily rainfall volume is projected
to exceed the historical local 95th percentile in 2030–2040 51
17 Projected change in wildfire potential in 2030–2040 52
18 Projected water stress risk in ASEAN countries in 2040 53
19 Historical occurrences of extreme weather events in ASEAN, 1900–2019 55
20 Average annual loss as percentage of GDP, by country 58
21 Annual expected fiscal burden arising as a consequence of natural disasters
as a percentage of annual government expenditure 60
22 Estimated probable fiscal burden arising as a consequence of a 1-in-200-year probable
maximum economic loss event as a percentage of annual government expenditure 60
23 Average additional investment required per year, 2016–2030 (US$ billion) 62
24 Proportion of ASEAN transport infrastructure exposed to climate hazards 63
25 Exposure of the Philippines transportation infrastructure to floods 64
26 Role of agriculture in GDP and employment, 2019 68
27 Average annual agricultural loss as percentage of GDP 68
28 Proportion of Viet Nam’s manufacturing facilities exposed to each climate hazard 75
29 Composition of ASEAN countries’ exports, 2018 77
30 Fuel exports (% of merchandise exports) vs merchandise exports as share of GDP 78
31 Fuel imports (% of merchandise imports) vs merchandise imports as share of GDP 79
32 ASEAN countries’ trade balance for goods (in US$ billion), including (straight line)
and excluding (dotted line) mineral fuels 80
33 Carbon footprint of exports (tCO2e/US$) vs exports of goods and services as share
of GDP (%) for ASEAN countries and OECD in 2015 81
34 Political stability and absence of violence and/or terrorism, 2018 82

v
Figures, Tables, and Boxes

35 Cost of sovereign debt and climate risk vulnerability, 2002–2017 86

36 Cost of sovereign debt and climate risk resilience, 2002–2018 86
37 Sovereign bond yields, climate risk, and resilience by country grouping 87
38 The impact of climate risk vulnerability and climate risk resilience on the cost
of sovereign borrowing 88
39 Adaptation cycle under the United Nations climate change regime 91

Tables
1 Fitch Ratings’s sovereign rating criteria 7
2 Fitch Ratings’s environmental relevance score 8
3 Nine “tipping points” that could be triggered by climate change 14
4 Climate-related fiscal risk factors and illustrative climate change channels 18
5 The 20 most damaging natural disasters, 1998–2019 19
6 Basic elements of climate change adaptation 21
7 Estimated rents from the extraction of oil, natural gas and coal resources in G20 countries 23
8 Macroeconomic impacts of climate change 26
9 Percentage loss in GDP per capita by 2030, 2050, and 2100 in the RCP 2.6
and RCP 8.5 scenario 28
10 Risk channels, potential effects and relevant indicators 49
11 Projected water stress ranking for ASEAN countries for 2040 under
a business-as-usual scenario 52
12 Climate Risk Index for 1999–2018 54
13 Impacts of climate-related disasters in ASEAN countries, 2000–2019 55
14 Losses from weather-related events, 1993–2018 56
15 Depletion of natural capital across Southeast Asia 57
16 Historic contingent liabilities of ASEAN countries, 1990–2019 59
17 Emissions and total investment to achieve Nationally Determined Contributions—scenario
and enhanced low-carbon goals in Indonesia and Viet Nam 65
18 Percent loss in GDP per capita in Southeast Asian countries by 2030, 2050, and 2100
under the RCP2.6 and RCP8.5 scenarios 66
19 Impacts of global warming (3°C) on the GDP of Southeast Asian countries 67
20 Projections on the GDP of ASEAN countries under different climate change scenarios 67
21 Percent of manufacturing facilities with at least high risk to climate hazards 74
22 Toolbox of sustainable monetary policy, prudential, and other measures for central banks
and supervisors 95
23 Summary of current regulatory treatment of sovereign exposures under the Basel
regulatory framework 97
24 Overview of policies to mitigate and manage climate-related sovereign risk 101

Boxes
1 The PRI Credit Risk and Ratings Initiative’s statement on ESG in credit risk and ratings 9
2 The Coral Triangle 57
3 Methodology and data 88

vi
Foreword
Climate change is an increasingly important issue for policy makers globally, with material impacts on
Southeast Asian economies and other regions highly vulnerable to climate risks. This report provides a
timely and very comprehensive assessment of the role played by climate change on sovereign risk. In
particular, a number of transmission channels through which climate change affects sovereign risk are
discussed in the report: the fiscal impacts of climate-related natural disasters, the fiscal consequences
of adaptation and mitigation policies, the macroeconomic impacts of climate change, the impacts of
climate risk on financial sector stability, the international trade and capital flow dimension, and the
impact of climate change on political stability. The report provides a thorough examination of how
these transmission channels apply to the economies of Southeast Asia, and shows that there are
substantial risks for the majority of Southeast Asia from a macrofinancial stability perspective. As well
as this, the report provides new empirical estimates on the impact of climate vulnerability on
sovereign risk, with vulnerability to climate change in the economies of the Association of Southeast
Asian Nations (ASEAN) being associated with sovereign bond yield premia of around 155 basis points
on average. Countries with higher exposure to climate risks are shown to incur even higher premia on
their sovereign borrowing costs.
The policy implications outlined in this report should be taken seriously. I would urge policy makers in
Southeast Asia and elsewhere to take particular heed of the recommendations provided in this report
on how to mitigate and manage climate-related sovereign risks. Without taking appropriate measures
to address vulnerability to climate risks, the implications for sovereign risk can have substantial
negative ramifications for financial stability, sovereign financing cost, and, indeed, economic growth.
With this in mind, I would like to draw attention to three of the policy recommendations in the report.
First, I fully concur with the importance for economies to carry out comprehensive climate risk
vulnerability assessments and develop national adaption plans that address macrofinancial risks. This
report provides valuable insights into the dimensions that should be incorporated into any such
assessment. Second, I would like to reinforce further that national governments need to consider the
mainstreaming of climate risk adaptation into their budgetary plans. The scale of the negative
implications of climate risks for sovereign risk require a full integration of climate risks into the public
finance architecture. Third, I would like to highlight the importance of central banks and financial
supervisors in addressing climate-related macrofinancial risks. The report provides a number of
pertinent policy recommendations related to incorporating climate risks into monetary and
prudential frameworks and the importance of financial sector policies to scale-up investment in
climate adaptation. It also highlights the role of international financial institutions in providing
technical assistance on improving adaptive capacity and macrofinancial resilience.
Overall, this report makes an important contribution to our understanding of the links between
climate change and sovereign risk, with concrete recommendations for policy makers on how to deal
with the sovereign risk implications of climate change. I hope that these recommendations will be
widely adopted. We urgently need to scale up our collective efforts to climate-proof our economies
and societies. This report will help us doing so.

Aladdin D. Rillo
Deputy Secretary-General of ASEAN for ASEAN Economic Community

vii
Acronyms
ABS Association of Banks in Singapore
ADB Asian Development Bank
AHA Centre ASEAN Coordinating Centre for Humanitarian Affairs
AMOC Atlantic meridional overturning circulation
AMRO ASEAN+3 Macroeconomic Research Office
ASEAN Association of Southeast Asian Nations
BCBS Basel Committee on Banking Supervision
BoE Bank of England
BoT Bank of Thailand
BNI Bank Negara Indonesia
BNM Bank Negara Malaysia
BSI British Standards Institution
BSP Bangko Sentral ng Pilipinas
CDS Credit default swap
CEIC China Economic Database
CPI Climate Policy Initiative
CRI Climate Risk Index
CTI Carbon Tracker Initiative
DNB De Nederlandsche Bank
EBRD European Bank for Reconstruction and Development
EC European Commission
ECB European Central Bank
EFI European Forest Institute
EM-DAT Emergency Events Database
EME Emerging Economies
ESG Environmental, social and governance factors
ESRB European Systematic Risk Board
EU European Union
FAO Food and Agriculture Organization of the United Nations
FDI Foreign direct investment
gCO2 Grams of carbon dioxide
GDP Gross domestic product

viii
 Acronyms

GFDRR World Bank and Global Facility for Disaster Reduction and Recovery
HS Harmonized Commodity Description and Coding Systems
HydroSHEDS Hydrological data and maps based on Shuttle Elevation Derivatives and
multiple Scales
IAG Insurance Australis Group
ICE Internal combustion engine
ICMA International Capital Market Association
IIF Institute of International Finance
IFRC International Federation of Red Cross and Red Crescent Societies
ILO International Labour Organization
IMF International Monetary Fund
IPBES Intergovernmental Science-Policy Platform on Biodiversity and
Ecosystem Services
IPCC Intergovernmental Panel on Climate Change
IRENA International Renewable Energy Agency
km2 Square kilometer
kW/h Kilowatt-hour
Lao PDR Lao People’s Democratic Republic
LGD Loss given default
MtCO2 Million tons of carbon dioxide
NAP National Adaptation Plan
NDC Nationally Determined Contribution
ND-GAIN Notre Dame Global Adaptation Initiative
NGFS Network for Greening the Financial System
NIC National Intelligence Council
NPL Non-performing loans
OECD Organisation for Economic Co-operation and Development
OMFIF Official Monetary and Financial Institutions Forum
PG&E Pacific Gas and Electricity
PPP Public-private partnerships
PPP Purchasing power parity
PRC People’s Republic of China
PRI Principles for Responsible Investment
QO Qualitative Overlay

ix
Acronyms

RCP Representative Concentration Pathway

RoW Rest of the world
S&P Standard & Poor’s
SBV State Bank of Vietnam
SOE State-owned enterprises
SRM Sovereign Rating Model
SVAR Structural panel vector autoregression
TBA Thai Bankers’ Association
TCFD Task Force on Climate-Related Financial Disclosures
tCO2e Tons of carbon dioxide equivalent
TEEB The Economics of Ecosystems and Biodiversity
UK United Kingdom
UN Comtrade United Nations Commodity Trade Statistics Database
UNCTAD United Nations Conference on Trade and Development
UNDP United Nations Development Programme
UNDRR United Nations Office for Disaster Risk Reduction
UNEP United Nations Environment Programme
UNEP FI United Nations Environment Programme Finance Initiative
UNESCAP United Nations Economic and Social Commission for Asia and the
Pacific
UNFCCC United Nations Framework Convention on Climate Change
VAR Vector autoregression
VIX Chicago Board Options Exchange’s Volatility Index
WAVES Wealth Accounting and the Valuation of Ecosystem Services
WDI World Development Indicators
WFE World Federation of Exchanges
WTO World Trade Organisation

x
Executive Summary
Climate change can have a material impact on sovereign risk through direct and indirect effects on
public finances. It raises the cost of capital of climate-vulnerable countries and threatens debt
sustainability. Governments must climate-proof their economies and public finances or potentially
face an ever-worsening spiral of climate vulnerability and unsustainable debt burdens.
This study focuses on the complex nexus between climate change and sovereign risk, identifying and
scrutinizing six transmission channels through which climate change can amplify sovereign risk and
worsen a sovereign’s standing:
1. Fiscal impacts of climate-related natural disasters
2. Fiscal consequences of adaptation and mitigation policies
3. Macroeconomic impacts of climate change
4. Climate-related risks and financial sector stability
5. Impacts on international trade and capital flows
6. Impacts on political stability
The transmission channels are not independent of each other. Climate impacts can magnify the
transmission of risk through multiple channels. The socioeconomic and fiscal effects of climate
change are multifaceted and depend on the policies taken or not taken to mitigate and adapt to
these risks.
This report illustrates the relevance of the six transmission channels for sovereign risk in Southeast
Asia, one of the most climate-vulnerable regions of the world. Physical risks are expected to
significantly impact economic activity, international commerce, employment, and public finances with
national and regional implications. Transition risks will be prominent as exports and economies
become affected by international climate policies, technological change, and changing consumption
patterns. 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 presents new empirical evidence on the relationship between climate vulnerability,
resilience, and the sovereign cost of capital. Using a sample of 40 developed and emerging
economies, econometric analysis shows that climate risks and resilience to these risks have significant
effects on the cost of sovereign borrowing.
Higher climate risk vulnerability leads to significant rises in the cost of sovereign borrowing. Premia on
sovereign bond yields amount to around 275 basis points for economies highly exposed to climate
risk, compared to 155 basis points for Southeast Asian countries, and 113 basis points for emerging
market economies overall. In contrast, exposure to climate risks is not statistically significant for the
group of advanced economies. We also find resilience to climate risk to be statistically significant in
reducing bond yields across all country groups, but with smaller magnitudes.
Overall, the analysis confirms that climate vulnerability has significant implications for sovereign
borrowing costs, and that the magnitude of the effect is much larger for countries highly vulnerable
to climate change. Impulse response analysis suggests that shocks imposed on climate vulnerability
and resilience have permanent effects on bond yields, and that economies highly exposed to climate
risks experience larger permanent effects on yields than economies with lower exposure.
All branches of government will have to address climate-related risks. Monetary and financial
authorities will have to play crucial roles in analyzing and mitigating macrofinancial risks. We
recommend five broad policy actions to mitigate and manage climate-related sovereign risk in a
coordinated manner.

xi
Executive Summary

First, governments need to conduct comprehensive sectoral and national vulnerability assessments
over multiple timespans to identify climate-related sovereign risk and develop national adaptation
plans. Systematic, scenario-based assessment of all sources of vulnerability for the macroeconomy,
the financial system, and public finances is needed, addressing both physical and transition risks. Such
an assessment could be conducted by a dedicated national climate risk board that should include the
central bank and supervisor along with the key government departments responsible for finance,
economy, planning, and agriculture, among others.
Second, based on vulnerability assessments, financial authorities need to mainstream climate risk
analysis into public financial management. This should include appropriate disclosure, analysis, and
management of climate risks to public finances. Budgetary processes need to account for climate risk
and mainstream climate-relevant policies and laws. Furthermore, finance ministries need to enhance
public sector funding and debt management strategies, including through debt instruments with risk-
sharing features, and diversification of government revenue streams away from high-risk sectors.
Third, central banks and financial supervisors need to address climate-related risks in their monetary
and prudential frameworks and operations. Disclosure of climate and other sustainability risks should
become mandatory, and climate stress tests of financial institutions should be conducted regularly.
Climate-related financial risks should be mainstreamed into macro and micro prudential supervision.
Monetary and prudential measures should be aligned with climate goals. Importantly, supervisors
should reconsider the prudential treatment of sovereign exposures in financial regulation.
Fourth, governments and financial authorities should implement financial sector policies to scale-up
investment in climate adaptation and develop insurance solutions. Monetary and financial authorities
can play an important role in supporting the development of local currency bond markets and fintech
solutions for mobilizing domestic savings for financing climate-resilient, sustainable infrastructure
and other adaptation measures. Developing insurance markets and broadening insurance coverage
can help to enhance the financial resilience of households and businesses and take the burden off
public finances.
Fifth, international financial institutions—including the International Monetary Fund, multilateral
development banks, and regional financing arrangements—have a special role in supporting
vulnerable countries to better address climate-related sovereign risks and strengthen adaptive
capacity and macrofinancial resilience. Building on their respective strengths, they can provide
technical assistance and training, support surveillance and risk monitoring, provide finance for
adaptation and resilience investment, help develop insurance solutions, and provide emergency
lending and crisis support.

xii
1. Introduction
For large countries with solid tax bases and relatively favorable climates, the socialization of
climate risk may be manageable. For smaller, highly exposed island nations, it will be
overwhelming. Before they are physically inundated, their sovereignty will be drowned under
an economic and financial deluge.
(Adam Tooze 2019)

Climate change has emerged as one of the mega-challenges of our time. It poses a potentially
catastrophic threat to humanity. Climate change is threatening livelihoods and will require our
economies to adapt in profound ways. As Weitzman (2011, 275) pointed out, “[d]eep structural
uncertainty about the unknown unknowns of what might go very wrong is coupled with essentially
unlimited downside liability on possible planetary damages.” Even in the most optimistic climate
mitigation scenarios, the effects of global warming are likely to have a substantial impact on our
economies. For many countries, climate change poses a significant risk to their macroeconomic and
financial stability and, as a consequence, threatens to undermine their fiscal and debt sustainability.
For some countries, there is a real danger that climate change will lead to a “fiscal tsunami” (Farmer
2019).
Over the last years, credit rating agencies have started to flag climate change as a potential risk to
sovereign credit ratings,1 and international organizations, including the International Monetary Fund
(IMF) and the World Bank, have acknowledged the macroeconomic and financial risks emanating
from climate change. Moreover, investors are increasingly “recognising the need for a broader
understanding of emerging risks in the bond markets” and the “mounting threat of systemic risks
outside of the financial system, notably environmental risk, which can impact multiple financial
markets” (UNEP FI and Global Footprint Network 2012, 3).
A growing body of research has studied the macroeconomic impacts of climate change (e.g.
Hochrainer 2009; Batten 2018). However, despite the potentially profound implications, little
systematic analysis has been conducted to date on the nexus between climate change and sovereign
risk. Furthermore, no meaningful research has focused thus far on how central banks and supervisors
may integrate the climate–sovereign risk nexus into their operational frameworks to help them
achieve their mandated goals of maintaining price and financial stability, thus contributing to broader
macroeconomic stability. Against this backdrop, this report puts forward an analytical framework for
analyzing the potential impact of climate change on sovereign risk and debt sustainability and
illustrates the relevance of these risk channels for the countries of Southeast Asia, which is one of the
regions that is most vulnerable to climate change. The report also assesses the implications from the
perspective of monetary and financial authorities. While this report focuses on climate risks, we
should emphasize that climate change is not the only environmental risk that can exert an impact on
sovereign risk. In particular, research has increasingly acknowledged that the depletion of natural
capital and biodiversity loss also pose a sovereign risk threat (Pinzón et al. 2020). As the report will
discuss later, climate change and the depletion of natural capital are closely intertwined.

1 Standard & Poor’s Ratings Services describes climate change as “a Global Mega-trend for Sovereign Risk” (S&P 2014a, 1).

1
Climate Change and Sovereign Risk

Sovereign risk is the risk that a government will become unable or unwilling to meet its debt
obligations.2 It has a direct link to fiscal risks, which the International Monetary Fund (IMF) (2018, 95)
defines as “factors that may cause fiscal outcomes to deviate from expectations or forecasts,”
comprising “potential shocks to government revenues, expenditures, assets, or liabilities, which are
not reflected in the government’s fiscal forecasts or reports.” The analysis of fiscal risk has tended to
focus on risks that “have a reasonable chance of materializing during a horizon of a few years” to
“keep the analysis manageable” (Cebotari et al. 2009, 2). Even when adopting a time horizon of a few
years, climate change is a material risk for many countries. The risks, however, are significantly higher
when taking a longer-term perspective. Estimates have put the cost of unmitigated climate change at
23% or more of the global gross domestic product (GDP) by the year 2100 (Burke, Hsiang, and Miguel
2015a). This will inevitably have impacts on public finances and debt sustainability. In the absence of
meaningful mitigation efforts, the world may indeed be at risk of “climate ruin” (Heine and Black
2019, 3).
While climate change is affecting the entire globe, global warming and the associated physical
processes will differ in their manifestation and severity across countries and regions. Poorer countries
with temperate and hot climates will suffer greater output losses. Indeed, the economic effects of
climate change are likely to be disproportionally larger in developing countries, which “are most
vulnerable to extreme events, [and] are projected to experience the strongest increase in
[temperature] variability” (Bathiany et al. 2018, 1) and sea-level rise (Lincke and Hinkel 2018). Some
small developing island states may even vanish entirely (IPCC 2019a). Poorer countries tend to be
economically less diversified and more reliant on sectors that are particularly vulnerable to physical
risk (including agriculture, fishing, and tourism) and transition risk (such as fossil fuel extraction),
while limited financial and institutional resources tend to constrain their capacities to adapt to climate
change. A lack of insurance compounds the risks. A recent study by Moody’s Analytics stated that
“[e]merging economies, oil producers, and those in warmer climates are most vulnerable” and that
the “most draconian effects [of climate change will] occur during the second half of this century”
(Lafakis et al. 2019, 12). As this report will analyze in detail, both physical and transition effects of
climate change can have profound consequences for fiscal sustainability and affect sovereign credit
risk in countries with a less diversified economy and climate impacts on key sectors that generate
high corporate tax revenue and provide large-scale employment.
Sovereign risk matters. Sovereign debt is the single most important asset class. At the end of 2019,
the total amount of outstanding government debt stood at US$70 trillion or 28% of total global
debt (IIF 2020). Government bonds account for 47% of the US$115 trillion global bond market.
Sovereign debt, which is often treated as a risk-free asset, serves as a benchmark for the pricing of
corporate debt. A worsening of sovereign risk means that the refinancing of public debt becomes
more expensive and fiscal space is constrained, limiting the scope for public investment in important
areas such as infrastructure, health, and education. A worsening sovereign risk profile also has
implications for corporate risk (Augustin et al. 2018). Recent evidence has shown a link between the
climate vulnerability of countries and the cost of corporate capital for the firms in these countries
(Kling et al. 2020).

2 As Fitch, the credit rating agency, pointed out, “[c]ountry risk and sovereign credit risk are related but distinct concepts”
(Fitch 2019, 3). Country risk is related to risks to doing business in a given country, including an unpredictable operating
environment, feeble property rights, and a weak legal framework, whereas sovereign credit risk is specifically related to a
government’s payments on its debt obligations.

2
 Introduction

The structure of this report is as follows. Chapter 2 reviews how the major credit rating agencies have
started to analyze climate change as a potential risk for sovereign credit ratings. Chapter 3 dissects
the ways in which climate change can amplify sovereign risk. Subsequently, and building on this
conceptual work, Chapter 4 examines the potential impact of climate change on sovereign risk for the
ten member countries of the Association of Southeast Asian Nations (ASEAN).3 Chapter 5 presents an
empirical analysis of the effects of climate vulnerability on the price of sovereign debt, using a global
sample of 40 advanced and emerging economies. Chapter 6 discusses the implications of the
preceding analysis for macro-financial governance. Finally, Chapter 7 concludes with a summary of
the main findings and insights of this report and puts forward a set of recommendations for monetary
and financial authorities to mitigate climate-related sovereign risk.

3 The members of ASEAN are Brunei, Cambodia, Indonesia, Lao People’s Democratic Republic, Malaysia, Myanmar, the
Philippines, Singapore, Thailand, and Viet Nam.

3
2. Rating Agencies and Climate Risk
Although rating actions mainly caused by environmental factors are not deemed to increase
considerably in the short- to medium-term, they may need to be recognized as a big risk factor
in the long term.
(Hosoda, Ishiwata, and Nagao 2018, 4)

Ratings agencies are increasingly paying attention to the exposure of sovereigns and local
governments to climate risk.4 To date, no major credit rating agency has downgraded a sovereign
based on an explicit attribution to climate risks (Buhr et al. 2018; Tigue 2019). However, when
Moody’s Investors Service (Moody’s) downgraded Sint Maarten in June 2019, the explanation
included “[t]he increase in Sint Maarten’s main debt metrics, resulting from the still-ongoing
economic and fiscal shock following Hurricane Irma’s landing in 2017” (Moody’s 2019a). Further,
ratings agencies are considering climate risks more strongly, though indirectly, in their sovereign
rating methodologies. The agencies’ methodologies of credit analysis themselves still remain vastly
unchanged, but a trend toward using additional tools for climate risk assessment is becoming clear. A
stronger consideration of climate change impacts would most likely lead to further downgrading of
those sovereigns affected the most by climate change, particularly in the global south.
Standard & Poor’s described climate change as a “global mega-trend for sovereign risk” in 2014 and
highlighted that “[t]he impact on creditworthiness will probably be felt through various channels,
including economic growth, external performance, and public finances” (S&P 2014a, 1). It also
emphasized that “lower-rated sovereigns tend on average to be more vulnerable than higher-rated
sovereigns” (S&P 2014a, 10) and that “[s]overeigns will probably be unevenly affected by climate
change, with poorer and lower rated sovereigns typically hit hardest, which could contribute to rising
global rating inequality” (S&P 2014a, 1). Moody’s (2020a) also recently highlighted sea-level rise as a
long-term credit threat to several Asian, Middle Eastern, North African, and small island countries.5

2.1 Climate risks in the current methodologies of the “big three”

rating agencies
S&P’s sovereign issuer criteria framework rests on the five pillars of institutional, economic, external,
fiscal, and monetary assessment (S&P 2017). An ESG Risk Atlas, which comprises a country risk
component for governance risks and natural disasters and a sector risk component in 34 sectors,
informs it (S&P 2019). According to S&P, the energy sector and the consumer products sector are the
most at risk from climate change, for example due to disruptions of supply chains or market
dislocations (S&P 2014b). S&P’s current sovereign rating methodology considers climate risks only as
intermediary variables influencing its key measures of economic, fiscal, and external performance
(S&P 2015b, 2017). It considers natural disasters such as tropical cyclones or floods—as a crucial part
of climate risks—to be responsible for the biggest single rating impacts. While most disaster events
are “relatively benign, and do not cause economic damage of a magnitude that would have any
meaningful repercussions on the credit standing of the sovereigns where they occur,” S&P highlighted

4 More generally, credit rating agencies have started to account for climate change risks across assets. See, for instance,
Mathiesen (2018).
5 In 2017, Moody’s was the first rating agency to place a sub-sovereign entity—the city of Cape Town in South Africa—
under review for downgrading on the grounds of climate-related credit repayment risks.

4
 Rating Agencies and Climate Risk

that, “in the rare cases when severe natural catastrophes hit densely populated and economically
developed areas, they bear large economic costs and are more likely to hurt a sovereign’s credit
standing” (S&P 2015a, 2). Figure 1 summarizes S&P’s sovereign issuer criteria framework.

Figure 1: S&P’s sovereign issuer criteria framework

Note: ICR stands for issuer credit rating.

Source: Compiled by authors based on S&P (2017, 2).

Moody’s bases its assessment of sovereign credit risk on the interplay of four factors: “economic
strength,” “institutions and governance strength,” “fiscal strength,” and “susceptibility to event risk”
(Moody’s 2019b). This methodology does mention climate risks briefly. Moody’s (2016b) has
identified four primary transmission channels through which physical climate change may affect
sovereign risk: (1) impacts on economic activity, (2) damage to infrastructure, (3) social costs, and (4)
population shifts (Figure 2). It views the susceptibility to climate risks as a function of exposure and
resilience. The former includes two dimensions: economic diversification (e.g. the size of the
economy, the concentration of agriculture as a share of the total output, and employment) and
geographic location (e.g. the magnitude and frequency of economic disruptive climate events and the
population density in low-lying areas). Resilience comprises three dimensions: the development level
(income per capita and adaptive capacity), fiscal flexibility (debt burden and debt affordability), and
government policies (e.g. insurance or savings funds to mitigate against natural disasters).

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Climate Change and Sovereign Risk

Figure 2: Moody’s primary transmission channels from physical climate change

Source: Compiled by authors based on Moody’s (2016b, 4).

Figure 3: Moody’s environmental considerations for sovereigns

Source: Compiled by authors based on Moody’s (2018b, 3).

Moody’s has also laid out how environmental, social, and governance (ESG) risks may influence
sovereign ratings (Moody’s 2018b). Environmental credit risks relate to the current and future
“physical conditions in which societies operate” (Moody’s 2018b, 3), including the impact of climate
change and the global transition to less carbon-intensive economic development (Figure 3). Moody’s
has developed a set of tools to improve the transparency of its climate risk-related rating changes,
including ESG taxonomies, a global heat map, and sector scorecards (Moody’s 2018a, 2018c).
Moody’s (2018a) has also published an assessment of the susceptibility of sovereigns’ credit quality to
climate change. It has identified 36 small, agriculture-reliant countries—17 in Africa and 12 in the Asia
and the Pacific region—as being the most susceptible to climate change.
Fitch Ratings bases its assessment of sovereign risk on a “synthesis of quantitative and qualitative
judgements that capture the willingness as well as the capacity of the sovereign to meet its debt
obligations” (Fitch 2019b, 1). The analysis comprises four analytical pillars: structural features;
macroeconomic performance, policies, and prospects; public finances; and external finances
(Table 1). The rating criteria and the rating model make no explicit reference to climate risks or
climate-related shocks. However, Fitch has affirmed that climate factors (and other ESG factors) can
influence each of the four analytical pillars and that increasing climate vulnerabilities could
undermine sovereign ratings (Fitch 2019a).

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 Rating Agencies and Climate Risk

Table 1: Fitch Ratings’ sovereign rating criteria

Macroeconomic
performance,
policies, and
Analytical pillar Structural features prospects Public finances External finances
Input Key criteria factors Governance quality Policy framework Government debt Balance of
Wealth and GDP growth Fiscal balance payments
flexibility of the Inflation Debt dynamics External balance
economy Real effective Fiscal policy sheet
Political stability and exchange rate External liquidity
capacity
Financial sector risks
Sovereign Regression-based, Governance Real GDP growth Gross government Reserve currency
Rating point-in-time rating indicators volatility debt/GDP flexibility
Model model based on GDP per capita Consumer price General government Sovereign net
(SRM) 18 key variables Share in world GDP inflation interest (% of foreign assets (% of
Years since default Real GDP growth revenues) GDP)
or restructuring General government Commodity
event fiscal balance/GDP dependence
Broad money supply Foreign currency Foreign exchange
government reserves (months of
debt/general cover of import
government debt payments)
External interest
service (% of current
external receipts)
Current account
balance + FDI (% of
GDP)
Qualitative Forward-looking Political stability and Macroeconomic Fiscal financing External financing
Overlay adjustment capacity policy credibility and flexibility flexibility
(QO) framework to Financial sector risks flexibility Public debt External debt
provide a subjective Business GDP growth outlook sustainability sustainability
assessment of key environment and (5 years) Fiscal structure Vulnerability to
criteria factors that economic flexibility Macroeconomic shocks
are not explicitly stability
included in the SRM

Source: Compiled by authors based on Fitch (2019b, 2).

Fitch, in an approach similar to that of S&P, relies on the ESG Relevance Scores in its consideration of
climate risks for its sovereign rating (Fitch 2019a, Table 2). Interestingly, it considers environmental
factors to be less impactful on the current ratings than social or governance factors. Only
two sovereigns have an environmental ESG element scored at “4” (“relevant to rating, a rating
driver”), while all the other sovereigns have a score of “3” (“relevant, but only impacts sovereign
rating in combination with other factors”) for at least three out of five environmental risk factors.
S&P acknowledged that lower-rated sovereigns have greater vulnerability to climate change (S&P
2015a). The same holds true for Moody’s (Moody’s 2018b), which, as early as 2016, highlighted that
those countries that are more reliant on agriculture and possess weaker infrastructural and
institutional quality are more susceptible to climate risks (Moody’s 2016b).

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Climate Change and Sovereign Risk

Table 2: Fitch Ratings’ environmental relevance score

General issues Key sovereign issue Sovereign rating criteria references
Greenhouse gas Emissions and air pollution as a SRM—macroeconomic performance, policies, and
emissions and air quality constraint on GDP growth prospects (macro); macro: real GDP growth; QO—
macro: GDP growth outlook
Energy management Management of energy resource SRM—external finances; commodity dependence;
endowments affecting exports, SRM and QO—indirectly affects other SRM variables
government revenue, and GDP and QO judgments
Water resources and Water resource availability and SRM—macro: real GDP growth; QO—macro: GDP
management management as a constraint on GDP growth outlook
growth
Biodiversity and natural Management of natural resource SRM—external finances: commodity dependence;
resource management endowments affecting exports, SRM and QO—indirectly affects other SRM variables
government revenues, and GDP and QO judgments
Natural disasters and Likelihood of and resilience to shocks SRM—structural features: share in the world GDP;
climate change macro: GDP volatility; QO—external finances:
vulnerability to shocks; SRM and QO—potential
impact on other variables

Note: SRM stands for sovereign rating model; QO stands for qualitative overlay.
Source: Compiled by authors based on Fitch (2019a, 5).

Some of the challenges in anticipating the impact of climate risks on sovereigns’ credit profiles relate
to the complexity of the relationship between climate change and rating factors, which involves
widely varying time horizons between increased severity of climate change and impact, the multiple
dimensions of resilience for sovereigns that ultimately determine the impact of exposure to a given
risk, and the many other factors that drive a sovereign rating. Whilst all rating agencies have pointed
out that the impact of climate change on sovereign credit profiles is most likely to grow further over
time and that can be expected the first changes soon, their projections do not extend beyond 2050.
S&P, with its focus on natural disasters as one dimension of physical climate change, highlighted that
they might lead to sudden downgrades by 1.5 notches at once and exacerbate the current negative
sovereign rating impacts due to climate change by as much as 20% (S&P 2015b).
In the case of Moody’s, it is necessary to highlight that the outlined transmission channels result from
the dimensions of climate trends and climate shocks. Hence, phenomena such as sea-level rising can
affect these transmission channels via one or even both of the dimensions simultaneously (Moody’s
2016b). Consequently, low-lying and densely populated states, such as Bangladesh, may become
equally more exposed and less resilient to sea-level rising in general and monsoon-related flooding in
particular due to worsened credit ratings themselves.

2.2 Greater awareness of climate risks for sovereigns

In the meantime, a number of initiatives have taken off. In 2016, the Principles for Responsible
Investment (PRI) launched the “ESG in Credit Risk and Ratings Initiative,” which put forward a
“Statement on ESG in Credit Risk and Ratings” (Box 1), which 20 credit rating agencies, the Big Three,
and 158 investors signed (as of March 2020). The statement highlighted risks at the sovereign and
sub-sovereign level related to “natural resource management, public health standards and corruption
[that] can all affect tax revenues, trade balance and foreign investment” (PRI 2019). In October 2019,
the World Bank launched an online sovereign ESG data portal to facilitate the analysis of sovereign
risk (World Bank 2020).

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 Rating Agencies and Climate Risk

Box 1: The PRI Credit Risk and Ratings Initiative’s statement on ESG in credit risk and ratings

We, the undersigned, recognise that environmental, social and governance (ESG) factors can affect
borrowers’ cash flows and the likelihood that they will default on their debt obligations. ESG factors are
therefore important elements in assessing the creditworthiness of borrowers. For corporates, concerns such
as stranded assets linked to climate change, labour relations challenges or lack of transparency around
accounting practices can cause unexpected losses, expenditure, inefficiencies, litigation, regulatory pressure
and reputational impacts.
At a sovereign level, risks related to, inter alia, natural resource management, public health standards and
corruption can all affect tax revenues, trade balance and foreign investment. The same is true for local
governments and special purpose vehicles issuing project bonds. Such events can result in bond price
volatility, and increase the risk of defaults.
In order to more fully address major market and idiosyncratic risk in debt capital markets, underwriters,
credit rating agencies and investors should consider the potential financial materiality of ESG factors in a
strategic and systematic way. Transparency on which ESG factors are considered, how these are integrated,
and the extent to which they are deemed material in credit assessments will enable better alignment of key
stakeholders.
In doing this the stakeholders should recognise that credit ratings reflect exclusively an assessment of an
issuer’s creditworthiness. Credit rating agencies must be allowed to maintain full independence in
determining which criteria may be material to their ratings. While issuer ESG analysis may be considered an
important part of a credit rating, the two assessments should not be confused or seen as interchangeable.
With this in mind, we share a common vision to enhance systematic and transparent consideration of ESG
factors in the assessment of creditworthiness.

Source: PRI (2019).

9
3. Transmission Channels of Risk
Recent research on the relationship between climate vulnerability, sovereign credit profiles, and the
cost of capital in climate-vulnerable developing countries has shown that these countries incur a risk
premium on their sovereign debt, reducing their fiscal capacity for investments in climate adaptation
and resilience (Buhr et al. 2018; Kling et al. 2018). This raises serious questions regarding the possible
impacts of climate risk on the sustainability of public finances for climate-vulnerable countries, the
fiscal health of which is also under threat from potential 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.
To assess and mitigate climate-related sovereign risk properly, it is important to understand the ways
in which climate change can amplify sovereign risk. In the following, we identify and analyze different
transmission channels, which Figure 4 displays. We first discuss the importance of natural capital and
natural services as the very foundation of economic well-being (3.1) before turning to the different
risk channels that could worsen a sovereign’s standing: the fiscal impacts of climate-related disasters
(3.2); the fiscal consequences of adaptation and mitigation policies (3.3); the macroeconomic impacts
of climate change (3.4); climate-related risks and financial sector stability (3.5); the impacts of climate
change on international trade and capital flows (3.6); and the impacts of climate change on political
stability (3.7).

Figure 4: Transmission channels of risk

Source: Compiled by authors.

3.1 Natural capital as the basis of economic prosperity

Debrun et al. (2019) emphasized the difficulty of assembling and assessing a government’s balance
sheet. Like a corporate balance sheet, a government’s balance sheet lists assets and liabilities.
However, it is not easy to determine the present value of many assets and liabilities. Many items on
the asset side, such as the present value of future tax income, the revenue from future natural
resource extraction, or the value of public infrastructure and cultural treasures, are hard to quantify
as they have no market value and therefore no known price. Likewise, many items on the liability side,
such as pension obligations and contingent liabilities, are very hard to establish. It is therefore also

10
 Transmission Channels of Risk

very difficult to assess a country’s sovereign net worth, which is the difference between its assets and
its liabilities. The exercise becomes even more complicated when trying to account for a country’s
natural capital or its depletion.
All economic activity, and hence a country’s economic and fiscal sustainability, is ultimately
dependent on natural assets and eco-services.6 Continued depletion of natural capital is clearly not
sustainable. As Pinzón et al. (2020, 4) pointed out, “[a]griculture and the soft commodity trade are
heavily linked to natural capital, as drivers of depletion and as processes reliant on a secure stream of
ecosystem services. The value of sovereign bonds relies in part on the management of natural capital
by the countries concerned. However, this dependency is still largely ignored or mispriced in
sovereign bond markets.” While it is difficult, if not impossible, to account for a country’s natural
capital, any analysis of sovereign risk ought at least to consider how trends in the ecosystem may
affect a country’s economic prospects and well-being in the future and the government’s ability to
remain fiscally sustainable.7
How natural capital underpins economies
The natural environment provides the foundation for all societies and economies. It does this through
the provision of natural capital assets and ecosystem services, henceforth “natural capital.”8 Natural
capital assets are natural resources such as forests and rivers. Ecosystem services derive from these
assets. The Millennium Ecosystem Assessment (2003) identified four ecosystem services that
contribute to human well-being:
• Provisioning services: products that people obtain directly from nature (e.g. wild foods, crops,
fresh water, and plant-derived medicines).
• Regulating services: benefits that people obtain from ecosystem processes (e.g. pollutant
filtration by wetlands, climate regulation through carbon storage, pollination, and disaster
risk reduction).
• Cultural services: non-material benefits that people obtain through recreation, spiritual
experience, and educational development.
• Supporting services: ecosystem services that are necessary for the production of all other
ecosystem services (e.g. soil formation, photosynthesis, water cycling, and nutrient cycling).
Natural capital directly or indirectly underpins all economic productivity, social well-being, and
ecological sustainability (TEEB 2011). One of the most published depictions of the Sustainable
Development Goals (SDGs) is the layer cake, developed by the Stockholm Resilience Centre, with
biosphere-related SDGs 6 (Clean Water and Sanitation), 13 (Climate Action), 14 (Life Under Water),
and 15 (Life on Land) underpinning those related to society and economy (Figure 5).
Natural capital can produce benefits in perpetuity if managed sustainably. However, their valuation is
rarely appropriate and there are major inconsistencies in the way in which stakeholders in decision-
making processes value ecosystem services. This has been a major reason for these resources’ and
services’ rapid and severe deterioration (TEEB 2011).

6 This notion is in line with Arrow et al.’s (2004) conceptualization of sustainability as non-decreasing net wealth
of a country.
7 The Wealth Accounting and the Valuation of Ecosystem Services (WAVES) partnership promoted by the World Bank is an
example of an attempt to integrate the accounting of natural resources into development planning to promote
sustainability.
8 For the purposes of this report, we consider biodiversity as a natural capital asset.

11
Climate Change and Sovereign Risk

Figure 5: Sustainable Development Goals wedding cake

Source: Azote Images for Stockholm Resilience Centre, Stockholm University.

Recently, the Intergovernmental Science–Policy Platform on Biodiversity and Ecosystem Services9

estimated that the annual economic value of the world’s terrestrial ecosystem services approximately
equals the global annual GDP (IPBES 2019). A recent report estimated the total asset base of the
ocean to be at least US$24 trillion,10 meaning that, if it were a country, it would be the seventh largest
in the world in terms of asset value (Hoegh-Guldberg 2015). Academic studies have arrived at similar
conclusions, with one seminal study estimating that globally nature provides annual assets and
services worth approximately US$125 trillion, therefore contributing more than twice as much to
human well-being as the global GDP (Costanza et al. 2014).
For many countries, some of their most important economic sectors depend directly on ecosystem
services as inputs into their production or value generation process. These include “nature-
dependent soft commodity” exports resulting from agriculture, aquaculture, and forestry as well as
others, such as tourism. These activities and others are not only of immediate importance to
employment but also have deeper macroeconomic importance, with impacts on the balance of
payments. However, it is important to note that all economic sectors depend on natural capital in one
way or another; even the power generation sector with coal-fired power plants depends heavily on
fresh water to function.

9 The Intergovernmental Science–Policy Platform on Biodiversity and Ecosystem Services is an intergovernmental

organization, the establishment of which aimed to improve the interface between science and policy on issues of
biodiversity and ecosystem services.
10 This conservative value derives from direct outputs (fishing, aquaculture), services enabled (tourism, education), trade
and transportation (coastal and oceanic shipping), and adjacent benefits (carbon sequestration, biotechnology). This
conservative estimate did not include intangible values, such as the ocean’s role in climate regulation, the production
of oxygen, or the spiritual and cultural services provided. Therefore, the actual value is much higher than the
reported figure.

12
 Transmission Channels of Risk

Fresh water is of paramount importance to economic prosperity and stability as it is a key input into
many industries, such as agriculture, textiles, mining, energy, transport, and the beverage industry.
The consequences of climate change will be most apparent through fresh water scarcity. The demand
for fresh water is increasing annually by 1%, with frequent forecasts of supply shortfalls (Boretti and
Rosa 2019). Currently, agriculture and meeting the demands of growing populations consume 70% of
fresh water. Conflict over water usage will increasingly become an issue as the expectation is that, by
2050, the water demand will increase by 55% and the food demand by 60% and approximately half of
the global population will live in water stressed areas (Schlosser et al. 2014; Opperman et al. 2018;
Granzo and Morgan 2019). The management of fresh water is a complicated issue to address as it is
often a transboundary problem requiring international cooperation (cf. Bernauer and Böhmelt 2020).
Low-income and otherwise disadvantaged groups, often those in rural areas, depend
disproportionately on natural capital for their livelihoods and are especially vulnerable to natural
hazards. Natural capital is of particular importance to wealth generation in low-income and
lower–middle-income countries (Lange, Wodon, and Carey 2018).
In addition to being a source of wealth generation, natural capital supports economic stability by
providing protection against natural hazards. Notable examples are wetlands and floodplains, which,
if managed sustainably, will reduce the damage from flooding. Natural capital underpins stable
economies by:
• Improving the ecosystem’s resilience to disturbances—and thus the likelihood that they will
persist and support economic activities.
• Enhancing the protective functions of ecosystems—and thus the degree to which they can
absorb natural hazards and protect economic activities.
• Contributing to social resilience—and thus the likelihood that societies can recover and
continue to function in the face of natural hazards (Monty, Murti, and Furuta 2016).
Economic systems are causing severe decline in natural capital
Across the world, economic activity is undermining the natural environment, and the damage is
accelerating (c.f. TEEB 2011; IPBES 2019). This in turn is causing a severe loss of natural capital assets
and biodiversity and devastating ecosystems and the services that they provide. Many of the
ecosystem services that nature provides are not fully replaceable, and some are not replaceable at all.
Countries need to value, account for, and protect natural capital.
Declining natural capital is a contributing factor behind many natural disasters that threaten
economic resilience, creating negative feedback loops that jeopardize economic growth and stability.
For instance, biodiversity loss and unsustainable land management practices cause soil degradation,
which can increase landslide and flood risk. This can further damage the productive layer of topsoil on
which agriculture depends, which in turn can exacerbate biodiversity loss. This example is especially
pertinent because, between 2012 and 2017, flooding accounted for 71% of natural disasters within
Southeast Asia (AHA Centre 2018).
Instead of sustainably managing natural capital, economies are utilizing ever more of the earth’s
resources. Approximately 33% of the world’s land surface and 75% of freshwater resources are
devoted to agriculture (IPBES 2019). Humans have combined technology with natural capital to
achieve impressive increases in production. Agricultural production has increased threefold since
1970. Forestry production has increased by almost 50%. However, these gains are not sustainable; of
the 18 categories of nature’s contributions that the latest IPBES study assessed, 14 have declined
(IPBES 2019).
In the last century alone, socioeconomic activity has resulted in the loss of 35% of mangrove forests,
40% of terrestrial forests, and 50% of wetlands (TEEB 2011). Overfishing has resulted in the full or
overexploitation of 80% of the world’s fisheries. Estimations have indicated that 60% of ecosystem
services that the natural environment provides have degraded in the last fifty years (TEEB 2011).

13
Climate Change and Sovereign Risk

Biodiversity loss is rampant, increasing, and undoubtedly a result of human activity. Of the estimated
8 million animal and plant species, around 1 million are facing the threat of extinction (IPBES 2019). In
the current period, the loss of species is 100 to 1,000 times greater than in previous geological times
(TEEB 2011; WWF 2018). In 2018, the WWF (2018) reported that humanity had wiped out 60% of
mammals, birds, fish, and reptiles since 1970.
While it always has impacts, the loss and associated cost of natural capital can pass unnoticed. This is
because the value of natural capital is often missing from decisions, indicators, accounting systems,
and market prices (TEEB 2011). The stress to ecosystems can remain unnoticed because many are
resilient up to certain thresholds before experiencing a decline. This decline can be abrupt, severe,
unpredictable, and irreversible. In other words, the risk profile associated with deteriorating natural
capital is nonlinear. For example, coral reef systems are vital biodiversity hotspots and provide
numerous ecosystem services, such as being important nurseries for many fish species. If ocean
waters are too hot over a prolonged period of time, coral reefs bleach rapidly and will die quickly
unless the waters quickly cool to safe levels.
Research is increasingly indicating that we are approaching multiple planetary boundaries. One much-
noted study presented nine planetary processes that regulate the stability and resilience of the earth
as far as it pertains to accommodating human life, concluding that only three natural systems (fresh
water use, stratospheric ozone depletion, and ocean acidification) are currently operating within the
limits, although ocean acidification is close to its safe boundary (Steffen, Kirschenmann, and Korte
2015). Importantly, the study found that we have crossed the safe planetary boundary for climate
change, which will further stress other planetary boundaries, such as fresh water use and ocean
acidification. Further deterioration will trigger multiple “tipping points,” points at which climate
change pushes a part of the earth’s system into abrupt or irreversible change with global implications
(Table 3).

Table 3: Nine “tipping points” that could be triggered by climate change

Tipping point Description Type Implication
Greenland ice sheet Irreversible retreat of the ice sheet as a result of rising Melting Sea-level rise of up to
disintegration temperatures 7 meters
Permafrost loss Abrupt increase in emissions of CO2 and methane Melting Greenhouse gas release
through the thawing of frozen carbon-rich soils
Atlantic meridional Shutdown of the AMOC caused by an increased influx Circulation Disruption to the ocean
overturning circulation of fresh water into the North Atlantic change ecosystem
(AMOC) breakdown Regional cooling
Boreal forest shift A shift in boreal forests, seeing expansion into the Biome shift Regional warming
tundra to the north and dieback to the south Ecological shift
Amazon rainforest Deforestation and hotter, drier conditions causing Biome shift Biodiversity loss
dieback dieback of the rainforest and a shift toward savannah Decreased rainfall
West Antarctic ice Collapse of the ice sheet triggered by persistent Melting Sea-level rise of up to
sheet disintegration grounding-line retreat in one sector, cascading to 3 meters
other sectors
West African monsoon An abrupt change in Sahel rainfall resulting from a shift Circulation Disruption to agriculture
shift northward (wetter) or southward (drier) in the West change Ecosystem change
African monsoon
Indian monsoon shift Strengthening of the monsoon caused by rising CO2 Circulation Disruption to agriculture
emissions or weakening as a result of high aerosol change Greater rainfall extreme
emissions
Coral reef die-off Rising temperatures pushing warm water corals Biome shift Ecosystem change
beyond tolerable levels of thermal stress into an Losses to fisheries and
alternative state dominated by macroalgae tourism

Source: Compiled by authors based on Carbon Brief (2020), which used various academic sources of information.

14
 Transmission Channels of Risk

Climate change will exacerbate the existing decline of natural capital

The impact of climate change as a direct driver of changes in natural environments is likely to increase
over the coming decades. Climate change is expected to have dramatic and adverse effects on natural
capital, even with the achievement of the mitigation goals of the Paris Agreement (IPBES 2019).
Furthermore, climate change will exacerbate the existing degradation of the natural environment and
further diminish natural capital.
The most notable example is coral reefs, which are already in decline and are highly sensitive to
climate change. Climate change is causing oceans to rise, warm, and become more acidic; this is
contributing to the death of coral reefs, with significant implications for food security and livelihoods.
Over 25% of all marine species live in coral reefs, and about 850 million people directly benefit from
their economic, social, and cultural services (WWF 2015), so the loss of these reefs will be
catastrophic. Another example is agricultural practices that have led to the degradation of soils and
made the surrounding landscape much more sensitive to heavy precipitation events and therefore
vulnerable to flooding, which in turn causes more soil degradation.
The natural environment will increasingly be unable to sustain healthy national economies
As the UNEP FI and Global Footprint Network (2012, 3) pointed out, “As resource constraints tighten
globally, countries that depend, in net terms, on levels of renewable natural resources and services
beyond what their own ecosystems can provide may experience profound economic impacts as
resources become more unreliable or costly.” Estimations of the loss in value of ecosystem services
vary, but they all indicate a significant decline, which climate change will exacerbate. Costanza et al.
(2014) calculated the global loss of ecosystem services during the period 1997 to 2011 due to land
use change at US$4.3 to US$20.2 trillion per year.11 A recent analysis by the Global Futures initiative
warned that continued erosion of natural capital at the current levels will lead to deterioration of the
annual global GDP of 0.67% by 2050, equivalent to US$479 billion, and total losses of US$9.87 trillion
between 2011 and 2050 (Roxburgh et al. 2020).12
Deteriorating natural capital means that the natural environment will be less able to support
economic prosperity and stability without major efforts at every level. There are already examples of
deteriorating natural capital and climate change affecting the economy.
An increasingly important area for concern is fresh water scarcity, which already exists in many places
and will increase due to climate change. A recent report found that 19% of the global GDP derives
from areas with high to very high water risk (Figure 6) (WWF and Investec Asset Management 2019.
The effects of freshwater scarcity are already apparent. In 2018, the CDP (2018) reported corporate
losses of US$38.5 billion due to water risks. Examples of material financial risks relating to fresh water
scarcity are higher price volatility of agricultural ingredients, reduced agricultural production, higher
transport costs, greater inconsistency in supply chains, and stranded assets due to shifting production
zones (Ceres 2018). It is an issue that affects every country. In 2018, a drought in Europe, with a link
to climate change, caused the river Rhine in Germany to fall so low that freighters could not transport
goods and materials, denting the GDP. Fresh water scarcity is an issue that reaches all aspects of the
economy. Electricity generation can depend significantly on fresh water and is vulnerable to droughts,
particularly electricity from hydropower and coal power. In 2018, disclosures demonstrated that
water risks caused US$9.6 billion in financial impacts on the power generation industry, often as a
result of increased operating costs, compliance costs, and impacts on assets (CDP 2018).

11 The differences in valuations are dependent on the unit values used.

12 The authors of this study consider these estimates to be highly conservative and not suitable as an assessment of the
total costs of nature’s loss. This is because the model only considers six ecosystem services (those for which there is
enough evidence to quantify). It also does not account for tipping points—thresholds beyond which habitats change
rapidly and irreversibly. The expectation is that future versions of the model will address these problems and further
strengthen the economic case for halting and reversing the deterioration in natural capital. The model also does not
capture climate change and water scarcity and other related environmental changes that are taking place.

15
Climate Change and Sovereign Risk

Figure 6: Relative total GDP purchasing power parity per HydroSHEDS

Source: WWF and Investec Asset Management (2019).

Deteriorating natural capital also increases disaster risk, which undermines economic prosperity and
stability (Monty, Murti, and Furuta 2016). The flooding event that occurred in Thailand in 2011 was so
significant that it had repercussions for the entire global economy. The United Nations Office for
Disaster Risk Reduction (UNDRR) estimated that the flood reduced the world’s industrial production
by 2.5% (Haraguchi and Lall 2015). The increased costs associated with disaster recovery and
rehabilitation mean that fewer resources can be devoted to other activities. According to the UNDRR
(2015), disasters worldwide caused more than US$1.3 trillion in damage from 2005 to 2015, a
significant proportion of which was uninsured.
Deterioration of natural capital will increasingly impact on sovereign risk
Deteriorating natural capital will inevitably become an increasingly core concern for financial
regulators as deterioration continues and climate change impacts increasingly worsen in line with
rising greenhouse gas emissions. Understanding the deterioration of natural capital and the
environmental and climate risks that it poses to economies is the key to profiling economic prospects
and the ability to repay debt at the national level. This has not been lost on sovereign debt investors
and ratings agencies, which are increasingly gauging how a country is using its natural capital (WWF
and Investec Asset Management 2019).
Unfortunately, there has been limited analysis of the impact of deteriorating natural capital on
sovereign debt and risk. There are several reasons for this, most notably the inability of traditional
measures of economic activity, such as GDP, to capture the goods and services that the natural
environment provides (WWF and Investec Asset Management 2019). Additionally, until recently, it
has been difficult to map economic activity as well as the intensity of that activity spatially and to
contrast it with the existing or projected deterioration in natural capital. New advancements in

16
 Transmission Channels of Risk

geospatial data and tools are helping to resolve this issue, particularly in relation to the way in which
sub-national vulnerability can influence national-level vulnerability (WWF and Investec Asset
Management 2019). However, analysis will continue to face the challenge of assessing the possibility
that depletion of natural capital in one geographic area may have a significant economic and credit
impact in other areas, including geographically distant ones.
One of the few studies that has specifically assessed the link between natural capital and sovereign
risk highlighted a stark choice for sovereign bond issuers: actively protecting and enhancing natural
capital and reinforcing the environmental fundamentals of sovereign bonds or instead continuing
with business as usual, which undermines flows of ecosystem services, increases vulnerability to
natural hazards, and intensifies market risk (Pinzón et al. 2020).
Disclosure of nature-related financial risks is required as part of efforts to stabilize economies
and protect long-term growth
Currently, the need for climate-related financial disclosures is receiving a considerable amount of
attention. This is due to the belief that a strong disclosure regime will increase market efficiency,
improve transparency and the accurate pricing of risk, support economic resilience, help to attract
capital, and maintain confidence in capital markets. There is also a belief that disclosures will enable
investors to assess climate change impacts and support them in understanding how climate-related
issues might affect future financial performance.
Deteriorating natural capital poses similar risks and has the potential to create systemic challenges to
global and economic financial systems as well as societies around the world. Consequently, calls for
“nature-related financial disclosures,” similar to climate-related financial disclosures, have recently
gained much traction (see WWF and AXA 2019), leading to the establishment of a Task Force on
Nature-Related Financial Disclosures in July 2020. Nature-related financial disclosures would improve
the understanding and monitoring of the impact of economic activities on nature, ascertain the
amount of impact before the resilience of ecological systems deteriorates, and ensure the integrity of
the ecological systems that provide the foundation of global economic activity (WWF and AXA 2019).

3.2 Fiscal impacts of climate-related disasters

Government finances and countries’ debt sustainability face exposure to different fiscal risks related
to climate disasters. There has been a clear upward trend in the number and severity of climate-
related hazards. Climate scientists have predicted an increase in extreme weather events. Although
the quantification of climate-related fiscal risks is challenging, it is safe to say that the fiscal risks
related to climate change are bound to increase.
The IMF classified fiscal risk into two categories: macroeconomic risks and specific fiscal risks, which
may “arise from the realization of contingent liabilities or other uncertain events, such as a natural
disaster, the bailout of a troubled public corporation or subnational government by the central
government, or the collapse of a bank” (IMF 2018, 95). The IMF’s (2011, 47) Public Sector Debt
Statistics guide defined contingent liabilities as “obligations that do not arise unless a particular,
discrete event(s) occurs in the future.” Whether such an event will happen, whether an obligation will
arise, and its potential size, are uncertain. Explicit contingent liabilities include public guarantees and
other legal or contractual liabilities. Law and contracts do not establish implicit contingent liabilities,
but they may arise because of public expectations or a necessity for the government to intervene.
Implicit contingent liabilities may result from fiscal problems at the sub-national level, the bailout of
public or private corporations or financial institutions, or spending on natural disaster relief (IMF
2011, 2018).
Table 4 provides an overview of the different fiscal risks stemming from climate-related disasters,
following the IMF’s classification of macroeconomic risks and contingent liabilities, respectively.
Macroeconomic risks related to natural disasters and extreme weather include risks of a disruption of

17
Climate Change and Sovereign Risk

economic activity, which may adversely affect tax income and other public revenues and increase
social transfer payments (e.g. Schuler et al. 2019); changes to commodity prices that could affect
revenue or increase spending via fossil fuel or food subsidies; effects on inflation and interest rates
through supply or demand shocks; and exchange rate effects (e.g. Farhi and Gabaix 2016).

Table 4: Climate-related fiscal risk factors and illustrative climate change channels
Risk factor Climate change channels
Macroeconomic risks
Economic growth (GDP or Drought, excessive rainfall, storms, etc. cause shocks to economic growth by disrupting
industry-level growth) agriculture, fishing, mining, tourism, transport, hydro-power, insurance, etc., and affect
revenue and spending
Reduced income tax revenue if climate hazards affect workers’ health and productivity,
employment, and output
Payouts for unemployment insurance and other social protection schemes differ from the
planned level
Extreme weather events in other countries can potentially boost the demand for exports or
affect commodity prices
Trade Changes and disruptions to trade affect customs duty collection
Commodity prices The increased severity and likelihood of extreme weather events in large producers increase
the volatility of world commodity prices
For extractives exporters: the government revenue differs from the expected level
Changes in agricultural prices may affect domestic farm and food subsidy spending
Interest rates Shortages in food or energy supply, among others, may cause inflation spikes
Exchange rates A disaster may cause devaluation of the currency and increase external debt service costs
Government procurement spending on imports differs from expectations
Contingent liabilities
Physical damage of public Destruction of government buildings or damage to public infrastructure through climate-
assets related disasters
Unexpected spending on the repair and reconstruction of government buildings and other
public assets
Unexpected relief and recovery spending; possible spending to cover private sector losses
(including, for example, government-run fire, flooding, and crop insurance)
State-owned enterprises SOEs suffer losses due to damage or lost revenue resulting from operation disruptions from
(SOEs) extreme weather events; increased costs for carbon-intensive operations
Sovereign loan guarantees are called
Expectation that the government will cover SOE losses
Public–private Infrastructure PPPs suffer damage or losses from extreme weather events
partnerships (PPPs) Contractual obligations (for example, service-level guarantees)
Expectation that the government will cover losses if the project fails
Humanitarian crisis and Changing climate and increased severity and likelihood of extreme weather events may affect
public health emergency the spread of vector-borne diseases, deaths from heat events, etc.
Increased health spending
Emergency relief and aid social safety net
Judicial awards Courts may determine that governments are liable for climate adaptation measures

Source: Compiled by authors, in part drawing from Schuler et al. (2019, Table 4.1).

There are several explicit and implicit contingent liabilities that expose governments to fiscal risks
(Mitchell, Mechler, and Peters 2014; Hochrainer-Stigler 2018; Schuler et al. 2019). Natural disasters
may damage or destroy physical government assets and public infrastructure. Governments may
hence have to spend on damage repair or reconstruction. Natural disasters may also affect the assets
or operations of state-owned enterprises (SOEs). This could diminish the asset value of SOEs or affect
dividend payments to the government. Governments may also have to realize contingent liabilities
and step in to bail out SOEs that a disaster has hit hard. Disasters may damage or destroy private

18
 Transmission Channels of Risk

property and require government support for households and corporations to rebuild homes and
businesses. To the extent that disasters cause instability to the financial sector, they may force
governments to bail out ailing financial institutions (cf. Section 3.5). Last but not least, disasters can
cause a severe humanitarian crisis, which may require public emergency measures, including rescue
missions, temporary relocation of people, provision of food and shelter, or medical treatment. Such
crisis response measures can be very expensive and have a significant impact on public spending.
Bova et al.’s (2019) analysis of contingent liability realizations in a sample of 80 advanced and
emerging economies for the period 1990–2014 showed that natural disasters (including geophysical
events) are one of the most important sources of contingent liabilities, the realization of which can be
a substantial source of fiscal distress.
Table 5 provides an overview of the 20 most damaging natural disasters, relative to the afflicted
countries’ GDP, in the period 1998–2019. By far the most damaging disaster was Hurricane Maria, in
2017, which caused estimated damage equaling 260% of Dominica’s GDP. In 2004, Hurricane Ivan
destroyed around 150% of Grenada’s GDP. Historically, climate-related disasters have inflicted the
most damage on small, disaster-prone countries (Cantelmo, Melina, and Papageorgiou 2019). Small
disaster-prone states also display higher volatility of tax revenue (Cabezon et al. 2015). It is therefore
not surprising that disaster-prone economies face significantly higher public debt than economies
that are less susceptible to disasters (Cabezon et al. 2015; Munevar 2018) and that natural disasters
have in the past been contributing factors to sovereign debt defaults (Moody’s 2016a, 2020b).13

Table 5: The 20 most damaging natural disasters, 1998–2019

Damage Disaster-prone Small
Country Year Type Name (% of GDP) country economy
Dominica 2017 Storm Hurricane Maria 260.0 Yes Yes*
Grenada 2004 Storm Hurricane Ivan 148.0 Yes Yes*
Dominica 2015 Storm Tropical Storm Erika 90.2 Yes Yes*
Honduras 1998 Storm Hurricane Mitch 72.9 No No
The Bahamas 2019 Storm Hurricane Dorian 66.0 Yes Yes*
Guyana 2005 Flood N.A. 35.5 No Yes*
Belize 2000 Storm Hurricane Keith 33.4 Yes Yes*
Tonga 2001 Storm Tropical Cyclone Waka 29.0 Yes Yes*
Belize 2001 Storm Hurricane Iris 28.7 Yes Yes*
Haiti 2016 Storm Hurricane Matthew 25.1 Yes Yes**
Nicaragua 1998 Storm Hurricane Mitch 21.3 No No
Samoa 2012 Storm Cyclone Evan 16.6 Yes Yes*
Tajikistan 2008 Ex. temp. N.A. 16.3 Yes Yes**
Mozambique 2019 Storm Tropical Cyclone Idai 16.0 Yes Yes**
Fiji 2016 Storm Tropical Storm Winston 12.9 Yes Yes*
Myanmar 2008 Storm Cyclone Nargis 12.6 No No
Guyana 2006 Flood N.A. 11.6 No Yes*
Thailand 2011 Flood N.A. 10.9 No No
Notes: The computation for damage (% of GDP) uses data for each single event. Small economies comprise small states and low-
income countries. * denotes small states, which are countries with a population below 1.5 million that are not advanced economies
or high-income oil-exporting countries (IMF). ** denotes low-income countries, which are countries with a GNI per capita below
$995 in 2018.
Source: Compiled by authors using data from the Emergency Events Database (EM-DAT) and the World Bank’s World Development
Indicators (WDI) database and from Cantelmo, Melina, and Papageorgiou (2019).

13 Hurricane Ivan, which caused damage of more than 200% of its GDP, prompted Grenada’s sovereign debt restructuring
during the period 2004–2006 (Moody’s 2016a; Asonuma et al. 2018). The Dominican Republic’s sovereign debt
restructuring in 2005 was also partly due to damage caused by hurricanes in the two preceding years (Moody’s 2016).

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Climate Change and Sovereign Risk

The economic and fiscal losses resulting from a disaster depend on the intensity of the disaster, the
vulnerability of the population and key industries, the physical resilience of the infrastructure and
buildings, the quality of the crisis response, and the speed of recovery. The amount of the costs borne
by governments themselves after natural disasters will vary based on how much infrastructure they
choose to or are able to rebuild or repair and based on how international financial institutions
support rebuilding efforts. The fallout also depends on the extent to which insurance covers assets
and economic activities. The empirical evidence suggests that the uninsured part of catastrophe-
related losses drives the macroeconomic costs (Von Peter, von Dahlen, and Saxena 2012; Cebotari
and Yousseff 2020), while insurance boosts financial resilience and supports the speed of recovery
(Tesselaar, Wouter Botzen, and Aerts 2020). A major problem, however, is that many risks are not
insurable or are insurable only at premiums that are unaffordable (IFRC 2018).
Melecky and Raddatz (2011) examined the effects of geological, climatic, and other natural disasters
on public expenditures and revenues in 81 middle-income and high-income countries over the period
1975–2008 and found that government expenditure increased on average by 15% while government
revenue fell by 10% over the five years following a natural disaster. They also found that countries
with low insurance penetration experience greater expansion of fiscal deficits (by 15%) whereas
government deficit remains unchanged in those with high insurance penetration. Using synthetic
control analysis, Koetsier’s (2017) investigation of the impact of natural disasters in 163 countries for
the period 1971 to 2014 revealed a significant surge in government debt following the most
damaging and deadliest disasters. On average, public debt rises by 11.3% of the GDP in comparison
with a synthetic control group, with a median effect of 6.8% of GDP. Some natural disasters cause an
increase in the debt-to-GDP ratio of over 20%.
Overall, it is clear that climate-related natural disasters pose a significant risk to sovereign debt
sustainability through both macroeconomic and contingent liability risks. Despite the complexities
involved in modeling these risks, it is crucial for fiscal sustainability analysis to incorporate climate
disaster scenario analysis. Risk projections of disaster losses and their fiscal implications need to
include changes to exposure and vulnerability under different climate pathways (Bouwer 2011).
Schuler et al. (2019) provided an example of fiscal sustainability analysis that aimed to quantify the
range and likelihood of potential fiscal consequences of alternative natural disaster scenarios. This
analysis included the simulation of stochastic shocks to important macroeconomic variables and
projections of public finance variables and the way in which shocks may affect them.
Of course, it will also be important to mitigate fiscal risk through adaptation policies. Bouwer et al.
(2007) emphasized that disaster risk reduction ought to be at the center of climate adaptation
policies and put forward three recommendations: (i) improve data collection for a better evaluation
of disaster policies, the identification of the factors driving loss trends, and the development of early
warning systems; (ii) expand the role of disaster risk reduction in adaptation; and (iii) develop and
apply innovative finance mechanisms including insurance and risk transfer instruments.

3.3 Fiscal consequences of adaptation and mitigation policies

Adaptation and mitigation policies are indispensable for responding to the challenges that climate
change poses. To achieve the Paris climate goals and limit global warming to manageable levels, large
investments are needed in a low-carbon transformation of infrastructure and energy systems.
Moreover, economies need to invest in resilience to address vulnerabilities from extreme weather
events and the effects of gradual global warming. The Global Commission on the Economy and
Climate (2016) estimated that globally, until 2030, it will be necessary to spend around USD90 trillion
on infrastructure, including energy, all of which needs to be sustainable and climate resilient. While
the private sector has to finance parts of these investments, governments will have to play an
important role in setting the right incentives through climate policies such as carbon prices/taxes,

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 Transmission Channels of Risk

border adjustments, and prudential frameworks for financial institutions. Moreover, the public sector
will have to finance a considerable share of adaptation and mitigation measures directly.14

3.3.1 Fiscal implications of adaptation policies

Public adaptation to climate change affects public budgets directly on the expenditure side
(e.g. Bachner, Bednar-Friedl, and Knittel 2019). Adaptation costs comprise all the expenses associated
with policies and measures aimed at easing the environmental, social, and economic impacts of
climate change, both preventive and remedial (Forni, Catalano, and Pezzolla 2019). The Global
Commission on Adaptation (2019) emphasized the need to invest strategically to reduce exposure
and vulnerability, prepare for climate impacts, and develop schemes that help recovery (Table 6).

Table 6: Basic elements of climate change adaptation

Reduce (and prevent) Prepare (and respond) Restore (and recover)
• Agriculture research and • Early warning systems • Insurance and risk finance
development • Forecast-based action (contingency instruments
• Climate-proofing buildings and planning) • Social safety nets
infrastructure • Strengthen first responders • Recovery services, including health
• Land use planning • Temporary evacuation and education
• Nature-based solutions to protect • Build back better
people and assets
• Permanent relocation (migration)

Source: Replicated by authors from Global Commission on Adaptation (2019).

The 2016 Adaptation Finance Gap Report estimated the costs of adaptation at between
US$140 billion and US$300 billion per year by 2030 and between US$280 billion and US$500 billion
per year by 2050, with potentially higher costs for worse emission pathways (Puig et al. 2016).
However, Neufeldt et al. (2018) pointed to the existence of major information gaps and emphasized
that particularly the omission of adaptation cost estimates for biodiversity and ecosystem services is
likely to increase the overall cost of adaptation further. Adaptation finance in 2016 amounted to only
USD22 billion (Oliver et al. 2018). There is general agreement that the current amounts financing
adaptation, both public and private, are insufficient (e.g. Micale, Tonkonogy, and Mazza 2018). This is
despite the dividends that adaptation investment generates (Tanner et al. 2015).
To scale up adaptation finance (as well as mitigation finance), multilateral development banks (MDBs)
have advanced the “billions to trillions” agenda to “unlock, leverage, and catalyze private flows
and domestic resources” (African Development Bank et al. 2015, 2). The idea is to use official
development assistance, or “blended finance,” to mobilize private capital for investment in
sustainable development. Critics of this approach have raised concerns about the financial stability
risks associated with “the escorting of international capital by multilateral development agencies into
frontier and emerging market settings” (Carroll and Jarvis 2014, 540). A fundamental problem of
initiatives aimed at leveraging private investment by “de-risking” is that the risk itself does not
disappear but merely shifts to public balance sheets (Mazzucato et al. 2018). This may create new
contingent liabilities (cf. Section 3.2).

14 Some have argued that the private sector should conduct adaptation measures and that the role of the government is
limited to setting the right incentives (e.g. Tol 2005; Jones, Keen, and Strand 2013).

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Climate Change and Sovereign Risk

In particular, concerns have been raised that issues around the “complexity, accountability and
transparency” of blended finance (Mawdsley 2018, 194) and the growing risks of related financial
innovation and over-financialization in developing economies (Akyuz 2017) may contribute to debt
crises. Financial stability risks may also arise from the fact that both development finance institutions
and private financers usually provide finance only in international currency, which leaves borrowers
with foreign exchange risk.15 UNCTAD (2019a, viii) stated critically that “the focus of the development
finance agenda on complex – and mostly non-transparent – new financial instruments and on
securitized finance, does not bode well for its ability to deliver reliable financing at the required scale
to where it is most needed.” UNCTAD’s (2019) estimations for a group of 31 developing countries
suggest that public debt-to-GDP ratios would have to rise from 47% to 185% to finance basic
investments to meet the SDGs in poverty, nutrition, health, and education if financed through debt
(alternatively, countries would have to grow at an average of 11.9% p.a.). Many of these investments
have a link to adaptation.
Especially lesser developed economies tend to have a relatively low debt servicing capacity and are
vulnerable to the build-up of external debt. Since these are the countries with the greatest needs for
adaptation finance, it will be important to develop robust debt management frameworks and limit
risk exposure to international debt financing.

3.3.2 Fiscal implications of mitigation policies

Mitigation costs comprise all the expenses associated with policies and efforts aimed at reducing or
preventing greenhouse gas emissions to limit global warming (Forni, Catalano, and Pezzolla 2019).
Climate change mitigation will require substantial investment in low-carbon sources of energy, which
will strain public finances. The IPCC (2018) estimated that USD1.6–3.8 trillion annually will be
necessary for investment in energy systems alone to limit global warming to 1.5°C. As discussed in the
context of adaptation finance, there is a risk that the necessary investments will overstretch public
finances and that opaque and complex financing practices will lead to higher debt burdens than
expected.
There are, however, further impacts that mitigation policies, both at home and abroad, may have on
public finances. Various “transition drivers” could trigger a (forced) decline of high-carbon industries
and cause macroeconomic disruptions (Semieniuk et al. 2020). These may require greater public
spending to offset the reduction in private investment and consumption, public support programs for
regions particularly affected by the transition, higher budget deficits because automatic stabilizers will
lead to higher social spending, or a bailout of dwindling financial institutions that failed to mitigate
the transition risk (cf. Section 3.5).
A low-carbon or even zero-carbon transition would inevitably have to involve the phasing out of
fossil fuels. This could cause trouble for governments that currently rely to a high degree on revenues
from fossil fuels. As can be seen in Table 7, some governments rely heavily on revenues from the
extraction of oil, natural gas, and coal resources. These make up 5.6% for G20 countries on average,
with France, Germany, Japan, the Republic of Korea, and Turkey earning (almost) no revenue from
fossil fuel extraction on the one side and the Russian Federation, where a third of government
revenues, and Saudi Arabia, where the government’s entire revenues stem from fossil fuel extraction,
on the other side. Clearly, governments that rely on fossil fuel revenue face high transition risks
and need to diversify their revenue streams away from fossil fuels (OECD, World Bank, and UN
Environment 2018).16

15 For a discussion of the shortcomings of blended finance in leveraging private capital, see Attridge and Engen (2019).
16 Morris, Kaufman, and Doshi (2019) analyzed the risk of fiscal collapse in coal-reliant communities in the US. They
emphasized that the coal industry is “an important contributor to local government finances through a complex system of
property, severance, sales, and income taxes; royalties and lease bonuses for production on state and federal lands; and
intergovernmental transfers” in 26 “coal-mining dependent” US counties.

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 Transmission Channels of Risk

Table 7: Estimated rents from the extraction of oil, natural gas and coal resources in G20 countries
Share of total
Estimated rent Share of GDP government revenue
(US$ billion) (%) (%)
2001– 2006– 2011– 2001– 2006– 2011– 2001– 2006– 2011–
Period average 2005 2010 2016 2005 2010 2016 2005 2010 2016
G20 (excl. European Union) 483 1,015 1,032 1.6 2.3 1.8 4.8 7.1 5.6
Argentina 6 12 11 3.6 3.6 2.0 16.4 13.3 6.1
Australia 8 25 24 1.6 2.7 1.7 4.6 7.9 4.9
Brazil 11 29 37 1.8 1.8 1.6 5.1 5.0 4.9
Canada 35 46 24 3.8 3.2 1.4 9.4 8.1 3.6
People’s Republic of China 51 180 184 2.9 4.1 1.9 18.2 18.3 6.8
France 0 0 0 0.0 0.0 0.0 0.0 0.0 0.0
Germany 2 5 3 0.1 0.1 0.1 0.2 0.3 0.2
India 13 37 41 2.2 2.9 2.1 11.9 14.8 10.3
Indonesia 11 27 30 5.0 5.3 3.3 27.1 31.8 22.6
Italy 1.0 2.0 3.0 0.1 0.1 0.1 0.2 0.2 0.3
Japan 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Mexico 27 50 47 3.5 4.9 3.9 17.6 21.1 16.7
Republic of Korea 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Russian Federation 82 195 230 16.9 14.5 12.2 44.8 38.6 33.8
Saudi Arabia 91 205 276 38.7 45.2 39.3 101.4 104.6 102.9
South Africa 5 12 9 2.8 4.0 2.5 11.5 14.5 8.8
Turkey 1 2 1 0.2 0.2 0.1 0.5 0.8 0.4
United Kingdom 17 26 19 0.8 1.0 0.7 2.3 2.6 1.9
United States 119 162 94 1.0 1.1 0.5 3.3 3.8 1.8
Rest of World 304 751 857 3.8 5.4 4.9 3.2 15.8 15.8
OPEC (excl. Saudi Arabia) 178 457 531 26.4 26.9 25.1 30.4 78 84.5
World 787 1,766 1,889 2.0 3.0 2.5 4.0 9.0 7.7

G20 = Group of Twenty, OPEC = Organization of the Petroleum Exporting Countries.

Source: Compiled with data from OECD, World Bank, and UN Environment (2018).

The decline of fossil fuel and other carbon-intensive industries may increase public social expenditure
to cushion the effects on unemployment. It may also require public investments to support structural
change in regions that the low-carbon transition affects badly to create new opportunities for
“stranded workers.” For instance, the European Union—where the coal sector and directly linked
activities employ 238,000 people—has announced funding plans to ease the socio-economic
consequences for coal regions, including a “Just Transition Fund” (Widuto 2019). Importantly, the loss
of jobs in carbon-intensive industries may be offset by good structural and industrial policies. Based
on empirical evidence from India, Ethiopia, and Mexico, Norton et al. (2020) highlighted the potential
of employment-based social assistance to address the “triple challenges of global inequality, climate
change and biodiversity loss.”
At the same time, a low-carbon transition could generate significant public savings, for instance from
phasing out fossil fuel subsidies. The IMF’s estimates put global subsidies for fossil fuel energy at
US$5.2 trillion in 2017, equal to 6.5% of the world GDP (Coady et al. 2019).17 By promoting greater

17 Coady et al. (2019, 2) defined fossil fuel subsidies “as fuel consumption times the gap between existing and efficient
prices (i.e. prices warranted by supply costs, environmental costs, and revenue considerations).”

23
Climate Change and Sovereign Risk

fossil fuel consumption, which disproportionally benefits the wealthiest parts of the population
(Coady, Flamini, and Sears 2015), fossil fuel subsidies exacerbate air pollution, which has dire
consequences for human health (Watts et al. 2019) and public health expenditure.
Moreover, governments could generate substantial revenue from carbon taxes, which they could use
for adaptation and mitigation investment or for financing a “just transition.” The IMF (2019a)
estimated that a tax of US$75 per ton of carbon would generate revenue amounting to 1.6% of the
GDP for G20 countries on average (weighted by the GDP). As Figure 7 shows, the revenue from
carbon taxes would vary considerably across the G20 countries, ranging from 0.6% of GDP in France
to 4.4% in the Russian Federation.

Figure 7: Revenue from comprehensive carbon taxation in 2030, selected countries (% of GDP)

Source: Compiled by authors with data from IMF (2019a).

It is impossible to give a wholesale assessment of the fiscal implications of mitigation policies as these
will depend very much on the structure of an economy and the specific policies that countries adopt
both domestically and internationally. The overall fiscal impact of introducing carbon taxes, phasing
out fossil fuel subsidies, and foregoing rents from the extraction of oil, natural gas, and coal resources
will differ across countries, as will the costs of structural change. It is apparent, however, that the
implications for public finances will be greater in economies centered on carbon-intensive activities
and those in which the government relies heavily on revenues from fossil fuel extraction. In addition,
as Huxham, Anwar, and Nelson (2019, 11) pointed out, “[w]ell managed and less concentrated risk
can facilitate the transition and lower its cost in countries across the world.”

3.4 Macroeconomic impacts of climate change

The physical and transition impacts of climate change can cause aggregate supply and demand
shocks. Table 8, which is loosely based on a taxonomy that Batten, Sowerbutts, and Tanaka (2018)

24
 Transmission Channels of Risk

proposed, shows different types of supply- and demand-side shocks that may result from either
physical or transition climate impacts. We will discuss them briefly in turn.

3.4.1 Supply shocks

Supply shocks affect an economy’s production or productive capacity and, accordingly, their actual or
potential output. Climate change may exert an impact on the aggregate supply in various ways
(e.g. Cœuré 2018; Batten, Sowerbutts, and Tanaka 2020).
As Section 3.2 discussed, extreme weather events can interrupt production, damage the capital stock
and infrastructure, or diminish the output in the agriculture, forestry, and fishing industries. They can
also disrupt transport routes and value chains and cause input shortages (see Section 3.6 for a more
detailed discussion). Climate disasters may divert resources from innovation to reconstruction and
replacement. Importantly, they can cause shocks to local labor markets (e.g. Belasen and Polachek
2009; Kirchberger 2017). With extreme weather events becoming more frequent, some have argued
that climate-related supply shocks may be “no longer temporary but close to permanent” (Debelle
2019, 4).
Gradual global warming can also cause supply shocks. Predictions indicate that climate change will
have a significant impact on land use through sea-level rise, desertification, and land degradation,
among others (IPCC 2019b; Kulp and Strauss 2019), as well as on marine ecosystems (IPCC 2019a). All
these can affect the productive capacity in agriculture, forestry, fishing, and other industries that
directly rely on ecosystems (cf. Section 3.1). Although macroeconomics has generally viewed land as a
production factor of relatively little importance (Hubacek and van den Bergh 2006), climate change
may impose new constraints on land use (e.g. Hertel 2018; Froese and Schilling 2019). Climate change
could also have substantial effects on the number of hours worked due to extreme heat and on labor
productivity (Burke, Hsiang, and Miguel 2015a; Day et al. 2019). Burke, Hsiang, and Miguel’s (2015a)
analysis of data on economic production for 166 countries over the period 1960–2010 revealed
nonlinear effects of temperature on economic production. They found that economic productivity
peaks at around 13°C, with higher temperatures causing productivity to decline. Colder countries
hence benefit from global warming up to a certain point, while temperate and hot countries
suffer. Building on Burke, Hsiang, and Miguel’s (2015a) analysis with expanded data coverage, the
IMF’s (2017) estimates indicate that a 1°C temperature rise from 25°C would reduce growth by
1.2 percentage points for the same year for a median low-income developing economy. Furthermore,
alterations in the physical environment could make living conditions in some regions unbearable and
cause large-scale migration, which would affect the labor supply. Impacts on productive assets
(e.g. loss of production sites through a sea-level rise) could affect capital stock. The need for
investment in adaptation may divert resources away from productive investment or spending on new
technologies, although adaptation investment could also spur innovation.
Supply-side shocks can also be a result of transition impacts (McKibbin et al. 2017). In particular,
climate policies can lead to stranded assets and stranded technology (Bos and Gupta 2019; Semieniuk
et al. 2020). There is a risk that structural change of an economy away from high-carbon and toward
low-carbon sectors will render parts of the workforce unemployed if the sectors that previously
employed them cease. If work skills are not transferable to other industries, this could lead to a
problem of “stranded workers” or migration. Climate policies may constrain the use of land or
ecosystem services, with impacts on an economy’s output potential. Climate policies could also lead
to substantive changes in the energy supply. It is not clear, however, whether decarbonization
policies and the development of new renewable energy sources would amount to a negative or a
positive supply shock.

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Climate Change and Sovereign Risk

Table 8: Macroeconomic impacts of climate change

Physical impacts
From extreme From gradual
weather events global warming Transition impacts
Demand Investment Damage to household and Changes to household and Effects on household and
corporate balance sheets corporate balance sheets corporate balance sheets
causes reduction of affect investment Growing demand for
investment responsible investment
Public investment push
(“green new deal”)
“Crowding out” from
climate policies
Consumption Loss of income and Effects on household income “Crowding out” from
damage to household Wealth effects due to climate policies
balance sheets reduce changes in property prices Changes of consumption
consumption Effects on corporate balance patterns because of a shift
sheets in preferences or taxation
Effects on public finances (e.g. carbon taxes)
Shifts in demand from
migration or political
instability
Wealth effects due to share
and bond prices
Effects on public finances
Trade Disruption to Changes to patterns and Distortions from
import/export flows due volumes of trade asymmetric climate policies
to climate disasters Changes to patterns and
volumes of trade
Supply Labor supply Loss of hours worked due Loss of hours worked due to “Stranded labor” Migration
to climate hazards extreme heat effects
Labor productivity effects of
climate change
Migration effects
Natural capital Loss of arable land, Climate policies may
biodiversity loss, water stress constrain/restrict the use of
land or ecosystem services
Energy, food, Food and other input Changes to the energy
and other inputs shortages (e.g. through supply through
supply chain disruptions) decarbonization policies
and new renewable energy
sources
Capital stock Damage due to extreme Loss of productive assets Stranded assets
weather Diversion of resources from Diversion of resources from
productive investment to productive investment to
adaptation capital mitigation capital
Technology Diversion of resources Diversion of resources from Technology may become
from innovation to innovation to adaptation stranded
reconstruction and capital Uncertainty about the rate
replacement of innovation and adoption
of low-carbon technologies

Source: Compiled by authors based on the taxonomy of Batten, Sowerbutts, and Tanaka (2018).

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 Transmission Channels of Risk

3.4.2 Demand shocks

As Batten, Sowerbutts, and Tanaka (2020) pointed out, climate change impacts can also cause
demand-side shocks. Extreme weather events can reduce household income and wealth and
therefore private consumption. Furthermore, damage to corporate balance sheets can lead to a
reduction of investment. However, after the initial stage of loss, a period of recovery, during which
the rebuilding of infrastructure and production sites and the replacement of stocks give a temporary
boost to investment and consumption, typically follows natural disasters (IMF 2016). A negative
demand shock is more likely to occur when a large share of losses is uninsured (Batten, Sowerbutts,
and Tanaka. 2016). Extreme weather events can also affect the international demand for goods and
services (cf. Section 3.6).
Furthermore, slow-onset changes to global warming can lead to structural economic changes, which
may affect the aggregate demand through effects on household income (e.g. income from farming or
fishery), wealth effects (e.g. through changes in property prices), effects on corporate balance sheets,
or effects on public finances. Global warming may also exert an impact on investment through effects
on household and corporate balance sheets. Last but not least, global warming can influence the
patterns and volume of trade, which we will discuss in greater detail in Section 3.6.
Climate policies aimed at advancing the transition to a low-carbon economy, changes in consumer
preferences, and technological change can have a significant impact on the domestic and foreign
demand as well as investment. A global transition to a low-carbon world economy would imply falling
demand for carbon-intensive goods and services, which could contribute to the stranding of assets.
Private investment could be affected through effects on household and corporate balance sheets
from structural changes to the economy (e.g. the growth or demise of different industries) or a
growing demand for sustainable investment. In particular, a stricter climate policy could cause a
reduction of investment in high-carbon sectors (Batten, Sowerbutts, and Tanaka 2020). Furthermore,
a boost in public investment to finance climate change mitigation (“green new deal”) could have
impacts on both public and private investment, including the potential crowding out of private
investments from climate policies.

3.4.3 Implications for long-run growth and sovereign risk

As Section 3.2 discussed, the economic impacts of extreme weather events can constitute a
significant risk for fiscal sustainability, especially for smaller developing economies. Supply and
demand shocks from extreme weather events, although short term in nature, can also have lasting
impacts on growth (Acevedo 2014; Klomp and Valckx 2014; Botzen, Deschenes, and Sanders 2019)
and public finances.
Moreover, the supply- and demand-side effects of gradual global warming and transition impacts,
which we discussed above, can cause fundamental and enduring structural changes to the economy.
For many countries, climate change will have profound impacts on their long-run productive capacity
and potential output. A country’s long-term growth potential will inevitably have ramifications for its
public finances and debt sustainability.
Models estimating climate change’s impacts on economic growth inexorably make a host of
assumptions about climatic trends, tipping points, technological innovation, adaptive capacity, and
the effects of all these on human well-being and economic activity. Long-term growth projections
hence require caution. In particular, quantifications of the long-term economic impact of climate
change, and as a corollary the impact on government debt, may underestimate the cumulated impact
by not taking into account the non-linear implications of increasingly frequent natural disasters on
investment and incomes, given the difficulties to model such implications. Still, they provide a useful
indication of growth trends in different climate scenarios. Most projections have suggested that the
economic cost of inaction is immense.

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Climate Change and Sovereign Risk

Table 9 displays Khan et al.’s (2019) recent projections on losses in GDP per capita by the years 2030,
2050, and 2100 in two different representative concentration pathway (RCP) scenarios, RCP2.6 and
RCP8.5. RCPs are the greenhouse gas concentration trajectories that the Intergovernmental Panel on
Climate Change (IPCC) uses. The RCP2.6 pathway is a relatively optimistic scenario in which the
increase in global warming is limited to 0.01°C per annum, in line with the Paris Agreement. RCP8.5 is
commonly referred to as the high-emission or “business-as-usual” scenario. The RCP2.6 scenario
projects that sea levels will rise between 29 and 59 centimeters, while the likely range in the RCP8.5
scenario would be between 61 and 110 centimeters, relative to 1986–2005 (Oppenheimer et al.
2019). Khan et al.’s (2019, 7) estimations suggested that “a persistent change in climate conditions
has a long-term negative effect on per capita GDP growth.” In particular, the world’s real GDP per
capita would be 7.22% lower in 2100 under RCP8.5 compared with an output loss of 1.7% under
RCP2.6. According to these estimates, GDP per capita would decline in all countries, both rich and
poor, cold and hot, in the business-as-usual scenario, although the estimated effects would differ by
country.

Table 9: Percentage loss in GDP per capita by 2030, 2050, and 2100 in the RCP 2.6
and RCP 8.5 scenario
2030 2050 2100
m=20 m=30 m=40 m=20 m=30 m=40 m=20 m=30 m=40
World
RCP2.6 –0.01 –0.01 –0.02 0.06 0.11 0.16 0.58 1.07 1.57
RCP8.5 0.40 0.80 1.25 1.39 2.51 3.67 4.44 7.22 9.96
People’s Republic of China
RCP2.6 –0.22 –0.45 –0.71 –0.38 –0.80 –1.31 0.24 0.45 0.67
RCP8.5 0.31 0.58 0.87 0.90 1.62 2.30 2.67 4.35 5.93
European Union
RCP2.6 –0.04 –0.08 –0.13 –0.06 –0.13 –0.22 0.05 0.09 0.13
RCP8.5 0.24 0.50 0.80 0.79 1.53 2.35 2.67 4.66 6.69
India
RCP2.6 0.12 0.26 0.42 0.41 0.81 1.27 1.44 2.57 3.69
RCP8.5 0.60 1.16 1.78 2.13 3.62 5.08 6.37 9.90 13.39
Russian Federation
RCP2.6 –0.07 –0.14 –0.23 –0.16 –0.34 –0.56 –0.33 –0.71 –1.19
RCP8.5 0.51 1.03 1.63 1.62 3.08 4.61 5.28 8.93 12.46
United States
RCP2.6 0.10 0.20 0.33 0.29 0.60 0.96 0.98 1.88 2.84
RCP8.5 0.60 1.20 1.86 2.13 3.77 5.39 6.66 10.52 14.32
Rich countries
RCP2.6 0.02 0.05 0.09 0.12 0.33 0.37 0.58 1.09 1.62
RCP8.5 0.42 0.84 1.33 1.46 2.67 3.93 4.74 7.76 10.75
Poor countries
RCP2.6 –0.08 –0.16 –0.25 –0.08 –0.18 –0.32 0.55 0.99 1.43
RCP8.5 0.37 0.72 1.09 1.24 2.18 3.11 3.78 6.05 8.25
Hot countries
RCP2.6 0.00 0.00 0.01 0.08 0.15 0.23 0.62 1.11 1.60
RCP8.5 0.39 0.76 1.17 1.35 2.37 3.39 4.17 6.65 9.10
Cold countries
RCP2.6 –0.01 –0.02 –0.03 0.05 0.09 0.14 0.56 1.05 1.57
RCP8.5 0.41 0.81 1.28 1.40 2.56 3.76 4.53 7.40 10.24

Note: The computation of the estimations uses moving averages of temperature and precipitation for the respective countries
based on the past m years, with m=30 as the baseline and m=20 and m=40 as robustness checks.
Source: Compiled with data from Khan et al. (2019, Table 7).

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 Transmission Channels of Risk

Burke, Hsiang, and Miguel’s (2015a) projections suggest that, because of global warming, global
average incomes will be 23% lower in 2100 in a “business-as-usual” (RCP8.5) emissions scenario
compared with a non-climate change scenario (Figure 8). Their estimates also implied that a small
number of cooler, rich countries will benefit from global warming while poorer countries with a
tropical climate will suffer particularly bad effects.

Figure 8: Economic impact of climate change on the world

Source: Burke, Hsiang, and Miguel (2015a), [Link]

Using a dynamic general equilibrium model, the IMF (2017) estimated the long-run effects of global
warming on GDP and public debt for a representative low-income country. Figure 9 shows the
estimates for an RCP4.5 scenario, leading to a temperature of about 2.4°C (left panel), and, for
the unmitigated RCP8.5 climate change scenario, leading to a 4.3°C temperature increase by 2100
(right panel). Assuming a static economic structure, in the RCP8.5 scenario, the estimates indicate
that the output would decline by about 9% and private investment by 11% by 2100, while the
public-debt-to-GDP ratio would increase by 5 percentage points. In the RCP4.5 scenario, the output
would only fall by 4% and private investment by 5% by 2100, while the public-debt-to-GDP ratio
would increase by 2 percentage points. In terms of net present value, these estimates would
correspond to cumulative losses amounting to 100% and 48%, respectively, of the current GDP.
However, the IMF emphasized that wide confidence intervals surround their central projections and
that there are “sizable downside risks”: the output could decline by more than 8% in the RCP4.5
scenario and more than 16% in the RCP8.5 scenario, while public debt could increase by 10% and 20%
of GDP, respectively.
Whilst projections have differed, most have suggested that climate change is likely to have significant
impacts on growth trajectories, with implications for debt sustainability. It is therefore imperative that
national authorities as well as international organizations such as the IMF integrate climate scenario
analysis into debt sustainability analysis.

29
Climate Change and Sovereign Risk

Figure 9: Long-term impact of a temperature increase

for a representative low-income developing country

Source: Compiled by authors with data from the IMF (2017).

30
 Transmission Channels of Risk

3.5 Climate-related risks and financial sector stability

3.5.1 Impact of climate risks on the financial sector
The Central Banks and Supervisors Network for Greening the Financial System (NGFS) highlighted
climate change as a key risk affecting the financial system. The NGFS (2019) noted four distinctive
characteristics of climate change: (i) a far-reaching impact in breadth and magnitude, (ii) a
foreseeable nature, (iii) irreversibility, and (iv) dependency on short-term actions. It is for these
reasons that it recommended that central banks and supervisors integrate climate risks into financial
stability monitoring and supervision.
Physical climate risks manifesting as credit risks for banks
Acute physical risks, that is, extreme weather events, and chronic physical risks, such as worsening
water stress or a sea-level rise, can result in direct damage to operating assets and reduce the
production output of borrowers. Raw material shortages in supply chains and disruptions to
transport, storage, distribution, or retail capabilities can lead to reductions in output and revenues.
Companies may not have adequate insurance coverage for both property and business interruption
risk or may find that their premiums rise significantly. Reduced household and corporate expenditure
due to the diversion of expenditure toward disaster recovery can also affect the demand for goods
and services. Other physical risks, such as heat stress, can reduce labor productivity and increase
energy consumption costs due to the need to cool buildings and manufacturing plants.
These pressures can combine to reduce borrowers’ operating margins and cash flows and the value of
collateral assets, leading to credit downgrades, a higher probability of default, and a reduction in the
secondary market value of loans held on bank balance sheets. In more severe situations, borrowers
will not be able to meet their debt service obligations, resulting in a higher incidence of non-
performing loans (NPL) and a higher loss given default (LGD) due to the reduced value of collateral
assets. Figure 10 illustrates the transmission mechanisms from physical risks to financial stability risks
for banks, investors, and insurers.

Figure 10: From physical risk to financial stability risks

Source: Replicated by authors from NGFS (2019, Figure 1).

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Climate Change and Sovereign Risk

The 2018 UNEP FI banking pilot project on the implementation of the recommendations of the Task
Force on Climate-Related Financial Disclosures (TCFD), involving 16 banks assessing physical risks,
showed a downgrade in credit rating and a higher probability of default in some cases (UNEP FI
and Acclimatize 2018). For example, one bank’s agriculture loan portfolio showed an increase of
1.1×–1.5× in the probability of default in a 4°C scenario, with the average portfolio rating
deteriorating by one notch. The Toronto Dominion Bank tested 20 borrowers in its North American
power and utilities portfolio and found that the majority experienced a one-notch credit downgrade
in all three climate scenarios that it employed.
The bankruptcy of Pacific Gas and Electricity (PG&E) company is a dramatic example of how physical
climate-related risks can affect banks, investors, and insurers. Its rating downgrade and 2019
bankruptcy filing triggered a default on all its debt (Kirong 2018). The company recently agreed a
US$24.5 billion settlement payable to victims and insurance companies that faced significant claims
from businesses and individuals under their insurance coverage for wildfire damage (Gonzales 2019).
The company’s equipment had ignited catastrophic wildfires, the size and extent of which were
significantly magnified by the worsening drought and heat due to climate change, causing severe
damage (Union of Concerned Scientists 2018; Borunda 2019). However, this bankruptcy does not
seem to have increased the perception of climate risk in the US utilities sector for a variety of reasons,
leading to weak market signals to encourage climate risk mitigation (Macwilliams, Lamonaca, and
Kobus 2019). In the long run, this may worsen the financial stress that utilities, banks, investors,
insurers, state and local governments, rate payers, and tax payers face.
Regarding other chronic physical risks, the International Labour Organization (ILO) has estimated that
an increase in heat stress resulting from global warming will cause productivity losses worth
US$2.4 trillion, with the impact being most pronounced in lower-middle- and low-income countries
(ILO 2019). The expectation is that the agriculture and construction sectors will be the worst hit,
accounting for 60% and 19%, respectively, of working hours lost in 2030, with potential negative
consequences for food prices.
Transition climate risks manifesting as credit risks for banks
Climate risks related to policy, technology, and market changes may also have a negative impact on
borrowers’ credit profile by stranding production assets and/or reducing the demand for their
products and services. Manufacturing assets, natural resources, and infrastructure assets, which
typically have longer useful lives, are at risk of obsolescence and early closure. For example, the
decision of a growing number of governments to phase out internal combustion engines (ICEs) will
result in reduced market demand for such cars and lower utilization rates or even early closure of ICE
auto manufacturing plants (Climate Centre 2018). The increasing cost competitiveness of renewable
energy versus coal-fired power generation is another case in point.
These risks can materialize to reduce the profitability and cash flows of businesses as well as the value
of assets that banks hold as collateral. These could result in credit downgrades, higher incidence of
NPLs, and more loss given defaults. Figure 11 illustrates the transmission mechanisms from transition
risks to financial stability risks for banks, investors, and insurers.
The above-mentioned 2018 UNEP FI-led TCFD pilot project showed more severe impacts from
transition risks than from physical risks (UNEP FI and Acclimatize 2018). Barclays Bank tested
35 electric utilities in the EU and US under the 2040 2°C scenario, which showed that the average
probability of default of the portfolio was 2.2 times higher in the US and 2.3 times higher in the EU
than the baseline. Another bank tested its metals and mining portfolio and found that the probability
of default increased by between 1.4 and 2.0 times by 2040.

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 Transmission Channels of Risk

Figure 11: From transition risk to financial stability risks

Source: Replicated by authors from NGFS (2019, Figure 2).

De Nederlandsche Bank (DNB), the Dutch central bank, performed an energy transition risk stress test
for the Dutch financial sector using four scenarios: a policy shock scenario, a technological shock
scenario, a confidence shock scenario, and a double shock scenario (policy and technology shocks
combined) (DNB 2018). The DNB found that banks had the lowest losses at 1–3% of the total stressed
assets, pension funds’ losses ranged from 7 to 10%, and insurers’ losses ranged from 2 to 11%.
The Bank of England intends to use its 2021 biennial exploratory scenario to assess the risks to the
United Kingdom (UK) banking and insurance sectors from climate change (BoE 2019). The intention is
to use three scenarios that include both physical and transition risk transmission mechanisms: (i) an
early policy action scenario in which countries implement policy changes early and global warming
stays below 2°C, (ii) a late policy action scenario in which the delayed policy response is more severe
and physical risks manifest more quickly, although the global average temperature rise is still below
2C, and (iii) a no policy action scenario in which the policy risk is low but the global average
temperature increases substantially by 2080.
The UK banking sector has considerable exposure to sectors with high climate risk. The loan
exposures to fossil fuel producers, energy utilities, and emission-intensive sectors are equivalent to
70% of the largest banks’ common equity Tier 1 capital. Around 12% of equity and 8% of corporate
bond portfolios of UK insurers face exposure to high-carbon technologies. As such, the potential
impact could be significant and the learnings from performing such a stress test will be invaluable for
other supervisors with similarly exposed finance sectors.
Banks: Climate risks as liquidity risks due to impact on balance sheet from credit risks and fire sales
of assets in financial markets
Unforeseen increases in NPLs and significant write-downs of assets due to abrupt policy changes or
physical climate events can lead to sharp downward revisions of profit forecasts for banks. A climate
Minsky moment, as the governors of the central banks in England and France (BoE 2019) warned

33
Climate Change and Sovereign Risk

about, would see fire sales of climate-affected assets that people perceive to be declining in value.
The credit and market risks can combine to create a lack of confidence in the financial soundness of
counterparties and uncertainty regarding banks’ own funding needs. These can lead to the freezing of
the interbank lending market or a spike in lending rates. A lack of insight into the level of climate-
related risks in loan portfolios is likely to worsen the situation.
A lack of data on banks’ and their corporate borrowers’ ESG policies and exposure to climate risk may
exacerbate any turmoil as counterparties cannot assess and price the true level of risk. This was
apparent during the sub-prime crisis due to the complexity of the financial instruments and the lack
of transparency (Dodd and Mills 2008). As such, any repricing due to climate risk may be more abrupt
and of a greater magnitude due to the fear factor, the complexity of measuring nonlinear climate
impacts, and the lack of data.
Investors: Effects on portfolio valuations due to stranding and repricing of assets
In the same way as physical and transition climate risks manifest as credit risks for banks via higher
NPLs and LGD arising from deteriorating operating margins, cash flows, and value of assets, climate
risks can affect the value of investors’ portfolios. The pressure on earnings, asset values, and lower
growth forecasts for businesses with less climate-resilient business models that cannot easily rebound
from short-term shocks will result in a drop in securities’ prices or valuations for non-listed assets.
Even if investors do not crystallize the losses through an immediate sale of the affected assets, the
mark to market value of their portfolios will receive a negative impact with no certainty of future
recovery.
In 2019, 20 institutional investors participated in a pilot study on climate risk scenario analysis to
quantify the physical and transition risks in investment portfolios (UNEP FI 2019). The study used a
portfolio of 30,000 companies to represent the investable market universe and found that an average
level of physical climate risk had a –2.14% impact on value. Transition risk in a 1.5°C scenario had a far
stronger negative impact of up to –13.16%. Adding both types of risk but netting off the +10.74%
upside from technological opportunities resulted in downside exposure of –4.56% to investment
portfolios. The agriculture and utility sectors faced the greatest exposure to policy changes with
–82.5% and –50.6% value at risk, respectively.
Insurers/reinsurers: Negative effects on margins due to higher insurance claims
Besides the impact on insurance firms’ investment portfolios, there will be an effect on the
underwriting business of insurers/reinsurers. Extreme weather events may cause unexpectedly high
insurance claims on property, casualty, medical, travel, and business interruption policies, which
predictions show will increase in frequency and intensity with climate change and chronic climate-
related changes. Transition climate risk can manifest as lower insurance premiums sold if corporate
assets become stranded or as higher claims on directors’ and officers’ liability policies as company
boards and management face lawsuits for inadequate management of climate risks (Willis Towers
Watson 2019). The higher claim incidence can reduce the profitability of insurance firms and
potentially influence their credit ratings. Insurers may respond by either reducing their insurance
coverage or increasing their premiums, both of which will have negative impacts on the credit profile
of businesses.
The DNB (2017) used climate scenarios of 1.5°C and 3.5°C warming by 2085 to assess the potential
impact of flooding damage on the non-life insurance sector. The DNB estimates suggested that
climate-related claims’ burden from homeowners’ insurance policies would increase by 25%–131% in
the 3.5°C scenario compared with 10%–52% in the 1.5°C scenario.
Even now, the insurance industry is already experiencing a higher incidence of loss events as well as
higher insured losses (Figure 12). The average number of weather-related loss events for the last
10 years up to 2018 was 612 registered events per year, compared with 425 for the period
1980–2018, as recorded by Munich Re’s NatCatSERVICE (Munich Re 2020). In 2018, there were

34
 Transmission Channels of Risk

798 registered loss events with US$166 billion overall losses, of which US$77 billion were insured
losses—the fourth costliest year since 1980 (Löw 2019). The insured loss for 2017 was US$142 billion,
the highest annual figure in the period 1980–2018 and considerably higher than the average of
US$49 billion for the ten years prior to 2017. The 2019–2020 Australian wild fires have already
affected the largest domestic insurance companies’ performance (Fernyhough 2020; Insurance
Australis Group (IAG) 2020), which may have consequences for their future cost of reinsurance and
capital and hence their appetite to insure Australian companies.

Figure 12: Number of relevant weather-related loss events worldwide and overall
and insured losses in US$ billion (in 2018 values), 1980–2018

Note: The numbers of events are on the left axis, and losses are on the right axis.
Source: Compiled by authors with data from NatCatSERVICE (Munich Re 2020).

3.5.2 The negative feedback loop between financial sector instability and sovereign risk
Climate risks in banking, credit conditions and growth in the real economy
The banking sector is the primary market for corporate finance. Climate risks that result in liquidity
issues for banks will reduce their ability to lend to corporates to fund their operations and growth. A
growing level of NPLs and the inability to project climate-related risks accurately will lead banks to
tighten their lending criteria. As insurers and reinsurers face higher insured losses due to climate
events, the ability of corporates to secure adequate insurance coverage decreases. This will mean
lower protection of the value of bank collateral and will further reduce banks’ appetite to lend to
high-risk companies and sectors. These are precisely the system-level impacts that a growing number
of central banks and supervisors, such as the Bank of England, are testing through climate stress tests
(BoE 2019).
In addition, if central banks raise the discount rate to counter inflation resulting from supply chain
shocks due to climate events, the higher borrowing costs that banks face will pass to borrowers,
making credit more expensive for the real economy. A resultant credit crunch would have additional
negative consequences for the GDP, employment, exports, and tax revenues from corporates, all of
which combine potentially to worsen the sovereign risk profile.

35
Climate Change and Sovereign Risk

Multiple studies have investigated the impact on the interbank market and the consequent effect on
the real economy as firms and households face credit constraints. Altavilla et al. (2019) estimated that
interbank rate uncertainty increased the lending rates of euro area banks for loans to non-financial
firms by up to a maximum of 100 basis points during the 2007–2009 global financial crisis and the
2010–2012 European sovereign crisis. Ivashina and Scharfstein (2010) estimated that, during the
2008 financial crisis, the US banking sector experienced new loans to large borrowers dropping by
47% during the peak period relative to the prior quarter and by 79% relative to the peak of the credit
boom. The reduction in lending was due to the combined effect of a run by short-term bank creditors
and a run by borrowers that drew down credit lines in anticipation of liquidity issues.
The credit squeeze also affects households. Antoniades (2014) used micro-level data on mortgage
loan applications to separate out any contraction in the loan demand and found that there would
have been a 14% increase in the number of mortgage applications originating during 2007 and 2008 if
banks had entered the crisis with levels of exposure to liquidity risk reduced to the lowest quartile.
Estimates have indicated that the economic costs of banking crises occurring across 13 countries
between 2007 and 2009 amounted to a median output loss of 25% of GDP (Laeven and Valencia
2010). This demonstrates that the combined direct costs—including impacts on the banking sector’s
contribution to GDP, tax revenues, and employment—and indirect costs of shocks to the banking
sector can have a significant impact on the economic and fiscal health of the country. Research has
also shown that banking recessions are deeper and last longer than other recessions, with the
recovery of pre-recession output levels requiring one more year in banking recessions (IMF 2015a).
This is due to banks’ need for rapid deleveraging via restrictions on credit expansion, exacerbating the
debt overhang and uncertain macroeconomic outlook arising from credit booms that typically
precede banking recessions.
Impact of financial upheavals on governments and state linked pension funds
and investment companies
Banks can form a significant component of local stock market capitalization and may have state
pension funds or sovereign wealth funds as anchor shareholders. State-owned banks are a case in
point, with the asset share of government-owned banks accounting for 18% of banking system assets
across 65 developing countries in 2010 (Cull, Soledad Martinez Peria, and Verrier 2017). Significant
reductions in their valuations due to climate shocks would result in lower investment income for state
pensions as well as lower sovereign fund returns and asset values. The potential pension deficits and
lower state investment returns could worsen the budget deficit, resulting in a strain on government
debt levels or reserves, which are considerations for sovereign credit ratings.
Impacts of government-funded bank bailouts or the expectation of such, and realization of finance
sector-related contingent liabilities on the debt burden and/or sovereign credit ratings
In a more severe crisis resulting from climate shocks, sovereign contingent liabilities, as defined by the
Public Sector Debt Statistics Guide (IMF 2011), may crystallize. Liabilities related to the finance sector
would include guarantees for non-sovereign borrowing by subnational governments and public and
private sector entities (including guarantees for mortgages and student and small business loans),
state insurance schemes for commercial bank deposits, minimum returns from private pension funds,
bank failures, and investment failures of pension funds (Bova et al. 2016). For example, there may be
a need for bank bailouts via asset purchase programs, equity injections, debt guarantees, and/or
renationalization, as occurred in the global financial crisis, the European sovereign debt crisis, and the
Asian financial crisis.
Both types of liabilities can result in a spike in government debt to GDP ratios, which affects sovereign
credit risk. There is also the risk of contagion across borders, which may be stronger in countries with
a monetary or fiscal union. Bova et al. (2016) found that, across 80 countries between 1990 and 2014,
realizations of contingent liabilities related to the financial sector cost an average of 9.7% of the GDP,

36
 Transmission Channels of Risk

significantly more than other types of liabilities, such as those related to subnational governments
(3.7%) or the private non-financial sector (1.7%).
The risk of central banks having to act as “climate rescuers of last resort” in a systemic financial crisis
and purchase significant amounts of financial sector assets with impaired value due to physical or
transition climate shocks arises as a serious consideration for central banks (Bolton et al. 2020). Using
their 13-country sample for recent crises from 2007 to 2009, Laeven and Valencia (2010) found a
median increase in public debt of 24% of the GDP over the 3-year period following the start of the
crisis. The European Central Bank’s analysis (ECB 2015) showed a similar impact, with the finance
sector bailout contributing to an increase of 27 percentage points in general government debt in the
euro area between 2008 and 2014.
Acharya, Drechsler, and Schnabl (2014) assessed the change in debt to GDP ratios in 2008–10 for the
eurozone countries, Denmark, Great Britain, Norway, Sweden, and Switzerland and found that a 10%
increase in financial sector distress prior to the bailouts predicted a 2.4 percentage point increase in
the public debt to GDP ratio. Their analysis suggested a significant transfer of financial sector credit
risk to sovereign balance sheets as the average pre-bailout period bank and sovereign credit default
swap (CDS) spreads of 63 bps and 14 bps increased to 184 bps and 112 bps, respectively, in the
post-bailout period. They also found that, during the bailout period, a 10% increase in the sovereign
CDS spread led to a 4.5% decrease in the bank CDS spread, further supporting this direction of
risk transfer.
Breckenfelder and Schwab’s (2018) analysis of cross-border contagion effects of such bank to
sovereign risk transfers concluded that, during the ECB’s comprehensive assessment of the
130 largest banks in the euro area, a 1% decline in bank equity in stressed countries was associated
with a 0.33% increase in sovereign CDS in non-stressed countries. Kallestrup, Lando, and Murgoci
(2016) modeled the potential for banks’ foreign exposures (public sector, banks, and non-bank private
sector) to affect their domestic sovereign risk, finding that a change of 1 basis point in risk-weighted
foreign exposure corresponded to an average change of 0.4 basis points in domestic sovereign CDS
spreads.
Outside of the EU, the US faced its first ever credit rating downgrade from AAA to AA+ due to
concerns about the government’s ability to manage and reduce its medium-term debt (Reuters 2011)
arising from bipartisan disagreements over fiscal policy. The debt burden increased due to the
bailouts necessary to stabilize the financial system during the sub-prime mortgage crisis.
Sovereign risk ratings as a ceiling on private credit ratings of banks, affecting their costs of lending
to the real economy
Credit rating agencies refer to sovereign ratings or country ceilings as a significant determinant of
private credit ratings (Moody’s 2019c). As such, any downgrades of sovereign ratings will put pressure
on banks’ own ratings. Banks’ own funding costs may increase as a reflection of higher domestic
sovereign risk, leading investors to require higher yields as compensation. This effect will be stronger
if a bank’s loan assets are largely domestic, have the national government as the borrowing
counterparty, or include loans with domestic sovereign guarantees, such as infrastructure-related
financing. The implicit sovereign guarantee of a bailout also figures in the equation.
Certain investors, such as pension funds and insurance companies, are also subject to stricter
investment restrictions regarding the credit rating profile of issuers, and, in a more severe
downgrade, the bank will have reduced access to wholesale funding and public bond markets. This
may result in banks’ on-lending to the real economy decreasing or becoming more expensive.
Acharya, Drechsler, and Schnabl (2014) demonstrated the negative feedback loop between the
government and the financial sector, whereby a fall in the value of public guarantees that an
overburdened sovereign provides exposes the banking sector to its own sovereign risk. For example,
they noted that the S&P downgrade of US Treasuries led to downgrades of Fannie Mae and Freddie

37
Climate Change and Sovereign Risk

Mac and a rise in the CDS rates of US financial institutions. In assessing European sovereigns and
banks, they found that, after the bailouts, a 10% increase in the level of sovereign CDS was associated
with a 0.9% increase in the level of bank CDS.
Breckenfelder (2018) found that the credit risk of the companies that are most reliant on bank
financing was most sensitive to increased sovereign risk. The analysis of 226 firms from 15 European
countries showed that a 10% increase in the level of sovereign credit risk resulted in a 1.1% increase
in the level of corporate credit risk. This was partly due to tighter lending conditions from an affected
domestic financial sector. The sovereign credit risk manifested via two channels, the financial channel
and the fiscal channel, through which governments increase taxes and reduce subsidies or
guarantees. The fiscal pressures, if significant, will deteriorate the borrower credit profile, creating a
secondary negative feedback loop to affect the credit ratings of banks.
Effects of economic or currency crises banks’ NPLs and credit ratings
Severe economic downturns can create significant pressure on the financial sector through a
widespread impact on borrowers’ cash flows. The European Systematic Risk Board (ESRB) (2019)
highlighted business cycles and asset price shocks as two of the main drivers behind system-wide
increases in NPLs, especially if shocks affect the sectors to which banks are most exposed, such as
retail and commercial real estate. The data suggested that most of the eurozone countries that had
experienced a system-wide NPL increase had faced a severe recession after the global financial and
European sovereign debt crises. Studying a panel of 27 banks from the Baltic region over the period
2005–2014, Kjosevski and Petkovski (2017) estimated that a 1 percentage point increase in
unemployment and inflation led to an increase of 1.4 and 0.7 percentage points in NPLs.
Currency crises can have a more devastating effect if the loans are foreign currency denominated
whilst borrowers’ revenues are local currency denominated or if the borrowers’ raw materials and
revenues have different currency denominations. Laeven and Valencia (2012) estimated that, of the
147 banking crises that occurred between 1970 and 2011, 16% were preceded by a currency crisis in
the same country within 3 years prior to the start of the banking crisis. All of these led to increases in
NPLs, which, if severe enough, will require the state to step in to bail out or even close banks. Banks
with more geographically diversified businesses may have a lower direct impact from their own
sovereign, but this also allows for the contagion effect from other countries that may face higher
climate risk-related shocks.
Sovereign risk in bank and non-bank financial institutions’ balance sheets
Banks hold government bonds, which are liquid and low risk, as part of their own liquidity
management strategy. The IMF (2015a) noted that the home bias in sovereign debt is due to factors
such as the preferential treatment of sovereign debt in regulator frameworks, the use of sovereign
debt as collateral, the liquidity of sovereign bond markets, and government policies. To the extent
that banks hold bonds issued by sovereigns that are impacted by climate risk, the worsening
sovereign credit will have a direct impact on the capital base of banks and hence their credit profile
and/or their lending appetite. The credit crunch feeds back to the sovereign profile through a
dampening of economic growth. Insurance firms and investors may also have large exposures to their
domestic sovereign, as Angelini, Grande, and Panetta (2014) noted. They found evidence to suggest
that sovereign insolvency risk transmits to all of a country’s private institutions and not just to its
banks. This would increase the potency of the negative feedback loop as it will affect the wider
finance sector.
Farhi and Tirole (2018) described the other feedback loop, the doom loop, as a deadly embrace,
which weakens the sovereign balance sheet due to public debt-funded bailouts of banks. This further
weakens the credit profile of banks due to their sovereign debt holdings. Governments may also rely
on domestic banks as a source of funding during periods of financial crisis, putting additional pressure
on them to hold more government bonds. The eventual sovereign default triggers a banking crisis.

38
 Transmission Channels of Risk

Acharya, Drechsler, and Schnabl (2014) found that the average European bank held about one sixth of
its risk-weighted assets in sovereign bonds, typically on their banking book rather than their trading
book. 69.4% of these bonds were issued by the country in which the bank was headquartered. Hence,
banks are directly exposed to home-country sovereign risk via their bond holdings.
Looking beyond Europe, Gennaioli, Martin, and Rossi (2018) conducted a wider study of 20,000 banks
in 191 countries and assessed the role of their public bond holdings in 20 sovereign defaults during
the period 1998–2012. They found that banks hold on average 9% of their assets (12% for non-OECD)
in government bonds and that the worsening sovereign credit directly affects the value of banks’
assets. Dell’Ariccia et al. (2018) found even more extensive holdings in their study of 858 banks from
46 countries over the period 1999–2014. They determined that the government debt-holding figure
for emerging and developing economies ranged from 15.6% to 20.9% of their total assets, potentially
reflecting the less developed private banking and bond markets and the greater role of state-owned
banks, among other possible reasons. The IMF (2015a) found that a higher ratio of bank loans to
GDP and a larger share of sovereign debt instruments on banks’ balance sheets had a significant
positive relationship with the probability of sovereign distress conditional on bank stress (bank to
sovereign contagion).
There is also evidence of cross-border contagion when banks face exposure to foreign sovereign risk.
Alogoskoufis and Langfield (2019) and Steffen, Kirschenmann, and Korte (2017) highlighted the need
for regulatory reform to consider cross-border contagion from banks’ concentrated exposure to
foreign sovereign credit risk.
The pressure or inclination for state-related banks to purchase more domestic sovereign debt was
apparent in the eurozone banking crisis. Ongena, Popov, and Van Horen’s (2019) analysis of 60 banks
in Greece, Ireland, Italy, Portugal, and Spain during the sovereign debt crisis of 2010–2012 found that
domestic banks, especially state-owned banks, purchased significantly more domestic sovereign debt
in the months when their governments needed to issue new or refinance debt. Altavilla, Pagano, and
Simonelli (2017), who investigated 226 banks in the euro area between 2007 and 2015 and found
that public, bailed out, and poorly capitalized banks purchased domestic public debt more than other
banks, supported this finding. Public banks in the stressed country increased their sovereign debt
holdings by 17% more than private banks, in line with the “moral suasion” hypothesis. These
purchases coincided with the largest ECB liquidity injections. Becker and Ivashina (2018) reported
findings consistent with this hypothesis of financial repression. Dell’Ariccia et al. (2018) affirmed a
more general pattern with their finding that exposure to domestic sovereign debt increased
disproportionately more in distressed eurozone countries (from 2.5% to 7% of assets) than in non-
distressed countries (2.7% to 4%).
Acharya et al.’s (2018) analysis of the impact of sovereign bond holdings on banks’ lending behavior
found that, during the European sovereign debt crisis, the impairment in banks’ value due to
exposure to sovereign debt and the risk-shifting behavior of weakly capitalized banks resulted in a
53% reduction in the probability of firms securing new syndicated loans. Lending contraction
explained between 44% and 66% of the overall negative real effects on European firms. Gennaioli,
Martin, and Rossi (2018) found a similar effect in their study covering 191 countries, estimating that a
1-dollar increase in government bonds was associated with a 0.60-dollar decrease in bank loans
during defaults and that the average quantum of bonds held before the default occurred accounted
for 90% of the decline.
Central banks’ exposure to climate risk and cross-border contagion risk for the financial sector
Central banks are lenders of last resort and hold on average 67% of their assets in government bonds
(OMFIF 2019). Hentov et al.’s (2019) assessment of 30 large reserve holders concluded that high-
grade sovereign and quasi-sovereign bonds made up 59.9% of the total portfolio of central banks
(or 68% of reserves excluding gold and IMF allocations). Central banks will need to understand their

39
Climate Change and Sovereign Risk

exposures to other countries’ sovereign risks arising from climate change if they hold those countries’
government bonds.
The ECB initiated its Corporate Sector Purchase Programme as part of a quantitative easing policy to
boost growth. As of 21 February 2020, the ECB held EUR194 billion of corporate bonds (ECB 2020).
This portfolio also faces exposure to climate transition risk. Nguyen and Merle (2019) found that, for
the portfolio to align with a 50% carbon footprint reduction to meet one of the requirements of the
Paris-aligned benchmark, the ECB would have to exclude 25 out of the 113 issues in the portfolio.
Some central banks have recently started to incorporate climate and sustainability matters into their
portfolio management practices. The Banque de France recently published its first responsible
investment report (BdF 2019), which reflected the requirements of Article 173 and the TCFD on
climate risk exposure and management. The Banque de France has also committed to aligning its
investments to a 2°C trajectory. The Swedish central bank divested bonds issued by the Canadian
province of Alberta and the Australian states of Queensland and Western Australia due to these
issuers’ large negative climate impact (Sveriges Riksbank 2019).
Sovereigns which are under financial stress may tighten fiscal policies, putting pressure on cash
flows of banks’ borrowers
Sovereigns that are stressed may increase taxes or reduce subsidies, which will have a negative
impact on banks via cash flow reductions for themselves as well as their borrowers. Reductions in
government guarantees will also weaken the credit risk profile of borrowers, increasing the LGD
for banks.
Cuadra, Sanchez, and Sapriza (2010) discussed the tendency of emerging market governments to
pursue procyclical fiscal policies whereby public expenditures fall and tax rates rise during recessions
and vice versa. Reinhart, Kaminsky, and Vegh (2004) (which Vegh 2015 updated) analyzed 104
countries over the period 1960–2003 and found that over 90% of low-income and middle–low-
income countries exhibited a positive amplitude of the fiscal spending cycle compared with 50% for
OECD countries. They also found that the inflation tax rate was procyclical for all groups, with low-
income countries showing the largest amplitude (3 percentage points) and OECD countries the
smallest (0.9 percentage points). They posited that these governments face difficulties in borrowing
during times of sovereign stress and that international creditors’ requirements for fiscal consolidation
(or austerity) in providing rescue packages result in the need to cut spending and raise taxes even
during severe recessions. Greece is a recent case study of this.
Breckenfelder (2018) attributed the finding that a 10% increase in the level of sovereign credit risk is
associated with a 1.1% increase in the level of corporate credit risk to the financial channel and fiscal
channel. Governments under fiscal stress may increase taxes and reduce subsidies or guarantees,
causing deterioration of their borrower credit profile and creating a secondary feedback loop to the
finance sector.
Clearly, multiple interacting channels create the sovereign–bank nexus. Dell’Ariccia et al. (2018)
provided policy reform recommendations that account for the nexus acting as a multiplier and
accelerant of vulnerabilities in both sectors. These do not factor in climate risk transmission
mechanisms, which add additional layers of complexity due to both the nonlinear dynamics of climate
risk and the difficulties of modeling socio-political responses to what is inherently a problem of global
common resources.
Banks, as well as investors and insurers, will need to apply climate stress testing to both their
sovereign bond assets and their loans, investments, and potential claims to understand how
sovereign-related climate risks can affect both their assets and their liabilities. Due to their cross-
border loan/claim and sovereign debt exposures, banks and insurers will have to work closely with
their supervisors to assess the risk of cross-border contagion. Regional contagion risk creates a

40
 Transmission Channels of Risk

greater need for central banks to work with each other to understand exposures and resilience to
climate risks.

3.6 Impacts of climate change on international trade and capital flows

Climate change can have substantial impacts on an economy’s trade in goods and services and capital
flows with the rest of the world. Both the physical impacts of climate change and the disruptions
resulting from the climate policies that trading partners adopt, technological change, or changes
to consumption patterns can affect international trade and financial flows. Historically, balance of
payments problems have often been at the root of country risk and led to external debt crises
(Bouchet, Fishkin, and Goguel 2018). Protracted current account imbalances tend to cause liquidity
problems and, if not resolved, solvency problems. We can hence consider the current account
balance to be an important indicator of sovereign risk, as discussed in Chapter 2.
A current account deficit is not a problem as such. For instance, a country may be a net borrower
internationally and use its external credit to finance productive investment that will enhance its long-
term productivity and development so that it can repay international debt without difficulty at a later
stage. A current account deficit will be problematic, however, if the underlying cause is a lack of
international competitiveness or if the economy in question simply lacks goods and services that it
could export to the rest of the world. A country with a large current account deficit is dependent on
foreign finance and, to paraphrase Mark Carney, relying on the “kindness of strangers.”

3.6.1 Impacts of climate change on international trade

There are several ways in which climate change could affect the patterns and the volume of
international trade flows (Wilbanks et al. 2007; WTO and UNEP 2009; Dellink et al. 2017; UNCTAD
2019b). These can have potentially significant effects on countries’ balance of payments positions
and, ultimately, sovereign risk. Impacts can be grouped in three categories: (i) disruptions to trade
from climate-related extreme events and disasters; (ii) long-term effects of global warming on
endowments and production; and (iii) transition impacts on international trade.
(i) Disruptions to trade from climate-related extreme events and disasters
Climate-related extreme weather events could cause physical damage and disruptions to critical
transport infrastructure and activities and make the industrial supply, transport, and distribution
chains more vulnerable. For example, ports or transport routes, including train lines, roads, and
waterways, may have to close temporarily due to impacts from extreme weather events.18 This could
cause delays in the shipping and distribution of goods and impede international commerce. An
increase in the frequency and intensity of weather events that results in disruptions of supply,
transport, and distribution chains may raise transportation costs. This would have a negative impact
on trade in general but could cause particular problems for the operation of international production
chains, which often rely on in-time delivery of parts and components. The impacts could particularly
affect developing economies, the export models and integration into the global economy of which
have often relied on participation in international trade–production networks (WTO and UNEP 2009).
Indeed, climate change could lead to permanent changes to trade–production networks and
transport routes and change a country’s access to and opportunities in international trade.

18 Curtin (2019), for instance, warned of major disruptions to container shipping because of rising sea levels and an increase
in the frequency and intensity of storms.

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Climate Change and Sovereign Risk

Moreover, climate-related disasters could damage the productive capital stock and physical
infrastructure that the export sector relies on, such as utilities’ infrastructure. Disasters could also
destroy facilities that were producing goods and services for the domestic market that now need to
be replaced by imports. Floods, droughts, storms, and other severe weather could also destroy
harvests, livestock, or fish production and diminish food exports or increase the demand for food
imports. The damage that extreme weather events causes could reduce profitability and make new
projects less attractive. Given the growing importance of global value chains and trade–production
networks, extreme weather events could also cause significant disruptions to production in countries
that are not directly affected by disasters. Empirically, the evidence suggests that natural disasters
diminish exports while exerting ambiguous effects on imports.19
(ii) Long-term effects of global warming on endowments and production
The physical effects of gradual global warming could affect domestic output in various ways through
changes in endowments and production, with potential impacts on an economy’s export capacity and
import needs. For instance, long-term climatic trends may have a significant impact on agricultural
output, for example crop yields, with positive or negative impacts on export capacity. Climate change
consequences, such as increasing average temperatures, water scarcity, or sea-level rise, may also
affect other sectors, including manufacturing. Additionally, climate change could have a significant
impact on international tourism, which often relies on natural assets and pleasant and safe climatic
environments (Scott, Jones, and McBoyle 2006; Wilbanks et al. 2007; WTO and UNEP 2009). For many
developing countries, tourism constitutes an important service export in the balance of payments.
Overall, rising temperatures and other effects of climate change could reshape comparative
advantages and thereby change international trade patterns and specialization. The impact is likely to
be greater for economies with a comparative advantage that is due to their climatic or geophysical
characteristics (WTO and UNEP 2009). It is necessary to note that regions within an economy may
experience very different effects, with some gaining and others losing.
The empirical evidence on the historical impact of physical climate change on trade flows is still
sketchy. Osberghaus’s (2019) recent survey of the empirical literature, covering 21 studies, found that
average temperature rises appear to affect export values negatively, particularly those of
manufactured and agricultural exports, while imports experience lower impacts. Using a dynamic
computable general equilibrium model, Dellink et al. (2017) projected that the economies that
climate change affects the most will experience a greater decline in exports than in imports and GDP,
while producers in the least-affected economies are likely to experience improvements in their
competitive position on both domestic and export markets. Their model predicted that trade in
agricultural commodities would experience particularly strong effects. Moreover, Dellink et al. (2017)
found that the impacts will be most pronounced in Africa and Asia.
(iii) Transition impacts on international trade
The climate policies that trading partners adopt, technological change, and changes to consumption
patterns, either at home or abroad, could have a significant impact on imports or exports. If major
economies adopted forceful measures to curb carbon emissions, including decarbonization of their
energy and transport systems, this would have significant repercussions for the global demand for
fossil fuels and their prices (Holz et al. 2018; Huxham, Anwar, and Nelson 2019). Oil price shocks have
led in the past to significant changes in the balance of payments of both oil exporters and oil
importers (e.g. Özlale and Pekkurnaz 2010; Cheung, Furceri, and Rusticelli 2013; Allegret 2014).
Moreover, oil price shocks can cause significant fiscal disruption (IMF 2015b).

19 Cf. Gassebner, Keck, and The (2010), Oh and Reuveny (2010), Felbermayr and Gröschl (2013), El Hadri, Mirza, and Rabaud
(2019), and Osberghaus (2019).

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 Transmission Channels of Risk

The pace of technological change will shape the global demand for fossil fuels, especially in the field
of renewable energy, climate policy, and other policy trends that affect their demand, including
policies to reduce local pollution (Holz et al. 2018). Stringent climate and environmental policies could
lead to rapid changes in a country’s energy mix, as could a continued fall in the cost of renewable
energy generation. Countries that are currently dependent on fossil fuel imports may be able to
substitute these with domestic renewable energy. Indeed, fossil fuel importers may benefit from a
double dividend from a reduced energy import bill and the ability to spend leftover income in the
domestic economy (Mercure et al. 2018). Current fossil fuel importers would also benefit from
greater energy security. Fossil fuel exporters, in contrast, would stand to lose a source of revenue. For
instance, the European Bank for Reconstruction and Development estimated that Kazakhstan, the
exports of which comprise more than 50% fossil fuels, could see its fiscal revenues declining by 40%
by 2040 compared with business as usual if the global economy were to transition to a green scenario
(EBRD 2018). At the same time, growing investment in renewable energy would create opportunities
for countries with endowments of materials (such as nickel, cobalt, lithium, or rare earth elements)
that certain renewable energy technologies or electrical vehicles require as well as countries that
have an edge in the development and production of these new technologies.
Climate change policies can have implications for competitiveness across sectors but also across
countries (Mani 2007). To address concerns about potentially adverse effects on the domestic
economy, proposals for border tax adjustment measures initially emerged in the late 1990s (Hoerner
1998), and researchers have discussed them more widely since the mid-2000s (e.g. Hontelez 2007;
Mattoo et al. 2009, Werksman, Bradbury, and Weischer 2009). Border tax adjustments are essentially
duties that countries with high carbon prices levy on imported manufactured goods from countries
without or with lower carbon prices. There are three main motives for introducing border
adjustments (Brandi 2010). First, countries that implement carbon prices may seek to protect their
domestic industry from the adverse effects that carbon prices may have on their international
competitiveness. The idea is to create a level playing field and make sure that domestic producers do
not have a competitive disadvantage compared with producers in places without similar climate
policies. Second, related to the first motive, countries may seek to avoid carbon leakage, that is, the
relocation of carbon-intensive operations to countries with laxer emission constraints. Third,
countries may introduce carbon border adjustments to put pressure on other countries to implement
more ambitious climate policies and prevent other countries from free riding on international
climate policy.
The discussions around carbon border adjustments have intensified recently, not least in the
European Union (EU) with the European Commission’s plans for a European Green New Deal (Brandi
2019). As Tooze (2020, 7) stated recently, “[i]f labor costs and migrant workers were the trade policy
issues of the 20th century, carbon border taxes are the frontier of trade policy in the 21st.” Indeed,
carbon border adjustments have become a real possibility in the EU, with a potentially significant
impact on the EU’s trading partners.20 Major trading partners’ climate policies and carbon border
adjustments could have substantial impacts on economies with carbon-intensive export sectors.

20 Imported carbon emissions account for a growing share of the EU’s consumption-based emissions, with most imported
carbon emissions originating from emerging economies, especially the PRC (Simola 2020). In 2018, the French
Government put forward a national strategy that seeks to end deforestation resulting from imports of beef, palm oil, soy,
cocoa, and wood. The EU–Mercosur Trade Agreement, which the parties reached in July 2019, has not received
ratification due to concerns that it contradicts the EU’s climate goals.

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Climate Change and Sovereign Risk

Overall, there are various ways in which the physical and transition impacts of climate change could
affect international trade volumes and patterns. Gains and losses will spread unevenly across
countries. Economies with high dependency on carbon-intensive exports and relatively undiversified
export sectors are particularly at risk, as are climate-vulnerable economies in geographies with a
relatively high average temperature. Commodity-dependent developing countries may be particularly
at risk. UNCTAD Secretary-General Mukhisa Kituyi described climate change as an “existential threat
to commodity-dependent developing countries” (UN News 2019).21
Climate-related supply and demand shocks could have short- or long-term impacts on international
prices and the terms of trade as well as on the exchange rate. There is little understanding of these
yet. Furthermore, climate-related supply and demand shocks and changes to international trade
patterns may have significant impacts on capital flows into and out of the economy.

3.6.2 Impacts of climate change on international capital flows

One of the three main goals of the Paris Agreement is “making finance flows consistent with a
pathway towards low greenhouse gas emissions and climate-resilient development” (Article 2.1c).
Dasgupta et al. (2016, 6) thus argued that the Paris Agreement “provides the seeds for deeper
reforms of the global financial system.” Nevertheless, only a few studies have so far investigated how
climate change may affect international financial flows.22 Of those that have, almost all have focused
on the impact of natural disasters on remittances or foreign aid inflows (Osberghaus 2019).
Osberghaus’s (2019) review of 12 studies revealed that most studies have found small increases in
remittances and aid inflows after disasters, as we may expect. David (2010) reported that bank
lending and equity funding have not helped to offset disaster effects and may even have amplified
negative economic outcomes. David therefore cautioned that countries with high vulnerability to
natural disasters should consider this in their management of their capital account. Escaleras and
Register (2011) found that natural disasters have a negative association with foreign direct
investment inflows.
One dimension that has been explored very sparsely thus far is the potential longer-term impact of
climate change on the international financial system and the patterns of international financial
flows.23 If climate change has an impact on trade and current accounts, by implication it will also have
impacts on financial flows and capital accounts. Countries in which the current account deteriorates
because of climate-related impacts on their economies may turn from current account surplus
countries into deficit countries; alternatively, those that previously had a current account deficit may
see this worsen, which could in turn enlarge the sovereign risk.
A corollary of major changes to countries’ current account positions is that the private and/or public
financial in- and outflows would change. While many small climate-vulnerable countries have never
had access to international capital markets, even countries with previous access to international
private capital may face permanent exclusion from foreign direct investment, portfolio investment,
and debt flows because of climate risk. These countries would then have to rely exclusively on export
income, remittances, and international aid transfers.

21 According to UNCTAD (2019b), all of the ten most climate-vulnerable countries in 2017 were commodity-dependent
developing countries, while only three of the 40 most climate-vulnerable countries were not reliant on commodity
exports.
22 A large and growing literature has examined climate finance, that is, international investment flows aimed at climate
change mitigation and adaptation in developing countries. For a framing, see, for instance, UNFCCC (2007).
23 Carnevali et al. (2019) developed an ecological open-economy stock flow-consistent model aimed at exploring the
international transmission channels of climate risk.

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 Transmission Channels of Risk

Importantly, major changes to a country’s current account position could have profound impacts on
its foreign exchange reserves, which in turn could have direct consequences for its sovereign risk.
Moreover, large-scale changes to the foreign exchange reserve holdings of several sizable economies
could have substantial implications for the global reserve system. For instance, a drying up of revenue
from oil exports would not only have an adverse impact on oil exporters’ current account positions.
The waning of petrodollar income, much of which has hitherto been invested in financial assets in
major international financial centers (Higgins, Klitgaard, and Lerman 2006), could reduce the
international demand for financial assets denominated in US dollars or other reserve currencies and
affect international interest rates.
Last but not least, the financial market instability that climate risk induces could affect international
capital flows, as we discussed in section 3.5. If a major financial center were to experience a financial
crisis, say because of the burst of a carbon bubble in its financial system, this may have regional or
global repercussions. Likewise, a crisis in a country’s domestic financial system, for example triggered
through climate-related losses in the banking system, could lead to capital flight, which could then
trigger an exchange rate and balance of payments crisis. These may be extreme scenarios, but it will
be important to explore them further.
To sum up, the physical and transitional impacts of climate change could affect the volumes and
patterns of international trade and finance in several ways. For some countries, this may have a
material impact on their balance of payments and hence their sovereign risk. How important these
impacts may be for individual countries depends, on the one hand, on the speed at which change
impacts are unfolding and, on the other hand, on the capacity of countries to adapt and safeguard or
enhance the resilience of their export and financial sectors.

3.7 Impacts of climate change on political stability

Political instability can undermine the ability or willingness of a government to repay its debt. For
instance, Clark (1997) emphasized the potential impact of political events on the probability of
sovereign default, while Cuadra and Sapriza (2008) maintained that countries that are politically
unstable and more polarized have higher default rates and as a result have to pay a higher default risk
premium in international credit markets.24,25 The economic and social effects of climate change may
accentuate the social tensions within a society and fuel political instability. Moreover, climate change
leads to large-scale migration movements, which could also lead to political tensions or even inter-
and intrastate conflicts. The following sections will briefly discuss in turn the links between climate
change and inequality, migration, and conflict.
Inequality
As we discussed earlier, climate change is disproportionally affecting developing countries in warmer
climates. Using counterfactual historical temperature trajectories, Diffenbaugh and Burke (2019,
9808) found a “very high likelihood that anthropogenic climate forcing has increased economic
inequality between countries.” Their results indicated that the ratio of per capita income in the top
and bottom deciles is 25% larger because of global warming. Even though between-country inequality
has fallen over the last five decades, their findings give a likelihood of about 90% that the reduction
was slower because of climate change.

24 See also Balkan (1992).

25 The literature on political risk has mostly focused on election outcomes (e.g. Block and Vaaler 2004; Kirikkaleli and
Ozun 2019).

45
Climate Change and Sovereign Risk

However, global environmental change can also affect inequality within countries and stir social
tensions. Islam and Winkel (2017) described the impact of climate change on within-country
inequality as a vicious circle, in which the adverse impacts of global warming disproportionately affect
disadvantaged groups, which causes inequality to worsen (Figure 13). They pointed to three main
channels: (i) greater exposure of disadvantaged groups to climate hazards; (ii) greater susceptibility to
climate-related losses and damage; and (iii) a lower ability to cope with and recover from losses and
damage, due to a lack of resources.

Figure 13: Effects of inequality of disadvantaged groups

Source: Compiled by authors based on Islam and Winkel (2017, Figure 1).

Migration
Climate-related disasters can lead to migration within and between countries, which may induce
political instability. Black et al. (2011, 447) predicted that climate change will “almost certainly alter
patterns of human migration” and that environmental factors will become a greater driver of
migration. Froese and Schilling (2019) described climate change as a multiplier of risk, which
exacerbates existing societal problems and aggravates human security risks, including food and water
insecurity. Extreme weather events, such as storms and droughts, can lead to a loss of livelihoods and
spur migration. Likewise, rising temperatures and sea-level rises can make entire regions inhabitable,
lead to displacements, and create “climate refugees.”
According to Hauer et al. (2020), a median sea-level rise of 0.79 meter by the year 2100 could
permanently inundate about 88 million people—0.79% of the world’s population. Burzyńskia et al.’s
(2019) projections indicated that climate change will lead to voluntary and forced displacement in the
magnitude of 100 to 160 million workers in the 21st century, a figure that would result in 200 to
300 million climate migrants when including dependents.

46
 Transmission Channels of Risk

Migration tends to flow from rural to urban areas and from poorer to more affluent locations
(Penning-Rowsell, Sultana, and Thompson 2013). In response to hazard events, people relocate to
locations where they are safe and can recover their income. With the socio-economic effects of
climate change being greater in countries with higher temperatures, predictions have shown that
inter-state migration will occur from low- to high-latitude countries. However, given the legal limits to
cross-border migration, around 80% of forcibly displaced people will relocate within their country
(Burzyńskia et al. 2019). The World Bank has estimated that, by 2050, 143 million people (or 2.8% of
the population) in Sub-Saharan Africa, South Asia, and Latin America could have to relocate within
their countries away from “less viable areas with lower water availability and crop productivity and
from areas affected by rising sea level and storm surges” to “escape the slow-onset impacts of climate
change” (Kumari Rigaud 2018, xix).
Climate and conflict
Conflicts are hardly ever monocausal, but research has emphasized climate change as an additional
driver that can trigger new or intensify existing conflicts (Gleick 2018). Buhaug (2016) stressed that
climate change has an indirect and conditional effect on crises, rather than a general causal effect.26
Burke, Hsiang, and Miguel’s (2015b, 577) meta-analysis of 55 studies found that “deviations from
moderate temperatures and precipitation patterns systematically increase conflict risk.” Abel et al.’s
(2019) empirical analysis with data on asylum-seeking applications for 157 countries over the period
2006–2015 suggested that climatic conditions had significant effects on the number of asylum
seekers in the years 2011–2015. They concluded that the impact of climate on conflict and asylum
seeking is limited to specific time periods and contexts. Nevitt (2020) argued that climate change
accelerates existing national security threats and acts as a “catalyst for conflict,” creating a “new
climate-security nexus.” As such, it is widely accepted that climate change can be a “threat multiplier”
(CNA Corporation 2007, 6) and influence the dynamics of interaction between societal actors
(Buhaug 2016).27
Importantly, climate change-induced migration could cause conflict in receiving areas (Reuveny
2007). Others have highlighted energy insecurity, resource scarcity, water insecurity, and poverty as
sources of vulnerability and conflict (Blondel 2012; ADB 2017). Figure 14 displays the direct and
indirect effects of climate change on resource availability, which can contribute to unleashing
potential conflict and cooperation dynamics. Land degradation and a change in land use related to
climate change mitigation and adaptation can lead to stress on food, water, income, livelihoods,
health, and transportation and energy systems (Froese and Schilling 2019). The increased stress could
trigger conflict, but it could also lead to efforts to find cooperative solutions.

26 See also Bernauer, Böhmelt, and Koubi (2012), Adger et al. (2014), Buhaug et al. (2014), and Salehyan (2014).
27 See also Wallace (2018), Mach et al. (2019), Van Weezel (2019), Vestby (2019), Work (2019), Roche et al. (2020), and
Scheffran (2020).

47
Climate Change and Sovereign Risk

Figure 14: Conceptual framework of the direct and indirect effects of climate change
on resource availability and potential conflict and cooperation dynamics

Source: Compiled by authors based on Froese and Schilling (2019).

3.8 Summary
The discussion in this chapter has shown that the impacts of climate change and the efforts to
achieve climate change adaptation and mitigation can constitute material risks to sovereign credit.
Table 10 summarizes the main points and lists the relevant indicators that could be useful for
analyzing climate risks.

48
 Transmission Channels of Risk

Table 10: Risk channels, potential effects and relevant indicators

Risk channel Potential effects Relevant indicators
Depletion of natural capital and • Loss of natural capital increases • Ecological footprint
natural services vulnerability to climate shocks • Dependency of an economy on
• Erosion of ecosystem services ecosystem services
undermines an economy’s output
potential
Fiscal impacts of climate- • Direct disaster losses/costs of • Projected frequency of climate-related
related disasters reconstruction or repair disasters
• Contingent liabilities • Historical insured and uninsured losses
• Loss of tax revenue from climate-related disasters
• Historical and projected contingent
liabilities
• Availability of contingency
arrangements/disaster funds
Fiscal consequences of • Direct public spending on adaptation • Projected change to land uses due to
adaptation and mitigation and mitigation investment climate change
policies • Public cost of facilitating structural • Expected fiscal cost of required
change (“just transition”) adaptation and mitigation investment
• Loss of revenue from carbon-intensive (adaptation finance gap/mitigation
sectors finance gap)
• Share of government revenues from
high-risk sectors
Macroeconomic impacts of • Greater intensity and magnitude of • Projected impact of climate change on
climate change supply and demand shocks economic sectors
• Economic diversification
Climate-related risks and • Financial stability risks to the financial • Exposure of financial institutions to
financial sector stability sector climate risks based on the
location/exposure of their investments
Impacts of climate change on • Disruption of international supply • Openness of the economy and export
international trade and capital chains and trade flows diversification
flows • Lasting changes to comparative • Carbon intensity of exports
advantages and international trade • Share of high-risk commodities (e.g.
patterns and specialization fossil fuels and agriculture) in total
• Impacts on balance of payments exports
Impacts of climate change on • Accentuation of social tensions and • Existing resource conflicts
political stability resource conflicts • Dependency on food imports
• Greater intra- and inter-state migration
movements, which may foster inter-
and intrastate conflicts
Source: Compiled by authors.

49
4. Climate Change and Sovereign Risk in
Southeast Asia and Implications for
Macrofinancial and Fiscal Stability
Southeast Asian countries are among those most heavily affected by climate change, with devastating
impacts on the economy that are increasing at a faster pace than in other regions (Yusuf and
Francisco 2009, ADB 2017). Financial investors in the region are increasingly recognizing the
investment risks associated with climate change (Munich Re 2013, CWR et al. 2019), and a growing
number of financial authorities across the Association of Southeast Asian Nations (ASEAN) have
started to address climate-related financial risks in their work (Volz 2019, Durrani, Masyitah, and Volz
2020). The central banks and monetary authorities of six ASEAN countries have already become
members of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS)
and started to consider impacts of climate change on their economies and how to address these.28
This chapter assesses the macrofinancial risk for ASEAN countries and the implications for
macrofinancial stability. We first review climate risks in Southeast Asia as a whole, before examining
which of the potential transmission channels discussed in Chapter 3 are particularly relevant for
ASEAN countries.

4.1 Climate risks in Southeast Asia

According to the IPCC (2014)’s Fifth Assessment Report (AR5), average temperatures in Southeast
Asia have increased by approximately 0.14°C–0.2°C every decade since 1960. If global increases in
greenhouse gas emissions follow the business-as-usual scenario, parts of Southeast Asia could enter
into new climate regimes due to the frequent occurrence of unprecedented heat extremes (IPCC
2014). Even if the 2°C goal of the Paris Agreement is achieved, Southeast Asia is projected to be
affected by summer heat extreme events every 2–5 years. Under a business-as-usual scenario they
are expected to occur every year (ADB 2017). Figure 15 displays the change in the number of days in a
year where the daily temperature is projected to exceed the local 90th percentile in 2030–2040,
compared to the baseline period of 1975–2005. The darkest orange represents the most days, while
grey represe4nts a decrease in days.
The AR5 IPCC report indicates that precipitation patterns will undergo significant changes at the
regional level, although inter-regional differences do exist and projections remain problematic (IPCC
2014). Annual total wet-day rainfall, rainfall from extreme rain days, and the ratio of rainfall between
the wet to the dry seasons has increased. However, while there has been an increasing frequency of
extreme events in northern Southeast Asia there are decreasing trends in Myanmar. Additionally,
Peninsular Malaysia has experienced a decrease in the frequency of wet days and total rainfall during
the monsoon season, but the Southeast Asian region has experienced an increase in rainfall intensity
(IPCC 2014). An increase in the frequency and intensity of extreme rainfall events is projected for the
Southeast Asia region (ADB 2017). In the Lao People’s Democratic Republic (Lao PDR), two-thirds of
the country’s population face an average of 1.5 serious floods or drought every year (World Bank and
GFDRR 2012). Figure 16 shows the change in the number of days in a year when the daily rainfall
volume is projected to exceed the historical local 95th percentile in 2030–2040, compared to the

28 The six central banks and monetary authorities are the National Bank of Cambodia, Bank Indonesia, Bangko Sentral ng
Pilipinas, the Bank of Thailand, Bank Negara Malaysia, and the Monetary Authority of Singapore.

50
 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

baseline period of 1975–2005. The darkest orange represents the most days, while light blue
represents a decrease in days.

Figure 15: Change in the number of days in a year where the daily temperature
is projected to exceed the local 90th percentile in 2030–2040

Source: Four Twenty Seven.

Figure 16: Change in the number of days in a year when the daily rainfall volume
is projected to exceed the historical local 95th percentile in 2030–2040

Source: Four Twenty Seven.

51
Climate Change and Sovereign Risk

Rising temperatures and droughts also increase wildfire risk. Figure 17 depicts projected change in
wildfire potential for the period 2030–2040, based on the availability of burnable vegetation and on
projected soil moisture deficit. The darkest areas have the most exposure to increased wildfire
potential, while the lightest areas have the least exposure.

Figure 17: Projected change in wildfire potential in 2030–2040

Note: Soil moisture deficit is modelled using the Keetch-Byram Drought Index. Wildfire fuel is derived from high resolution land
cover data from the European Space Agency.
Source: Four Twenty Seven.

Several ASEAN countries are at high risk of experiencing water stress, i.e. the competition among
water users relative to available surface water resources (Table 11, Figure 18). Singapore is facing
extremely high water stress, and is ranked number 1 globally in terms of water stress. Indonesia and
the Philippines are also projected to face high water stress, while Malaysia and Thailand face low to
medium water stress. Global warming of 1.5°C is projected to increase the number of people exposed
to water scarcity by 79 million across Southeast Asia (UNESCAP 2020).
Sea level rise rates in the Western Pacific Ocean were about three times greater than the global mean
during 1993–2012. This is a particular concern for Southeast Asia and especially for the Philippines
and Indonesia which are archipelagic states (IPCC 2014). Projections indicate an increase in sea levels
of 3–6 meters by 2030 (Marzin et al. 2015). This will result in land loss and contribute to coastal
erosion, flooding, and salt-water intrusion. Global warming of 1.5°C is also projected to increase the
incidence of river flooding. The population affected by river flooding is projected to increase by 71%
in Cambodia, 135% in the Lao PDR, 47% in Myanmar, 129% in Thailand, and 139% in Viet Nam
(UNESCAP 2020). Resulting economic damage is projected to increase by 70% in Cambodia, 143% in
the Lao PDR, 49% in Myanmar, 119% in Thailand, and 148% in Viet Nam (UNESCAP 2020).

52
 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Table 11: Projected water stress ranking for ASEAN countries for 2040
under a business-as-usual scenario
Rank All sectors Industrial Domestic Agricultural
Brunei Darussalam 157 0.01 0.01 0.01 0.01
Cambodia 135 0.38 0.52 0.41 0.37
Indonesia 51 3.26 3.42 3.28 2.99
Lao PDR 149 0.08 0.10 0.11 0.07
Malaysia 83 1.78 1.78 1.70 2.00
Myanmar 146 0.17 0.20 0.20 0.15
Philippines 57 3.01 2.96 2.92 3.26
Singapore 1 5.00 5.00 5.00 NA
Thailand 80 1.82 1.71 1.59 1.85
Viet Nam 107 0.96 1.02 0.98 0.95

Note: Higher scores on the scale from 0 to 5 correspond to greater competition among water users relative to available surface
water resources. A score of 0–1 corresponds with low water stress, with a ratio of withdrawals to available water of <10%; a score
of 1–2 corresponds with low to medium water stress, with a ratio of withdrawals to available water of 10–20%; a score of
2–3 corresponds with medium to high water stress, with a ratio of withdrawals to available water of 20–40%; a score of
3–4 corresponds with high water stress, with a ratio of withdrawals to available water of 40–80%; and a score of 4–5 corresponds
with extremely high water stress, with a ratio of withdrawals to available water of >80%.
Source: Compiled with data from Luo, Young, and Reig (2015).

Figure 18: Projected water stress risk in ASEAN countries in 2040

Note: Distribution of water-stress levels, comprised of six indicators that measure current water stress, water availability, and
projected changes in water availability in volume and in relative terms in 2040. Data derived from Aqueduct Global Maps 2.1 and
Aqueduct Water Stress Projections.
Source: Four Twenty Seven.

53
Climate Change and Sovereign Risk

Even though the vulnerability to climate risks varies significantly across Southeast Asian countries, the
region constitutes one of the most climate vulnerable regions in the world where economic impacts
of global warming are predicted to be among the largest (Yusuf and Francisco 2009; ASEAN 2017;
Kompas, Pham, and Che 2018; UNESCAP 2020). More than 152 million people (24% of the population)
across Southeast Asia reside in areas that experience flood events, and more than 389 million people
(62% of the population) reside in areas that experience drought events (UNESCAP 2020). There are
numerous multi-hazard hotspots across Southeast Asia, including the Mekong Delta in Cambodia and
Viet Nam, the eastern coastline of Viet Nam up to the Red River Delta, the Ayeyarwady (Irrawaddy)
Delta in Myanmar, the Chao Phraya Delta in Thailand, Manila and other vulnerable areas across the
Philippines, and various populated islands in Indonesia (Thomalla, Boyland, and Calgaro 2017). In Viet
Nam and the Philippines, 76% of the population lives in high multi-hazard risk areas, in Cambodia the
percentage is 56%, in Indonesia 53%, and in Myanmar 51% (UNESCAP 2019).
In the widely-used Climate Risk Index by Germanwatch, which ranks countries according to fatalities
and economic losses due to weather-related loss events, four ASEAN countries—Myanmar, the
Philippines, Viet Nam, and Thailand—are listed among the 10 countries most affected by climate-
related disasters over the period 1999 to 2018, with Cambodia coming close behind on rank 12
(Table 12). At the same time, Brunei Darussalam and Singapore rank among those countries with the
least fatalities and damage. Figure 19 shows a significant increase in the absolute number of extreme
weather events in ASEAN since the start of the last century. The increase has been driven by a rapid
growth in the number of floods, storms, and landslides.

Table 12: Climate Risk Index for 1999–2018

Fatalities per Losses in
100,000 million US$ Losses per unit
Fatalities inhabitants 1999– (PPP) GDP in %
1999–2018 2018 1999–2018 1999–2018
CRI Rank Country CRI score (Rank) (Rank) (Rank) (Rank)
175 Brunei Darussalam 169.17 168 154 179 180
12 Cambodia 35.33 40 34 52 26
77 Indonesia 76.83 16 92 21 120
76 Lao PDR 76.33 86 77 92 63
114 Malaysia 103.33 64 102 66 143
2 Myanmar 10.33 1 1 19 20
4 Philippines 17.67 7 16 9 29
180 Singapore 172.17 172 172 163 177
8 Thailand 31.00 22 62 4 18
6 Viet Nam 29.83 14 42 13 34

CRI = Climate Risk Index, GDP = gross domestic product, PPP = purchasing power parity.
Note: The CRI score is calculated as a weighted average of the individual scores. For instance, with Viet Nam ranking 14th in
fatalities among all countries, 42nd in fatalities per 100,000 inhabitants, 13th in losses, and 34th in losses per unit GDP, Viet Nam’s
CRI score is calculated as follows: 14x1/6 + 42x1/3 + 13x1/6 + 34x1/3 = 29.83.
Source: Compiled by authors with data from Eckstein et al. (2019).

54
 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Figure 19: Historical occurrences of extreme weather events in ASEAN, 1900–2019

Source: Compiled by authors with data from EM-DAT (2020).

Table 13 provides a breakdown of the average number of annual fatalities, people affected, absolute
losses, losses as share of GDP for the period 2000–2019, as well as the total number of events over
this period. Average total annual losses amounted to 0.44% of GDP in Cambodia, 0.27% in the Lao
PDR and Myanmar, and 0.19% in Thailand. These averages, however, conceal the damage that can be
caused by single events. In 2008, Cyclone Nargis caused economic damage totaling an estimated
12.6% of GDP in Myanmar. The damage caused by the 2011 flood in Thailand is estimated at 10.9%
of GDP. Over the period 1993–2018, the 10 ASEAN countries and their combined population of
622 million experienced direct economic losses from weather-related events worth US$124 billion,
which equates to an annual loss of US$5.2 billion (Table 14). Of these, only 14% were insured.
However, this figure is due to a relative high insurance coverage in Thailand, where 27% of losses
were insured. In the Lao PDR, Myanmar, Viet Nam, and Cambodia, hardly any losses were insured,
while insurance covered only 5% of losses in the Philippines, 8% in Indonesia, 11% in Singapore, and
14% in Malaysia.

Table 13: Impacts of climate-related disasters in ASEAN countries, 2000–2019

Total people Total losses in Total losses as
Total deaths affected US$ million share of GDP in %
(average (average (average (average Number of events
Country 2000–2019) 2000–2019) 2000–2019) 2000–2019)* (total 2000–2019)
Cambodia 42 646,601 54.46 0.44 24
Indonesia 30 37,010 44.78 0.01 189
Lao PDR 14 177,989 22.85 0.27 20
Malaysia 4 65,377 30.19 0.01 47
Myanmar 3,489 158,644 104.62 0.27 40
Philippines 83 522,994 76.23 0.04 273
Thailand 31 941,647 574.33 0.19 82
Viet Nam 34 268,182 135.4 0.11 142
Notes: No events were reported for Brunei Darussalam and Singapore between 2000 and 2019. Numbers for total deaths and
people affected are rounded. * These numbers are not weighted by GDP/year but by the average of total losses in US$ million by
the GDP average between 2000 and 2019.
Sources: Compiled by authors with data from EM-DAT (2020), World Development Indicators, and International Monetary Fund.

55
Climate Change and Sovereign Risk

Table 14: Losses from weather-related events, 1993–2018

Overall losses Insured losses
(2018 values in US$ million) (2018 values in US$) Fatalities
Brunei Darussalam 3 NA 2
Cambodia 2,200 2.3 1,221
Indonesia 15,000 1,200 5,960
Lao PDR 460 NA 188
Malaysia 2,300 330 974
Myanmar 5,500 NA 143,070
Philippines 24,000 1,200 20,617
Singapore 42 4.4 2
Thailand 55,000 15,000 3,681
Viet Nam 19,600 43 9,247
Source: Compiled by authors with data from NatCatSERVICE. [Link]

4.2 How can climate change affect sovereign risk in Southeast Asia?
The preceding overview clearly shows that climate risk is very high for the region as a whole, although
there are marked differences across countries. The following analysis will first review the depletion of
natural capital in Southeast Asia and then examine the relevance of the six risk channels discussed in
Chapter 3 for sovereign risk in Southeast Asia.

4.2.1 Natural capital as the basis of economic prosperity

The consumption of natural capital in all Southeast Asian countries has increased dramatically over
the last thirty years as consumption and population sizes have increased. According to Global
Footprint Network data, every country in Southeast Asia has a higher ecological footprint per capita in
comparison to bio-capacity per capita (Table 15). “Ecological footprint per capita” represents the
domestic and foreign biologically productive land and water individuals require to produce all
resources they consume and absorb all associated waste generated, using prevailing technology and
resource management practices (Global Footprint Network 2020). “Bio-capacity per capita”
represents the capacity of ecosystems to produce the biological materials used by an individual and
to absorb waste material generated, under current management schemes and extraction
technologies (Global Footprint Network 2020). The result is a bio-capacity deficit meaning that the
region is importing bio-capacity through international trade, liquidating domestic ecological assets, or
emitting wastes into global common resources such as the atmosphere in the case of greenhouse gas
emissions. Myanmar and the Lao PDR are the only countries which do not operate at a bio-capacity
deficit; however, they are close to operating at net-zero.
The depletion of natural capital is reflected in the deteriorating of ecosystems across the region.
Southeast Asia is home to some of the world’s most diverse terrestrial and marine ecosystems. As of
2007, 792 key biodiversity areas—sites of global biodiversity significance—were identified. Globally,
approximately one-third of all coral reefs (Box 2), mangroves, and seagrass areas are in Southeast
Asia. Unfortunately, Southeast Asia is experiencing massive habitat and species loss, largely due to
economic activities (production and pollution). Reducing the rate of biodiversity loss is a major
challenge. Deforestation of tropic forests has and continues to be a problem, historically due to
logging, but recently largely due to oil palm cultivation. Mangrove losses are among the highest in the
world with 630 square kilometers being stripped away annually over the last two decades. Losses of
coral reefs are also reported to be the highest in the world, in 2008 the rate of loss was estimated at
40% (Brander and Eppink 2012).

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Table 15: Depletion of natural capital across Southeast Asia

Bio-capacity per capita Ecological footprint per capita Bio-capacity reserve/deficit
Brunei Darussalam 2.8 4.3 –1.5
Cambodia 1.1 1.4 –0.3
Indonesia 1.3 1.7 –0.4
Laos PDR 2 1.9 0.1
Malaysia 2.3 3.9 –1.6
Myanmar 1.9 1.7 0.2
Philippines 0.6 1.3 –0.7
Singapore 0.1 5.9 –5.8
Thailand 1.2 2.5 –1.3
Viet Nam 1.0 2.1 –1.1

Source: Compiled by authors with data from Global Footprint Network (2020).

Box 2: The Coral Triangle

The Coral Triangle is a 6 million square kilometer (km2) region spanning six countries, where 76% of the
world’s coral species and six of the world’s seven marine turtle species can be found (WWF 2019). There
is over 100,000 km2 of coral reefs within the Coral Triangle, comprising 30% of the global total
(Hoegh-Guldberg et al. 2009). The Coral Triangle directly provides livelihoods to 120 million people and
supports a nature-based tourism industry worth US$12 billion a year (Brander and Eppink 2012).
Commercial fisheries within the Coral Triangle amount to over US$3 billion, with annual tuna exports alone
amounting to US$1 billion. The natural capital within the Coral Triangle provide significant ecosystem
services such as contributing to water quality maintenance along coastlines, stabilizing sediments, and
acting as filtration systems as water runs from land to sea. Coral reefs act as vital green infrastructure by
reducing wave power. These functions cannot be economically replaced if these ecosystems are lost
(Hoegh-Guldberg et al. 2009). The annual economic net benefits per km2 of healthy coral reefs in Southeast
Asia ranges from US$23,100 to US$270,000 in relation to the benefits they provide in relation to coastal
protection, fisheries, tourism, recreation, and aesthetic values (Burke, Selig, and Spalding 2002).

If unsustainable practices continue, these ecosystems will be under considerable threat and are at risk
of collapse. It has been estimated that 96% of coral reef areas will be in highly, very highly, and critical
condition by 2050. This will significantly damage and alter coastal economies and livelihoods,
particularly for the fisheries and tourism sectors. The foregone value of reef-related fisheries is
estimated at US$5.64 billion per year (Brander and Eppink 2012). Mangrove areas are expected to
decline by 2.08 million hectares from 6.04 million hectares by 2050 if current trends continue, with
associated losses of US$2.16 billion (Brander and Eppink 2012).
Climate change will exacerbate existing and introduce new risks posed by declining natural capital in
the ASEAN region. Projected sea level rise in the Western Pacific Ocean will result in land loss and
contribute to coastal erosion, flooding, and salt-water intrusion, deteriorating the natural capital of
coastal environments with subsequent impacts on coastal economies such as agriculture and
aquaculture. This will subsequently impact local food security through straining livelihoods and
food supply.

57
Climate Change and Sovereign Risk

4.2.2 Fiscal impacts of climate-related disasters

As discussed before, the Southeast Asian region has seen an increase in the number and intensity of
climate-related disasters. Figure 20 shows the average annual loss as percentage of GDP for ASEAN
countries. The Lao PDR (8.7%), Cambodia (8.0%), the Philippines (6.7%), and Viet Nam (6.2%) face the
largest average annual losses, relative to GDP. In contrast, Brunei Darussalam and Singapore face
almost no losses.

Figure 20: Average annual loss as percentage of GDP, by country

Note: Figures are based on probabilistic risk assessment. Singapore is not displayed as its value is below 0.5%.
Source: Compiled by authors with data from UNESCAP (2020).

The immediate impact of disasters on public finances, which comprises the cost of damage and repair
of public property, spending on crisis responses and recovery, as well as foregone tax income due to
output losses, is not easy to measure, given indirect effects. The account of contingent liabilities
related to climate-related disasters in Southeast Asia is patchy. Table 16 provides an overview
of historic contingent liabilities of five ASEAN countries—Indonesia, the Lao PDR, Malaysia, the
Philippines, and Thailand—over the last three decades. Besides financial crises (and associated
problems with public–private partnerships), natural disasters were the main trigger of contingent
liabilities. In this list the largest contingent liability related to a climate-related disaster was realized in
Thailand after the flooding of 2011, amounting to 3% of GDP.

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Table 16: Historic contingent liabilities of ASEAN countries, 1990–2019

Subtype of Impact
contingent amount
Country Year(s) liability (% of GDP) Additional information
Indonesia 1994 Financial 2.0 Nonperforming assets equaled to more than 14% of banking system assets,
sector with more than 70% in state banks. Recapitalization costs for five state banks
amounted to nearly 2% of GDP.
1997–2001 Financial 56.8 Widespread systemic banking crisis associated with the Asian crisis affected
sector both state-owned banks and private commercial banks. The government
declared a temporary blanket guarantee and a bank restructuring package
that ultimately implied the closure of more than 60 banks and gross outlays of
over 50% of GDP.
1997–1998 Natural NA Total damage from huge fires estimated at 3.1% of GDP in 1997 and 1.3% of
disaster(s) GDP in 1998.
1998 SOEs 4.0 During the 1998 crisis the central government paid for the electricity
company's fuel costs, amounting to 4% of GDP.
1998 PPPs NA Substantial obligations on PPP contracts in power plants and roads became
due during the Asian crisis.
2004 Natural 1.8 Public expenses for recovery and reconstruction efforts following the Aceh
disaster(s) and West Sumatra tsunami amounted to US$4.6 billion.
2005–2007 Natural 0.7 Total damage estimated at 1.6% of GDP. Total cost of reconstruction
disaster(s) estimated at US$4.5 billion but a large part donor financed (around $4 billion
pledged for 2005–2009 on and off budget). Total impact on overall balance
(considering budget disaster related expenditures minus on budget grants
and concessional loans) for 2005–2009 was 0.7% of GDP.
Lao PDR 2009 0.4 Public expenses for recovery and reconstruction efforts following Typhoon
Ketsana.
Malaysia 1997–1999 Financial 16.4 Large systemic banking crisis (associated with the Asian crisis) with
sector nonperforming loans peaking at 25–35% led to substantial government
support.
2001 Private 3.5 An assumption of debt by the government (equivalent to about 3.5% of GDP)
nonfinancial associated with the debt restructuring of the Malaysian Airline System and
sector two other large infrastructure projects (Putra and Star Light Rail), which until
then were managed and operated by the private sector.
Philippines 1991 Natural 0.4 EM-DAT estimates the total damage at 1.7% of GDP. A powerful earthquake in
disaster(s) July 1990 and a strong typhoon in November interrupted export production
and inflicted heavy damage on infrastructure. A sharp rise in capital outlays
for earthquake reconstruction (by P$5 billion, or 0.4% of GNP) was included in
the 1991 budget.
1995 Natural NA Total damage from storm estimated at 1.2% of GDP.
disaster(s)
1997–2001 Financial 13.2 The crisis raised the magnitude of NPLs in bank portfolios. This in turn
sector necessitated recapitalization to restore asset qualities.
2009 Natural 1.4 Typhoon Ketsana and a second typhoon directly after resulted in recovery and
disaster(s) reconstruction requirements totaling US$4.4 billion, including US$2.4 billion
public spending needs.
2014 Natural 1.0 Typhoon Yolanda, the strongest storm ever to make landfall, struck the
disaster(s) central Philippines in November 2013, causing an estimated total damage of
4.6% of GDP. The government earmarked about ₱120 billion (1% of GDP) for
reconstruction spending in 2014.
Thailand 1993 Natural NA Total damage due to flood estimated at 1.7% of GDP.
disaster(s)
1997–2000 Financial 43.8 Finance companies had large exposure to the property sector and were
sector severely affected by the economic downturn. Widespread nationalization and
bank closures took place amid large systemic crisis and very high
nonperforming loans.
1998 PPPs NA Substantial obligations on PPP contracts in power plants and roads became
due during the Asian crisis.
2011 Natural 3.0 The total damage of the Thai flooding is estimated at 11.7% of GDP. A
disaster(s) reconstruction investment program equivalent to 3% of GDP was initiated as a
response.

PPP = public–private partnership, SOE = state-owned enterprise.

Source: Compiled with by authors with data from Bova et al. (2019), Cevik and Huang (2018), and World Bank and GFDRR (2012).

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The expected annual fiscal burden arising as a consequence of natural disasters (including recovery
and reconstruction liabilities) as a percentage of government expenditure was estimated by the
World Bank and the Global Facility for Disaster Reduction and Recovery (GFDRR) at 2.5% for
Myanmar, 1.5% for the Philippines, 1.0% for Cambodia, 0.9% for the Lao PDR, 0.7% for Viet Nam,
0.3% for Indonesia, and 0.1% for Thailand and Malaysia, respectively (World Bank and GFDRR
2012, Figure 21). However, the estimated probable fiscal burden arising as a consequence of a
1-in-200-year probable maximum economic loss event as a percentage of annual government
expenditure are significantly higher. The World Bank and GFDRR (2012) estimate these at 23% for the
Lao PDR, 19.5% for the Philippines, 18% for Cambodia, 5% for Viet Nam, 4% for Indonesia, and 1.5%
for Malaysia and Thailand, respectively (Figure 22). With global warming accelerating, chances are
that disaster losses will rise further, unless investment in adaptation and resilience is scaled up
substantially, which would also increase direct fiscal burdens.

Figure 21: Annual expected fiscal burden arising as a consequence of natural disasters
as a percentage of annual government expenditure

Note: Limited data were available for Myanmar and therefore the data may not accurately reflect long-term average annual losses.
Source: Compiled by authors with data from World Bank and GFDRR (2012).

Figure 22: Estimated probable fiscal burden arising as a consequence of a 1-in-200-year probable
maximum economic loss event as a percentage of annual government expenditure

Note: Myanmar and Brunei Darussalam did not represent sufficient number of loss years, either historically or simulated, to
compute reliable probable maximum economic losses.
Source: Compiled by authors with data from World Bank and GFDRR (2012).

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

A major problem is that disaster losses, both private and public, are largely uninsured across
Southeast Asia. According to the ASEAN Insurance Pulse 2019 report, in 2018 nonlife insurance
premiums in ASEAN accounted for only 1.0% of GDP, less than one-third of the global average of 2.8%
(Schanz, Alms & Company 2019). Because of this insurance protection gap, governments will have to
step in to cover losses more often, requiring them to fund disaster response and recovery and
reconstruction activities.
Most ASEAN countries have contingency lines in public budgets or reserves for unforeseen
expenditures, often explicitly related to natural disasters. However, these tend to be modest and
insufficient in the face of larger events. A prominent example is the Philippines, which has established
Calamity Funds and Quick Response Funds to provide contingency financing in case of disasters. Every
local government unit is required to allocate 5% of its annual budget to a Calamity Fund, 30% of
which goes into a Quick Response Fund, while the rest is dedicated to mitigation, prevention, and
preparedness programs (Cevik and Huang 2018).

4.2.3 Fiscal consequences of adaptation and mitigation policies

Fiscal implications of adaptation policies
To protect people and the economy from the physical effects of climate change, ASEAN countries will
need to substantially scale-up adaptation finance, including investment in physical and social
infrastructure that will help to reduce exposure and vulnerability, and prepare for climate impacts.
ASEAN governments will also need to invest in faster and more efficient recoveries. Although various
studies look into the cost of adaptation (e.g. UNEP 2016, 2018), the literature is sketchy and
comprehensive assessments or syntheses of the cost of adaptation for Southeast Asian countries are
lacking to date.
In many ways, public infrastructure forms the backbone of a nation and is essential for health, safety,
and economic continuity. Transportation infrastructure provides an important example when
discussing the fiscal consequences of climate adaptation. Economies and communities depend on
continuous transportation infrastructure and a system that is not prepared for climate change is likely
to affect fiscal resources by necessitating increased expenditures due to repair costs and potentially
reducing revenue when assets such as toll roads, ports, and airports are disrupted. Climate-resilient
infrastructure is critical to economic continuity. Persistent disruptions to infrastructure can lead to
declines in economic productivity and reduced revenue. By investing in adaptation and proactive
planning, governments can avoid some of these costs. However, upfront infrastructure investment is
also costly and presents significant fiscal challenges. How and when sovereigns invest in infrastructure
adaptation can have impacts on their fiscal resources as well as other credit indicators.
ADB (2017) estimates infrastructure investment needs in Southeast Asia at US$2,759 billion (in 2015
prices) for the period 2016–2030. This amounts to annual investment needs of US$184 billion on
average, or 5.0% of projected GDP. Taking into account additional cost for climate mitigation and
adaptation,29 climate-adjusted estimates of total investment needs are US$3,147 billion or
US$210 billion annual average, or 5.7% as share of GDP. Compared with the baseline estimates, the
estimated costs are US$388 billion or 14% higher when investments are climate proofed, i.e. made
resilient to climate change impacts such as sea level rise and intensified extreme weather events that
can damage infrastructure and reduce its lifespan. In terms of annual expenditure, costs would rise
from US$184 billion to US$210 billion. ADB (2017) estimates total infrastructure investment needs
in Indonesia at US$1,108 billion, or US$74 billion annual average (5.5% of GDP) for the period
2016–2030. The climate-adjusted estimates for Indonesia are US$1,229 billion or US$82 billion or 6%
of GDP annually.

29 In terms of climate mitigation, these figures include incremental costs for low-carbon energy investment. It should be
noted that low-carbon energy is in most cases cheaper now than fossil-fuel based energy (IRENA 2020).

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Figure 23 shows estimates by UNESCAP (2020) for annual average additional investment of ASEAN
countries to meet global average investments in the social sectors and 2% of GDP in infrastructure
required to reduce disaster losses over the period 2016–2030. UNESCAP (2020) points out that the
additional investment needs are lower than the average annual expected losses from disasters.
Indeed, their estimates suggest that in Cambodia, the Lao PDR, the Philippines, Thailand, and Viet
Nam the additional investments required per year are more than 50% lower than the average annual
expected losses. Considering the potential loss and damage related to major disasters, returns of
these investments are even more favorable. For instance, the US$47 billion in additional investment
estimated for Thailand over the period 2016–2030 is only 13% of the losses incurred as a
consequence of the 2011 flood (UNESCAP 2020).

Figure 23: Average additional investment required per year, 2016–2030 (US$ billion)

Note: Additional investment figures refer to the difference between projected average annual investment if public expenditure in
each sector, from 2016–2030, continues at the same percentage of GDP as in 2016, and average annual investment required over
2016–2030, if investments in each sector meet global averages.
Source: Compiled by authors with data from UNESCAP (2020).

When reviewing 4,135 transportation infrastructure sites across ASEAN, we find that floods present
the most significant risks to a large proportion of these assets (Figure 24). Transportation
infrastructure is most at risk in Myanmar, where 62% of the roads are exposed to floods.
Transportation infrastructure is essential for commuters and supply chains, underpinning national
economies. While infrastructure can be funded in several different ways, public assets require
government financing for maintenance and repairs. In many cases, infrastructure is built to withstand
the historical occurrences of extreme events but is not prepared for the repeated severe inundation
or record high temperatures that it will increasingly endure in a changing climate.
Public infrastructure funding typically comes from national or local budgets or from spending
supported by financing instruments such as debt, insurance or grants from development finance
institutions (Ambrosio et al. 2019). Climate change can have impacts on each of these funding
options. For example, shifting temperature patterns or rainfall regimes can affect travel demand at
airports and ports, as commodity production and tourism may shift. This can lead to reduced revenue
and in turn make it more challenging to pay back loans, which can eventually lead to reduced credit
ratings and more expensive debt in the future. This creates a negative feedback loop in which those
cities and countries that are most vulnerable to climate hazards often find it the most challenging to
obtain financing. The increasing frequency of floods and storms can complicate insurance options and

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

increase premiums. However, there is a potential for increased grant opportunities as development
finance institutions increasingly identify climate adaptation as an investment opportunity. When
approached proactively, infrastructure adaptation will change fiscal planning but not deteriorate
fiscal resources.

Figure 24: Proportion of ASEAN transport infrastructure exposed to climate hazards

Source: Compiled with data from Four Twenty Seven.

Infrastructure projects have long-life times and it is thus essential to factor changing climate
conditions and resilience into their development. If climate resilience is not integrated into decision
making, there will be fiscal impacts as governments incur sudden costs, reduce their debt reserves,
and ultimately have trouble repaying their loans. However, if governments integrate climate
considerations up front into both infrastructure development and fiscal planning, they will likely
incur lower unexpected costs and can work climate change resilience into the infrastructure
investment upfront.
In the Philippines, 80% of assessed infrastructure, primarily ports and airports, has at least high risk
for heat stress (Figure 25), 75% has at least high risk to hurricanes and typhoons, 52% has at least
high risk to floods, and 32% has at least high risk to sea level rise. Each of these hazards has potential
to cause disruption and increase costs, with rippling impacts on public finances. For example, when
flood events that used to be rare increasingly occur every several years, ports, airports, and highways
experience inundation that they were not built for.

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Climate Change and Sovereign Risk

Figure 25: Exposure of the Philippines transportation infrastructure to floods

Source: Four Twenty Seven (2020).

In the Philippines, infrastructure has traditionally been funded and operated publicly, although
public–private partnerships have started to increase (MacLean 2017). The Duterte administration,
which began in 2016, has identified infrastructure development as a high priority, with a commitment
to spending up to 7% of the country’s annual GDP on these investments (UNESCAP 2017). Integrating
climate resilience and adaptation into these considerations in the initial investment phase can help to
make the best use of these fiscal resources and reduce unexpected costs in the future. The federal
government is responsible for most of the country’s infrastructure funding, along with official
development assistance and the private sector. The government’s funding is dependent on
comprehensive tax reform, which can be particularly vulnerable to climate change. Population
displacement after storms can reduce the tax base, while business disruptions and reduced labor
productivity affect economic activity and consumer behavior with implications for tax reform, political
sentiment, and associated revenues.
In its National Communications to the United Nations Framework on Climate Change, the Philippines
identified climate proofing infrastructure as an adaptation priority (Philippines 2014), which has
implications for its budgeting and fiscal planning. It is exploring the possibility of implementing levies
on road and port users, as well as airline and shipping services, to help finance adaptation.
Fiscal implications of mitigation policies
According to ADB (2015), if the goals of the Paris Agreement are to be met, then greenhouse gas
emissions reductions in Southeast Asia will be driven mostly by improving energy efficiency, halting
deforestation (critical to reducing decarbonization costs), and increasing low-carbon energy
investment. ADB estimates put the annual cost for the region at US$2 billion—roughly 0.6% of the
combined GDP of ASEAN countries.

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Table 17 shows a summary of the emissions and the carbon intensity of generation in the year 2030,
as well as the total investment required under the Nationally Determined Contributions (NDCs) and
an enhanced low-carbon action scenario for Indonesia and Viet Nam. The latter foresees a significant
rise of renewable energy in the overall energy generation mix as well as enhanced energy efficiency.
The total investment needs to achieve the NDCs in the energy sector are estimated at US$298 billion
for Indonesia and US$209 billion for Viet Nam. To achieve the more ambitious enhanced low-carbon
action scenarios, which would reduce power sector emissions compared to the NDCs by 13% in
Indonesia and 12% in Viet Nam, US$330 billion and US$194 billion are needed, respectively. It should
be noted that the estimated additional cost of achieving the enhanced scenario, compared to the
NDCs, are negative, partly because of energy efficiency savings.

Table 17: Emissions and total investment to achieve Nationally Determined Contributions—
scenario and enhanced low-carbon goals in Indonesia and Viet Nam
Power sector emissions in 2030 Carbon intensity of generation in 2030 Total investment
Power (MtCO2) (gCO2/kwh) (US$ billion)
sector Enhanced Enhanced Enhanced
emissions low low- low-
in 2014 NDC carbon NDC carbon NDC carbon
(MtCO2) Scenario scenario % change Scenario scenario % change Scenario scenario % change
Indonesia 168 496 431 –13 606 526 –13 298 330 11
Viet Nam 50 299 264 –12 537 503 –6 209 194 –7

gCO2 = grams of carbon dioxide, kWh = kilowatt-hour, MtCO2 = million tons of carbon dioxide, NDC = nationally determined
contribution.
Source: Compiled by authors with data from Zhai, Mo, and Rawlins (2018).

The ADB pointed out that mitigation costs for ASEAN are lower than the amount spent on subsidizing
fossil-fuels, which in 2010 equated to 3% of GDP; gradually and predictably reducing fossil-fuel
subsidies would free financial resources to finance mitigation efforts and set the right price signals
for the low-carbon transformation to occur (Raitzer et al. 2015). However, a low-carbon or even
zero-carbon transition would have to involve a phasing out of fossil fuels. This could cause trouble for
governments that currently rely to a high degree on revenues from the extraction of oil, natural gas,
and coal resources. In Indonesia, revenues from fossil fuel accounted for 22.6% of total government
revenues in the period 2011–2016 (OECD, World Bank, and UN Environment 2018). A back-of-the-
envelope calculation for Indonesia suggests that the introduction of a US$75 per ton carbon tax
(+1.8%/GDP), the loss of fossil fuel revenues (–3.3%/GDP for 2011–2016), and the saving of fossil fuel
subsidies (0.7%/GDP in 2017) would worsen the fiscal balance by 0.8% of GDP.30 Foregone revenues
from fossil fuel extraction would be a particular problem for Brunei Darussalam, where the oil and gas
industry contributes around 60% of the country’s GDP.

4.2.4 Macroeconomic impacts of climate change

ASEAN members will likely experience larger economic losses from climate change than most other
areas of the world due to climate change impacts on agriculture, tourism, energy demand, labor
productivity, health, and ecosystems integrity (Raitzer et al. 2015). Estimations of climate change
impacts on economic growth are inexorably based on a host of assumptions on climatic trends,
tipping points, technological innovation, adaptive capacity and the effects of all these on human
well-being and economic activity. Long-term growth projections hence need to be taken cautiously.

30 Estimates for carbon tax revenues and data on fossil fuel revenues are from OECD, World Bank, and UN Environment
(2018), while data on fossil fuel subsidies are from International Energy Agency’s Energy Subsidies database (2019).

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Still, they do provide a useful indication of growth trends under different climate scenarios. Most
projections suggest that the economic cost of inaction is immense. The ADB estimates that under a
business-as-usual scenario, Southeast Asian GDP will decline by 11% by 2100 (Raitzer et al. 2015).31
Table 18 displays recent country-by-country projections by Kahn et al. (2019) on losses in GDP per
capita by the years 2030, 2050, and 2100 under RCP2.6 and RCP8.5 scenarios. As discussed earlier,
Kahn et al. (2019)’s estimations suggest that the world’s real GDP per capita would be 7.22% lower in
2100 under RCP8.5, compared to an output loss of 1.7% under RCP2.6. According to Khan et al.
(2019)’s estimates, under RCP8.5 real GDP per capita would be 8.46% lower in 2100 in the
Philippines, 7.51% in Indonesia, 5.15% in Viet Nam, 4.12% in Malaysia, and 3.89% in Thailand.

Table 18: Percent loss in GDP per capita in Southeast Asian countries by 2030, 2050, and 2100
under the RCP2.6 and RCP8.5 scenarios
RCP2.6 Scenario RCP8.5 Scenario
2030 2050 2100 2030 2050 2100
Brunei Darussalam –0.15 –0.07 1.41 0.16 0.50 1.65
Cambodia –0.36 –0.38 1.84 0.10 0.26 0.74
Indonesia 0.19 0.61 1.92 0.91 2.79 7.51
Lao PDR –0.09 –0.07 0.78 0.19 0.65 2.34
Malaysia –0.15 –0.31 –0.34 0.53 1.51 4.12
Myanmar –0.34 –0.61 0.25 0.29 0.80 2.24
Philippines 0.29 0.98 3.05 0.98 3.09 8.46
Thailand –0.03 –0.05 0.06 0.29 1.12 3.98
Viet Nam 0.00 0.01 0.02 0.38 1.51 5.15

RCP = Representative Concentration Pathway.

Note: No data available for Singapore.
Source: Compiled by authors with data from Kahn et al. (2019, Table A.2).

Projections by Burke et al. (2015a) are even bleaker (Table 19). Their estimates suggest that because
of global warming, global average incomes will be 23% lower in 2100 under a RCP8.5 emissions
scenario compared to a scenario without climate change. According to their estimates, climate
change will not only hold back economic growth of Southeast Asian countries but even reverse their
economic development in the second half of the century. By 2050, the estimated impact of global
warming on per capita GDP ranges from –30.6% in the Philippines to –38.9% in Cambodia. By the end
of the century, GDP per capita is projected to be lower by around 80% across the region. Projections
by Kompas, Pham, and Che (2018), presented in Table 20 show a similarly bleak picture.

31 Earlier estimates by the ADB put these losses at 6.7% of GDP (ADB 2009).

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

Table 19: Impacts of global warming (3°C) on the GDP of Southeast Asian countries
GDP per capita
Projected Peak of positive Peak of GDP without Change in
average growth rate per capita over climate Change in GDP per
temperature over time with time with change in GDP per capita,
increase by climate change climate change 2099 capita, 2080–
Country 2100 (in °C) (approximately) (in US$) (in US$) 2040–2059 2099
Brunei Darussalam 3.25 2,044 41,737.88 126,684.7 –34.16 –81.47
Cambodia 3.60 2,075 3,740.398 24,706.32 –38.94 –81.57
Indonesia 3.32 2,067 8,841.082 38,561.36 –31.44 –77.93
Lao PDR 3.84 2,069 3,567.634 17,327.95 –32.31 –79.17
Malaysia 3.41 2,058 11,768.98 48,048.28 –33.53 –80.70
Myanmar 3.85 NA NA NA NA NA
Philippines 3.05 2,074 6,785.432 32,200.74 –30.61 –76.38
Singapore 3.23 NA NA NA NA NA
Thailand 3.69 2,058 8,341.051 40,265.12 –37.81 –84.70
Viet Nam 3.74 2,066 3,593.551 17,668.67 –33.60 –80.82

Source: Compiled by authors with data from Burke et al. (2015a).

Table 20: Projections on the GDP of ASEAN countries under different climate change scenarios
Impacts of Global Warming (3°C) on GDP Long-Run Impacts of Climate Change
(% Change/Year) Scenarios on GDP (% Change/Year)
Country 2027 2037 2047 2067 Long run 1°C 2°C 3°C 4°C
Brunei Darussalam –0.373 –0.815 –1.308 –2.385 –5.563 –1.202 –3.314 –5.563 –8.173
Cambodia –1.175 –2.439 –3.758 –6.482 –12.101 –3.509 –7.572 –12.101 –17.183
Indonesia –1.242 –2.594 –4.020 –6.973 –13.267 –3.347 –7.980 –13.267 –19.040
Lao PDR –1.039 –2.164 –3.342 –5.765 –10.621 –3.369 –6.795 –10.620 –15.759
Malaysia –1.091 –2.293 –3.568 –6.229 –12.118 –3.084 –7.145 –12.118 –17.339
Philippines –1.206 –2.592 –4.093 –7.275 –14.798 –4.113 –9.185 –14.798 –20.986
Singapore –0.905 –1.958 –3.106 –5.562 –11.652 –2.729 –6.923 –11.652 –16.566
Thailand –0.766 –1.605 –2.500 –4.401 –9.243 –2.541 –5.749 –9.243 –13.269
Viet Nam –0.802 –1.636 –2.500 –4.276 –7.959 –2.223 –4.862 –7.959 –11.641
Rest of Southeast Asia –1.342 –2.767 –4.237 –7.234 –12.924 –3.811 –8.110 –12.924 –18.573

Note: separate data for Myanmar are not available.

Source: Compiled by authors with data from Kompas, Pham, and Che (2018).

The agricultural and fisheries sectors are among the sectors most exposed to the physical impacts of
climate change. Despite a growing importance of manufacturing, agriculture (including forestry,
hunting, and fishing, as well as cultivation of crops and livestock production) still plays a major role
in most economies of Southeast Asia, with the exception of Brunei Darussalam and Singapore
(Figure 26). Except for these two countries, employment in agriculture constitutes between 10% and
62% of total employment, and value added to GDP ranges between 7% and 21%. Climate change is
projected to lower employment in agriculture due to lower crop yields (Rutten et al. 2014). Rising
temperatures and changing precipitation patterns, along with rising sea levels, a higher probability of
floods and droughts, and more intense tropical storms will impact the availability of arable land and
agricultural production, (Parker et al. 2019) and could have material impact on the economy at large.
Already now, average annual losses in agriculture are estimated at 2.4% of GDP for ASEAN countries

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on average, with losses highest in Cambodia and the Lao PDR, with 5.5% and 5.4% of GDP,
respectively (Figure 27).

Figure 26: Role of agriculture in GDP and employment, 2019

Note: Agriculture includes forestry, hunting, and fishing, as well as cultivation of crops and livestock production.
Source: Compiled by authors with data from World Development Indicators.

Figure 27: Average annual agricultural loss as percentage of GDP

Note: Data for Myanmar are not available.

Source: Compiled by authors with data from UNESCAP (2020).

In Viet Nam, climate-related flood risks threaten the population, economic assets, and food security
in the Red River Delta and the Mekong River delta (Rutten et al. 2014). In the Red River Delta and the
Mekong River Delta, both of which are vital agricultural and industrial regions in Viet Nam, floods are
imperiling around 67% of the total population and over US$400 billion in assets, and up to 32% of

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built-up land, 47% of paddy rice areas, and 32% of other agricultural land are at risk of flooding
(Rutten et al. 2014). Overall, as much as 7% of agricultural land may be lost in Viet Nam in the case of
a 1-meter sea level rise (Dasgupta et. al 2009). In case of sea level rise of 5 meters, Viet Nam is
estimated to lose 23% of its agricultural land, while 11% of agricultural land would be inundated in
Myanmar, 6% in Indonesia, 4% in Thailand, and 2% in the Philippines (Chen, McCarl, and Chang 2012).
The coastal Mekong Delta is also facing growing problems of soil and water salinization linked to
climate change (Tuong et al. 2003). Moreover, agricultural production in the Mekong Delta will be
affected by a “high exposure to flooding, sea level rise and drought” and “a decline in the climatic
suitability of rice and maize” (Parker et al. 2019: 1). In Viet Nam’s highlands, coffee production will be
affected by “a loss of climatic suitability for coffee” and “the presence of flooding and drought (Parker
et al. 2019: 1). Overall, large parts of Viet Nam’s agricultural sector are at risk of being severely
affected by climate change, with potentially devastating effects on the livelihood of tens of millions of
people. This underlines the crucial importance of enhancing adaptive and protective measures to limit
adverse socioeconomic effects of climate change. Going forward, ASEAN countries need to conduct
comprehensive climate-risk vulnerability assessments to systematically mitigate risks.

4.2.5 Climate-related risks and financial sector stability

The financial sector, and especially banking, forms an important part of ASEAN economies. In
Singapore, Southeast Asia’s leading financial hub, the finance and insurance sector accounted for
13.9% of GDP in 2019 (SingStat 2020), while in Malaysia it accounted for 11.4% of GDP in 2019 (MOF
Malaysia 2020). Across ASEAN, the financial, insurance, and pension sectors combined are a net
exporter of services, accounting for 9.3% of 2018 exports and 6.2% of imports (ASEANstats 2019).
Section 3.5 discussed the physical and transition risks that financial institutions are exposed to, and
how these risks can translate into sovereign risk. Given the substantial climate-related risks facing
Southeast Asian economies, it is evident that financial institutions across the region are exposed to
material financial risks. For the time being, however, only a few ASEAN-based financial institutions
have started to systematically analyze and quantify their exposure to climate-related risks, and
financial supervisors across the region are also in early stages in understanding and monitoring
these risks.
Physical climate risks manifesting as credit risks for banks
ASEAN is already witnessing the negative impact of climate risks on the banking sector. The severe
floods in Thailand in 2011 impacted borrowers’ credit profiles and ability to repay debt. The Bank of
Thailand had to step in to support flood-affected borrowers by allowing banks to maintain pre-flood
credit ratings, reduce interest rates, delay repayment amounts, and extend repayment periods for
these borrowers (BOT 2012). Insurance was also inadequate to cover losses, with insured losses
accounting for approximately US$10.8 billion of the US$45.7 billion economic costs of the floods
(Aon Benfield 2012).
Bangkok Bank, one of the largest commercial banks in Thailand, announced at the start of 2020 that it
expected the level of NPLs in the Thai banking industry to increase that year due to Thailand’s worst
drought in 40 years, which was compounding a global economic slowdown (Banchongduang 2020).
Bangkok Bank already had to reschedule and suspend repayments for some of its own clients, while
Bank of Thailand data showed that NPLs in small and medium-sized enterprises increased from 4.25%
in Q2 to 4.75% in Q3 2019 (Banchongduang 2020). The state-backed Bank for Agriculture and
Agricultural Cooperatives had to step in to offer emergency and restoration loans to support affected
farmers (Chantanusornsiri 2020).
Other ASEAN countries have seen similar increases in NPLs due to extreme weather-related events,
which will increase in severity and frequency with climate change. In Cambodia, NPLs in the
agriculture sector increased in 2018 due to natural disasters, rising to 8.2%, which was considerably
higher than other sectors such as manufacturing (4.1%) and construction (4.2%) and the overall rate

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of 2.8% (NBC 2019). The recent drought led the Ministry of Agriculture, Forestry and Fisheries to ask
farmers to plant only one crop during the 2019–2020 dry season to prevent water shortages (Vireak
2019). This may also lead to higher NPLs for 2020 for the agriculture sector (Hutt 2020).
In the Philippines, which has one of the highest rates of extreme-weather related events in ASEAN,
has also seen its agriculture sector impacted. In 2018, the agriculture, hunting, forestry, and fishing
sector grew by only 0.8%, compared to a 4% expansion in 2017 (BSP 2019a), due to the 19 typhoons
that hit the Philippines, especially typhoon Ompong which hit the major rice-producing area of
northern Luzon. The central bank, the Bangko Sentral ng Pilipinas (BSP), provided temporary
rediscounting relief measures to banks in calamity-affected areas in 2018. This is not the first time the
BSP had to step in. In 2013, the BSP granted regulatory relief (e.g. reduced loan loss provisions) to
banks so they could assist customers affected by extreme weather events (BSP 2013a). In December
2012, cooperative banks saw their NPLs rise to 19.84% compared to 9.49% six months earlier, largely
due to typhoons (BSP 2013b).
The International Labour Organization (2019) estimated that 3.1% of working hours in ASEAN were
lost in 2015 due to rising temperatures and this is projected to rise to 3.7% (equivalent to 13 million
full time jobs) in 2030. Viet Nam, Thailand, and Cambodia are projected to bear the brunt of the heat
with over 5% of working hours lost. If these effects are not factored into bank credit projections,
there will be unforeseen and unpriced credit risks. For Cambodia, the agriculture, forestry, and
fisheries sector accounted for 9.4% and the construction sector accounted for 9.1% of overall bank
credit in 2018, so the two sectors most impacted by heat stress together account for almost 20% of
banks’ exposure (NBC 2019).
Transition climate risks manifesting as credit risks for banks
The European Union recently decided to transition away from palm oil as a biofuel by 2030 and also
published a new framework to address deforestation through measures including shifting demand
toward deforestation-free products (Dusser 2019, EC 2019a, EC 2019b). Such policy and market
changes may result in stranded landbanks for Indonesian and Malaysian palm oil growers if no
alternative sources of demand materialize (Morel et al. 2016). The Indonesian and Malaysian
governments have stepped up the domestic use of palm oil-based biofuel to absorb the oversupply.
The French government’s decision to remove tax breaks for the use of palm oil in biofuel has already
resulted in stranded capital expenditures and losses for the Total biorefinery in France (De Clerq and
Trompiz 2019).
Similarly, the necessary transition toward renewable energy for the People’s Republic of China (PRC),
India, Japan, and the Republic of Korea in a sustainable development scenario compatible with the
Paris Agreement (IEA 2019) has potential implications for the medium and long-term profitability of
coal mines in Indonesia. Reduced demand in these key export markets will reduce the ability of coal
companies to service and refinance debt obligations.
In the power sector, over three-quarters of onshore wind and four-fifths of solar photovoltaic projects
due to be commissioned in 2020 across the globe will produce energy at lower cost than the cheapest
fossil fuel options, even without subsidies (IRENA 2019). For example, there is increasing evidence of
the cost competitiveness of solar energy versus coal-fired energy in India due to technological
advances, which is enhanced by the lower water requirements of solar energy in water scarce India
(Buckley 2019). The technological risk compounds the policy risk.
If Viet Nam, Indonesia, and Philippines are to meet the necessary commitments under the Paris
Agreement, estimates show that up to US$60 billion of coal-fired power plants are at risk of stranding
through earlier retirement at 15 years rather than 40 years (CTI 2018). The Carbon Tracker Initiative
estimates that a phasing out of coal power in Indonesia in accordance with the Paris climate goals
would lead to asset stranding in the order of US$34.7 billion (CTI 2018). Under the same scenario,
owners of assets of coal power utilities in Viet Nam stand at risk of losing US$11.7 billion of mostly

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

operating capacity. In the Philippines, US$21 billion of assets associated the current expansion of coal
capacity at risk of stranding (CTI 2018). Caldecott, McCarten, and Triantafyllidis (2018) estimate that
87.7% of Southeast Asia’s current fossil fuel generation assets are incompatible with a 1.5°C budget,
and 17.8% are incompatible with a 2°C budget. Around half of planned generation assets are
incompatible with both the 2°C and 3°C carbon budgets. These pose significant risks for both the
banks financing the projects as well as for the sovereign where state guarantees are provided.
Banks: Climate risks as liquidity risks due to impact on balance sheet from credit risks and fire sales
of assets in financial markets
In ASEAN, the lack of disclosure and relatively slow progress on portfolio level climate scenario
analysis by banks may increase liquidity risk. None of the 35 largest ASEAN headquartered and listed
banks disclose the breakdown of their energy financing portfolio (coal/fossil fuels vs. renewables), nor
their exposure to other high climate risk sectors such as mining and agriculture. 14 of the 35 banks
disclosed sensitive sector policies but some have only one or two policies, suggesting potential
unmitigated climate risk in other sectors. Only three Singapore banks stopped financing new
coal-fired power plants, while other banks continue to increase balance sheet exposure to coal. Only
two banks have disclosed a climate risk strategy and only two banks have undertaken a portfolio
climate analysis.
To address the uneven progress by ASEAN banks, there has recently been positive momentum on the
harmonization of ASEAN sustainable banking regulations. Banking regulators and associations in
Indonesia (Otoritas Jasa Keuangan 2017, 2018), Malaysia (BNM 2019), Singapore (ABS 2018), Thailand
(TBA 2019), and Viet Nam (SBV 2015, 2018) have recently issued sustainable banking guidelines that
require banks to strengthen their governance of environmental, social and governance issues and
highlight climate change as a key issue. The BSP is currently conducting an industry consultation on its
proposed sustainable finance framework (BSP 2019b). Thus far, only the Monetary Authority of
Singapore has highlighted the need for forward looking stress tests and increased supervisory focus
on climate risk (Kung 2019).
Investors: Effects on portfolio valuations due to stranding and repricing of assets
ASEAN capital markets had an aggregated market capitalization size of US$2.5 trillion as of December
2018 (WFE 2019). The ASEAN bond market has been growing, with Indonesia, Malaysia, Philippines,
Singapore, and Thailand seeing robust growth in their local currency bond markets which grew from
US$1.117 trillion in March 2017 to US$1.518 trillion in December 2019 (ADB 2020). The equity and
debt capital markets are an increasingly important source of funding for companies. Potential
reductions in portfolio value faced by investors could be greater due to the higher physical climate
risks faced by Southeast Asian countries compared to Europe or North America and also the relatively
slower progress to transition business models to improve climate alignment. Of the 800 companies
that have committed to set science-based targets to decarbonize their business models in line with
the Paris Agreement, only nine are based in ASEAN.
Indonesian coal mining companies saw their bond prices fall to 70–85 cents in the dollar in the
six months to October 2019 (Wee and Dahrul 2019). This has been attributed by some investors
partly as a result of the shift to renewable power in Europe, and partly due to the highest production
volumes in the last decade. The Government of Indonesia has responded to the 28% drop in
Indonesian coal prices by ordering production cuts (Listiyorini 2020).
Insurers/reinsurers: Negative effects on margins due to higher insurance claims
The fact that Southeast Asia is one of the most vulnerable regions to physical climate risk will have a
negative impact on insurers providing coverage in this region if they are unable to either increase
premiums or purchase adequate reinsurance. Thai insurers suffered at least US$10.8 billion in losses
from the 2011 Thai floods, and rating agencies highlighted the negative impact on the insurance
sector. Due to the significant losses incurred by reinsurers, some reinsurers decided to limit future

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exposure to flood risk through various measures including total exclusion of natural catastrophe
cover, significant increases in the price of reinsurance cover, and for some, a total exit of the Thai
market (AON Benfield 2012). The high cost of reinsurance will reduce the coverage and/or
affordability of insurance for companies and could have implications for the value of banks’ collateral
assets in the event of any default by their clients and also for the value of investors’ portfolios when
catastrophe recovery costs are not adequately covered.
Overall, depending on the extent of physical risks and the abruptness of transition risks, climate risks
can have a significant negative impact on banks, investors, insurers, and other financial institutions.
ASEAN financial authorities in each country need a deep understanding of climate risk resilience of
their financial sector and must work with other national policy makers to create a smoother transition
to reduce shocks. Given the complexities involved in modelling the nonlinear effects of climate
change and the lack of robust data, there could be significant turmoil and instability in ASEAN’s
banking systems and financial markets. As such, there is an urgent need to understand the data and
types of analysis required for robust risk management.
There is a high risk of contagion due to the interconnectedness of ASEAN markets and supply chains,
as well as to the exposure of ASEAN banks, in particular banks in Malaysia, Singapore, and Thailand, to
regional assets. ASEAN central banks, financial supervisors, and policy makers will need to work
together to assess and manage intra-ASEAN risk exposures and harmonize policies and regulations to
address the potential contagion effect and maximize regional climate resilience.
Financial sector risk can become sovereign risk
Although ASEAN does not have a monetary or fiscal union and may not face the same contagion risk
as was seen in the eurozone’s sovereign debt crisis, the Asian financial crisis of 1997–1998 showed
how contagion effects could cause a crisis to spread from one country—Thailand—to the entire
region, even affecting countries with relatively strong macroeconomic fundamentals like Malaysia
(Hassan 1999). The large intraregional trade and supply chain linkages and intraregional exposure of
banks may increase the risk of contagion. Moreover, the Asian crisis showed how weaknesses of
initially a few financial institutions could fuel speculation and capital flight and develop into a systemic
financial crisis that would then turn into a sovereign crisis. As discussed earlier, contingent liabilities of
ASEAN countries were historically often related to financial crisis, often with serious fiscal implications
(Table 16). After the global financial crisis, the Philippines government highlighted financial sector
risks as one of the five main sources of risk that could threaten fiscal stability (Republic of the
Philippines 2012).
Even though ASEAN economies have reduced the currency and maturity mismatch problems that
contributed to the Asian crisis, and most have turned into current account surplus countries, the
speed and scale of capital outflows during the COVID-19 crisis have revealed the vulnerability to
changes in market sentiments (Beirne et al. 2020). Government-funded bank bailouts or the
expectation of such, or a weakened banking sector may worsen the debt burden and/or sovereign
credit risk by exacerbating economic or financial crises.
Governments and state linked pension funds and investment companies are significant
shareholders of banks and will be directly exposed to decreased stock market valuations
of bank stocks
Sovereign risk may also be affected because of the close links that exist between ASEAN
governments, their state linked pension funds and investment companies, and the banking sector.
Banks feature prominently in the largest companies by market capitalization on ASEAN stock
exchanges. For example, seven out of the largest 30 companies listed on Bursa Malaysia’s main board
are financial institutions (Bursa Malaysia 2019), and three Singapore banks make up over 39% of the
weighting of the STI Index of the largest 30 companies on the Singapore Exchange (FTSE Russell
2020). In Malaysia, government-linked pension funds and investment companies such as the

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Employees Provident Fund, Permodalan Nasional Berhad, Kumpulan Wang Persaraan, and the
sovereign wealth fund Khazanah Nasional Berhad are key stakeholders in several banks. Together
they hold directly or via trustees 54.5% of CIMB Bank (CIMB 2020) and 23.7% of Maybank (Maybank
2019), the two largest banks in Malaysia. Singapore’s sovereign wealth fund Temasek owns 11.1% of
DBS Bank (DBS 2019), Southeast Asia’s largest bank. The government of Indonesia owns 56.75% of
Bank Rakyat Indonesia (BRI 2019), 60% of Bank Negara Indonesia (BNI 2020), and 60% of Bank
Mandiri (Bank Mandiri 2020)–three of the four largest banks in the country. In Myanmar, the four
state-owned banks account for 31% of the banking system’s assets as of September 2018 (AMRO
2019). In the Philippines, two of the top 10 banks are state owned, including Land Bank of the
Philippines, the country’s fourth largest bank. The predominance of state-linked shareholdings in
ASEAN banks creates a very direct transmission channel from the financial sector to sovereign risk via
the value of state-owned assets, even in a more benign scenario.
Due to the dual role of the financial sector as a direct contributor to GDP, tax revenues, employment,
exports, and sovereign assets and as the main source of funding for businesses and to some extent
for governments, climate shocks to the financial sector will reverberate across the wider economy.
This could result in a larger negative impact, which may be exacerbated by a worsening of
government debt burden to fund any required bailouts, leading to increased sovereign risk.
The potential for cross-border contagion is not trivial due to the high levels of intra-ASEAN business,
trade, and financing activity and also dependence on key trading partners. ASEAN central banks and
supervisors will have to work together to understand the vulnerabilities and resilience of the financial
sector in each of their home markets and any potential cross-border contagion effects.

4.2.6 Impacts of climate change on international trade and capital flows

Most Southeast Asian economies are highly integrated into the world economy. In 2018, the ratio
of exports of goods and services over GDP was larger than the OECD average of 29.2% in all
ASEAN countries but Indonesia (21.0%). Given the importance of the export sector for growth and
employment, ASEAN countries are exposed to a number of material climate-related risks. There are
several ways through which climate change could affect the patterns and the volume of international
trade flows of ASEAN countries, with potentially significant effects on countries’ balance of payments
positions and, ultimately, sovereign risk.
Supply chains across Southeast Asia face disruptions from climate-related hazards
As discussed, physical impacts of climate change can interrupt production and transportation, which
can disrupt trade. Such disruption may be particularly problematic in Southeast Asia given the
region’s trade is closely related to regional and global value chains, where parts and components are
shipped between different production sites across countries to benefit from countries’ respective
comparative advantages. These value chains depend on timely delivery and are sensitive to
disruptions. Starting with Singapore and Malaysia, Southeast Asian countries have become major
participants and regional and global trade-production networks since the early 1970s, especially in
the electronics and automotive sectors. Indeed, engagement in global production sharing has been a
major factor behind the export-led development success of Southeast Asian countries. The share of
network trade in total manufacturing exports is much larger in Southeast Asia than in any other
region of the world, with products related such networks accounting for 71.5% of merchandise
exports of Southeast Asia over the period 2011–2012 (Athukorala 2016). Malaysia, the Philippines,
Singapore, Thailand, and Viet Nam are particularly integrated in network trade, and to a somewhat
lesser degree Indonesia (Athukorala 2016, 2019). More recently, Cambodia and the Lao PDR have also
started to participate in regional production networks, especially in the garment sector (DiCaprio and
Suvannaphakdy 2017).
The most prominent example of a large-scale disruption of supply chains are the Thai floods of 2011.
Among other impacts, the floods inundated numerous industrial parks where components for the

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supply chains of automotive and electronic products were produced, causing standstill of operations
across the region and the world, prominently in Japan (Haraguchi and Lall 2015). Although often
unnoted, the region regularly experiences impactful weather events that degrade infrastructure and
disrupt commerce and supply chains. In 2019 alone, landslides and rainstorms damaged roadways
along major transportation routes in Thailand, Cambodia, Myanmar, and Viet Nam (BSI 2020).
Manufacturing is exposed to multiple climate hazards
Manufacturing accounts for the majority of merchandise exports in all ASEAN countries except
Brunei Darussalam and the Lao PDR.32 As manufacturing centers, most ASEAN countries provide key
inputs into global supply chains and economies. The impacts of climate hazards on manufacturing
facilities pose significant economic risks where the damage occurs, but can also significantly affect
international trade and capital flows, particularly in industries with complex global supply chains.
Manufacturing is an industry that is particularly vulnerable to climate hazards due to its reliance on
energy intensive equipment, onsite operations, employee labor, in addition to complex supply chains.
Manufacturing facilities are disrupted during floods and storms, sometimes due to onsite damage but
often due to employees’ inability to get to work due to damaged regional infrastructure, or lack of
critical components due to disrupted supply chains. Likewise, during extreme heat events, employee
health can be threatened and productivity can decline. Energy intensive facilities are also vulnerable
to blackouts due to high demands on the grid during heat waves. As average temperatures increase
this can lead to a persistent decline in productivity and increase in energy costs.
Manufacturing facilities from large listed companies in the ASEAN countries are highly exposed to
climate hazards, with 99% of assessed facilities in the region at least highly exposed to heat stress and
43%, 38% and 21% at least highly exposed to water stress, floods, and hurricanes and typhoons,
respectively (Table 21). Newman and Hewston (2018, 1) identify Southeast Asia as one of four
regional hotspots (besides West Africa, Central Africa, and the Middle East and North Africa), “where,
without adaptation, rising heat stress will drive labor capacity losses in key sectors, with the potential
to substantially undermine their export economies.” Based on the current sectoral composition of
exports and projected daily temperatures for the period 1980–2045, they estimate that 5.2% of
Southeast Asia’s export value—including agriculture, forestry and fishing, as well as extractive
activities—is projected to be at risk by 2045 because of heat stress-induced labor capacity losses.

Table 21: Percent of manufacturing facilities with at least high risk to climate hazards
Total number
Hurricanes and of facilities
Heat stress Water stress Floods Sea level rise typhoons assessed
ASEAN 99 43 38 4 21 2,931
Indonesia 98 66 57 2 0 576
Malaysia 100 36 36 3 0 280
Philippines 96 79 39 7 88 380
Singapore 100 99 33 7 0 335
Thailand 100 8 27 2 0 612
Viet Nam 100 1 34 4 48 522

Note: Percent of manufacturing facilities owned or operated by large listed companies in ASEAN Countries with high exposure to
key climate hazards.
Source: Compiled with data from Four Twenty Seven.

32 In 2018, the share of manufacturing in total merchandise export was 8.6% in Brunei Darussalam, 94.4% in Cambodia,
54.4% in Indonesia, 41.1% in the Lao PDR, 75.0% in Malaysia, 50.2% in Myanmar, 87.5% in the Philippines, 77.1% in
Singapore, 81.3% in Thailand, and 85.2% in Viet Nam (ASEANstats database).

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Viet Nam in particular stands out with all of its assessed manufacturing facilities exposed to at least
high heat stress and almost half with at least high exposure to hurricanes and typhoons (Figure 28).
Viet Nam’s key exports include broadcasting equipment, telephones, integrated circuits, textile
footwear, and leather footwear. These are industries with many manufacturing operations, as well as
global supply chains, making Viet Nam’s exports largely dependent on resilience to climate hazards
both domestically and in nations that produce the other components upon which Viet Nam
manufacturing relies.

Figure 28: Proportion of Viet Nam’s manufacturing facilities exposed to each climate hazard

Source: Compiled with data from Four Twenty Seven.

Viet Nam’s exports have increased consistently over the past several years, but disruption to
manufacturing of its key export products could adversely affect its trade balance. Circuits and other
electrical equipment are typically components in long supply chains with both downstream and
upstream manufacturing operations across Southeast Asia. Meanwhile these products’ end
destinations are consumer markets across the globe. Viet Nam’s top export destination is the United
States, followed by the PRC, Japan, the Republic of Korea, and Germany. These trade partners may
begin to seek products elsewhere if Viet Nam’s manufacturing is consistently disrupted due frequent
storms. Likewise, if companies need to increase their products’ prices to respond to an increase in
operating cost due to consistently warmer temperatures, countries that do not have this exposure
will likely have a competitive advantage. For example, one of the PRC’s top exports is also telephones.
As a larger nation with more financial resources and more diverse climate risk exposure, the PRC may
continue to produce telephones with similar prices even when Viet Nam manufacturers may have to
consider increasing prices. The exposure of other key industries such as agriculture, may also reduce
the nation’s exports or increase its import demands. With a relatively small trade balance, Viet Nam
could see its trade balance become negative if its key industries are constantly affected by climate
hazards and its export partners have to look elsewhere for a stable supply of products.

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Risks to agricultural exports and tourism

Manufacturing is not the only export sector across Southeast Asia that is being affected by the
physical impacts of climate change. Figure 29 displays the composition of ASEAN countries’ total
exports for 2018. The agricultural and fisheries sectors of Southeast Asian countries have become
increasingly involved in international agro-food trade (OECD and FAO 2017). For most ASEAN
countries, agricultural exports—displayed in yellow—are of great importance, accounting for 23.6% of
exports in Indonesia, 17.2% in Myanmar, 16.8% in the Lao PDR, 12.3% in Thailand, 10.9% in Viet Nam,
10.2% in Cambodia, 8.9% in Malaysia, and 6.2% in the Philippines. Thailand and Viet Nam are among
the largest exporters of rice globally, and Myanmar and Cambodia have also ranked among the top 10
exporters. The only two ASEAN countries for which agricultural exports are not substantial are
Singapore and Brunei Darussalam, with shares of 3.0% and 0.3%, respectively. As was discussed
earlier, the agricultural and fisheries sectors are among the sectors most exposed to the physical
impacts of climate change. Agricultural production and hence export capacity will be severely affected
in several parts of Southeast Asia. Simulations by Le (2016) suggest that under a low-emissions
scenario and without interventions, Viet Nam’s rice production would drop by as much as 18% by
2030 relative to the 1980–1999 average. Although (export) prices would rise by about 7%, export
quantity would fall by 55%, with an overall loss of export sales of 48%. Modeling by Chen, McCarl, and
Chang (2012) indicate that along with Myanmar and Egypt, Viet Nam would be one of the three rice
exporters globally that would turn from a rice exporter to an importer in the case of extreme sea level
rise. Besides the socioeconomic implications, this would also impact on food supply and security
across the region.
In services exports (colored red in Figure 29), the tourism sector plays an important or very important
role for most ASEAN countries. Travel and tourism account for 21.8% of total exports in Thailand,
20.1% in Cambodia, 11.0% in the Lao PDR, 10.4% in Myanmar, 8.3% in Malaysia, 6.8% in Indonesia,
6.3% in the Philippines, 4.1% in Singapore, and 2.7% in Brunei Darussalam (no data for Viet Nam).
International tourism across ASEAN relies to a large degree on pleasant nature and safe climatic
environments. While sea level rise will hurt coastal tourism (Marks 2011), heat stress and other
natural hazards may diminish the attractiveness of Southeast Asia as a tourist destination. The ADB
(2009) raised concerns that an increase in coastal erosion and deterioration of natural resources may
cause losses for the tourism industry in Thailand. With more than 10% of Thailand’s workforce
employed in the tourism sector before the outbreak of the COVID-19 crisis, adverse effects of climate
change could have a significant impact on the Thai economy, and the same may be true for
Cambodia, and, to a lesser extent, for the Lao PDR.
Transition impacts on international trade
A decarbonization of the global economy would have profound impact on most Southeast Asian
economies and their international trade. ASEAN comprises both importers and exporters of fossil
fuels, and some ASEAN countries are both. While importers of fossil fuel energy would benefit from
reduced energy import bills (Dowling and Russ 2012), the impending decline in global demand for
fossil fuels will hurt major exporters if they fail to anticipate it (Holz et al. 2018).

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Figure 29: Composition of ASEAN countries’ exports, 2018

Brunei Darussalam ($7.07 billion) Cambodia ($22.4 billion)

Indonesia ($208 billion) Lao PDR ($6.8 billion)

Malaysia ($310 billion) Myanmar ($20.2 billion)

Philippines ($118 billion) Singapore ($496 billion)

Thailand ($336 billion) Viet Nam ($280 billion)

Note: Standard International Trade Classification categories disaggregate to 4-digit detail level.
Source: Compiled by authors with Harvard Growth Lab’s Atlas of Economic Complexity, based on UN Comtrade data.

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Among the fossil fuel exporters, Brunei Darussalam stands out: 45.4% of its total exports are in
petroleum gases and another 38.6% in petroleum oils and crude (colored copper in Figure 29). It is no
exaggeration to say that a drying up of fossil fuel exports would cause severe trouble to the economy
and public finances. The effects would be less severe in other ASEAN countries but could still be
problematic for some. With petroleum gases constituting 16.7% of Myanmar’s total exports, and coal
constituting 9.9% and petroleum gases 4.9% of Indonesia’s total exports, a rapid transition of
Myanmar’s and Indonesia’s trading partners to a low-carbon economy would have significant impact
of these countries’ trade balances. As pointed out by Holz et al. (2018, 5), along with other major coal
exporters to the PRC (such as Australia), Indonesia could find itself “in a very vulnerable position quite
quickly” if the PRC was to reduce its coal consumption soon. The effects of dwindling fossil fuel trade
would be less severe for Singapore, where refined petroleum oils account for 9.7% of total exports,
and Malaysia, where refined and crude petroleum oils constitute 5.7% and 3.7% of total exports,
respectively.
Figure 30 plots fuel exports as share of merchandise exports of ASEAN countries as well as the OECD
average against merchandise exports as share of GDP. Figure 31 shows the same for imports. Brunei
Darussalam’s merchandise exports, which amount to 40% of GDP, constitute almost entirely (96%) of
fossil fuels. With 23.2%, Indonesia has also a significant share of fossil fuels in its total merchandise
exports, as has Myanmar with 21.6%, Malaysia with 15.3%, and Singapore with 13.5%. For these
countries, a sudden drop in fossil fuel exports would likely pose problems. For Thailand, the share is a
mere 3.9%, and for all others it is lower. The countries with the largest share of fossil fuel imports in
total merchandise imports are Singapore with 24.7%, Thailand with 17.8%, Indonesia with 16.7%, the
Lao PDR with 15.3%, Malaysia with 14.6%, and Philippines with 12.0%. Among the fossil fuel
importers, Singapore, Myanmar, Thailand, Indonesia and the Lao PDR have the highest share of fossil
fuel imports as share of merchandise imports. A switch to non-fossil fuels would reduce the import
bill. Indeed, the Lao PDR is not only seeking to reduce energy imports; it envisages to boost exports of
hydroelectricity generated at the Mekong river, becoming the “battery” of Southeast Asia.

Figure 30: Fuel exports (% of merchandise exports) vs merchandise exports as share of GDP

Note: Fuel exports for Cambodia and the Lao PDR from 2016, for Viet Nam from 2017.
Source: Compiled by authors with data from WDI.

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Figure 31: Fuel imports (% of merchandise imports) vs merchandise imports as share of GDP

Note: Fuel imports for Cambodia and the Lao PDR from 2016, for Viet Nam from 2017.
Source: Compiled by authors with data from WDI.

Figure 32 shows the balance of trade in goods for all ASEAN countries. The straight lines show the
actual values, while the dotted lines show values excluding mineral fuel imports and exports.
Unsurprisingly, countries with large net imports or exports of mineral fuels see significant changes to
their balance of trade when mineral fuels are excluded. In such a scenario, Brunei Darussalam would
have seen its trade balance for goods turn into a deficit. For instance, in 2018, Brunei Darussalam
would have recorded a deficit of US$3.3 billion—the equivalent of 24.3% of its US$13.6 billion
GDP—in its goods trade, instead of a US$2.4 billion (or 17.8% of GDP) surplus. In 2012, the difference
in the balance of trade in goods would have been a whopping US$12.1 billion (or 49.5% of GDP).
Between 1989 and 2018, Indonesia would have recorded a deficit in its balance of trade in goods in
13 years, instead of the 4 years it actually did. The US$ 8.5 billion deficit in its goods trade—0.8% of
GDP—that Indonesia recorded in 2018, would have been US$10.4 billion larger in the absence of
mineral fuel trade, so that the goods trade balance would have stood at –1.8% of GDP. Malaysia’s
accumulated trade surplus in goods over the same period of US$530 billion would have been reduced
to almost half in the absence of mineral fuel trade, to US$277 billion. In contrast, the Lao PDR’s
accumulated goods trade deficit over the period 2010–2016 would have been only US$1.6 billion,
instead of the actual US$5.8 billion—a significant amount for an economy of US$15.1 billion in 2016.
Thailand would have accumulated a goods trade surplus of US$399 billion over the period 1988 to
2018, instead of a deficit of US$24 billion.
One should be careful not to take the results of such simplistic simulations literally, but they illustrate
an important point: a rapid replacement of fossil fuel-based energy and transport systems would have
a significant impact—positive or negative—on the trade balance of most ASEAN countries. A
significant worsening of the balance of payments could have material impact on macroeconomic
stability and sovereign credit risk.
It should be noted, however, that also new export opportunities may open up. For instance, Indonesia
may benefit from growing demand for industrial metal such as nickel, the demand for which is
projected to rise significantly due to its role in electrical vehicle batteries. The government of
Indonesia is seeking to develop nickel processing and battery production in Indonesia to capitalize on
expected strong global demand (Sanderson 2020).

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Figure 32: ASEAN countries’ trade balance for goods (in US$ billion), including (straight line)
and excluding (dotted line) mineral fuels

Note: The definition of mineral fuels follows the Harmonized Commodity Description and Coding Systems (HS), where HS27
comprises mineral fuels, mineral oils, and products of their distillation; bituminous substances; and mineral waxes.
Source: Compiled by authors based on calculations with UN Comtrade data.

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A decarbonization of the world economy would inexorably also affect Southeast Asian countries’
external trade beyond imports and exports of fossil fuels. Figure 33 shows the carbon footprint of
exports (t CO2/US$) plotted against the exports of goods and services as share of GDP for ASEAN
countries as well as the OECD average for the year 2015. It clearly shows that the carbon intensity of
exports of ASEAN countries is much larger for all ASEAN countries, compared to the OECD average.
The exports of Viet Nam, Malaysia, Thailand, and Indonesia have a particularly large carbon footprint.
Moreover, Figure 33 also shows that most ASEAN economies are export-dependent, as discussed
before. This implies that they are facing large transition risks. For instance, carbon border taxes, as
they are currently being discussed in the European Union, could have a significant impact on external
revenue and domestic employment, and by implication also on public finances.

Figure 33: Carbon footprint of exports (tCO2e/US$) vs exports of goods and services
as share of GDP (%) for ASEAN countries and OECD in 2015

Note: Data on carbon footprint of exports were not available for Myanmar and the Lao PDR. tCO2e = tons of carbon
dioxide equivalent.
Sources: Compiled by authors with data from World Development Indicators and OECD Statistics.

While more granular analysis is certainly needed, several ASEAN countries show vulnerabilities in their
external balance to climate-related physical and transition risk. ASEAN economies with a high
dependency on carbon-intensive exports and little diversified export sectors—most notably Brunei
Darussalam—are particularly at risk. All of them face an increase in heat and water stress, along with
an increase in other climate hazards, which may have severely adverse effects on manufacturing
exports and participation in regional and global value chains.

4.2.7 Impacts of climate change on political stability

According to S&P (2016, 2), “political developments have the most potential to shape sovereign rating
trends in parts of Southeast Asia”. Figure 34 displays the scores of ASEAN countries for an indicator of
political stability and absence of violence and/or terrorism from the World Bank’s Worldwide
Governance Indicators. This indicator is based on perceptions and should be interpreted with caution,
but it does reflect that several ASEAN countries—Myanmar, the Philippines, Thailand, and Indonesia
in particular—have been dealing with issues of political instability and/or intrastate violence or
terrorism. One should be cautious with making any predictions about future trends regarding political
stability as a consequence of climate change, but the literature reviewed in Section 3.7 indicates that

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environmental change can accentuate existing social tensions and resource conflicts and cause
greater intra- and inter-state migration movements which may contribute to political instability or, in
the worst case, even intra- and inter-state conflicts. As highlighted before, climate change is
worsening heat and water stress in large parts of Southeast Asia. Not only will a more frequent
occurrence of drought cause water shortages, sea level rise will cause an intrusion of saltwater into
coastal and groundwater resources, threatening supplies of fresh water for drinking and irrigation.

Figure 34: Political stability and absence of violence and/or terrorism, 2018

Note: The indicator measures perceptions of the likelihood of political instability and/or politically-motivated violence, including
terrorism. Estimate gives the country’s score on the aggregate indicator, in units of a standard normal distribution, i.e. ranging from
approximately –2.5 (weak) to 2.5 (strong).
Source: Compiled by authors with data from the World Bank’s Worldwide Governance Indicators (World Bank 2019).

There are already numerous examples of prolonged droughts that had devastating effects on
livelihoods in Southeast Asia. A severe drought in 2010 saw the water level of the Mekong River falling
to its lowest level in 50 years and affected at least 7.6 million people in 59 of Thailand’s 76 provinces
(Marks 2011). A prolonged drought from early 2015 to mid-2016 caused “an increased level of food
insecurity” that affected around 2.5 million people in 18 out of 25 provinces in Cambodia (FAO 2016).
Over the last decades, Indonesia also experienced several severe droughts that reduced harvests and
threatened food security, including extreme droughts in 1998 (which worsened the socioeconomic
situation at a time when Indonesia was facing the economic fallout from the Asian financial crisis) and
in 2015 (which caused food shortages in 16 of Indonesia’s 34 provinces) (FAO 1998, Dagur 2015). In
2019, Indonesia’s Meteorology, Climatology and Geophysics Agency warned that a longer and more
intensive dry season that year could threaten food security (Jakarta Post 2019). Rising food prices and
food shortages can fuel social tensions and unrest.
Environmental change has already exacerbated social tensions in some areas. For instance, water
shortages in Viet Nam gave rise to local conflicts between farmers and other stakeholders (Van Huynh
et al. 2019). Examining the case of northern Myanmar, Borras, Franco, and Nam (2020) highlight that
climate change and land are linked politically, and show how land rush can incite old and new
conflicts both between states and within societies. In an analysis of climate impacts on Thailand,
Marks (2011) asserts that climate change will exacerbate the socioeconomic gap between the capital
and underdeveloped rural regions, particularly the northeast, and heighten class-related tensions.
Social tensions in Thailand may be compounded by internal migration to urban centers and the influx

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 Climate Change and Sovereign Risk in Southeast Asia and Implications for Macrofinancial and Fiscal Stability

of climate refugees from poorer neighboring countries (ADB 2012).33 In Viet Nam, between 2008 and
2015 more than 2 million people were internally displaced by natural hazards (Anh, Leonardelli, and
Dipierri 2016).
Climate change is worsening competition over shared water resources, both within countries and
across borders. Singapore, for one, is dependent on and vulnerable to Malaysia for its water supplies.
Malaysia has several times threatened to cut off Singapore’s water supplies. There is also a complex
situation around shared water resources involving many nations in the Mekong Delta region
(European Parliament 2018), with some even worrying of a rising risk of a “water war” on the Mekong
(Hutt 2019). The Mekong River flows from the PRC through Myanmar, the Lao PDR, Thailand,
Cambodia, and Viet Nam and provides water, food, and livelihood to more than 60 million people
along its banks (Shkara 2018). It has also become a source of tension between neighboring countries.
For example, Thailand’s plans to divert water from the Mekong to irrigate agriculture in northeast
Thailand has caused concerns in Viet Nam about resulting water shortages in the Mekong Delta.
To reduce dependency on fossil energy, countries have been turning to generating hydropower,
which can give rise to water conflicts (Klöpper 2008). The PRC has already built several hydroelectric
dams along the Mekong, and more are being planned. The Lao PDR has also constructed numerous
dams in its quest to export hydroelectricity. The construction of dams often requires large-scale
displacement of people, which can cause friction and new land and resource conflicts elsewhere.
Moreover, dams have downstream effects as they disrupt the natural cycle and reduce variations
between wet and dry seasons, with adverse effects on agricultural production along the riverbanks
(European Parliament 2018). Dams also disrupt migration of fish along the river, with potentially
adverse effects for fishery. A report by US intelligence agencies has raised concerns that water
conflicts along the Mekong would be aggravated by climate change, reducing regional food security,
and negatively impacting livelihoods, thereby fueling instability and regional tensions (NIC 2012). The
same report also highlighted the potential to use water as a leverage over neighboring countries or
even as a weapon, “with more powerful upstream nations impeding or cutting off downstream flow”
or governments using water “to pressure populations and suppress separatist elements”
(NIC 2012, 4).
Marginalized people are more vulnerable to climate disasters. Regions that face high levels of disaster
risk and high economic losses due to disaster tend to cope also with high inequalities of income and
opportunity, which can incite social and political tensions. According to UNESCAP (2020), on average
the richest quintile of populations in Southeast Asia are 49% less likely to live in high multi-hazard risk
areas than the poorest quintile. UNESCAP (2020) highlights that disaster risk can perpetuate
inequality and poverty and estimates that 13 million people across ASEAN will remain in extreme
poverty by 2030 because of vulnerability to disasters.
Jasparro and Taylor (2008, 232) highlight that climate change could enlarge potential vulnerability to
transnational security threats across Southeast Asia as “livelihood and social systems will be
pressured, while state and civil society capacity will be strained.” (see also Moran 2011). This could
strengthen substate networks and enhance violence, crime, smuggling, trafficking, and terrorism,
among others. Climate change can also alter the causes and dynamics of violent conflict in Southeast
Asia (Nordqvist and Krampe 2018). Increased poverty and reduced state capacity as outcomes of
climate-related impacts may provide functional space for terrorist groups to flourish (Smith 2007). A
loss of livelihood in coastal areas could also give rise to piracy and threaten maritime security
(Germond and Mazaris 2019).

33 In Indonesia, flood risk in Jakarta led to the government’s decision (now postponed) to relocate the capital city to Borneo.
This has been described as “one of the first examples of systematic, mass migration expected to occur linked to the
climate change crisis” (Van de Vuurst and Escobar 2020, 1).

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Overall, this review suggests that potential impacts of unmitigated climate change could indeed
destabilize societies by diminishing economic progress in parts of Southeast Asia. The likelihood that
this could affect sovereign risk are higher for countries which are already facing issues of political
instability and/or intrastate violence or cross-border tensions of resources.
Governments across ASEAN need to work toward climate-proofing their economies and public
finances. In addition, scalable social safety nets should be promoted further in Southeast Asia to
enable a rapid transmission of financial support to targeted populations following climate-related
disasters. At the level of the corporate sector, more efforts need to be made in ASEAN to incorporate
science-based targets into business models. ASEAN may consider launching its own regional initiative,
similar to the global ‘Climate Action 100+’ initiative, targeting regional corporate greenhouse gas
emitters. Related to this, given the interconnectedness of supply chains in Southeast Asia, the
corporate sector in the region should be encouraged to clean up their supply chains though the
adoption of regional, industry carbon emission standards, as well as financial instruments such as
transition bonds. In addition, pension funds in ASEAN should be encouraged to champion the
promotion of climate change adjusted investment into their portfolios for the region, such as
currently takes places with major pension funds in the US and Europe.

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5. Climate Risk and Sovereign Bond Yields:
An Econometric Analysis
While there is a rich body of literature analyzing the drivers of the price of sovereign risk, studies have
focused on macroeconomic fundamentals as well as international financial contagion. Only recently, a
new strand of the literature has emerged that tries to empirically assess the link between climate
change and sovereign risk. The first study to systematically analyze the impact of climate change on
the cost of sovereign capital is Kling et al. (2018) who show that countries particularly vulnerable to
climate change incur a risk premium on their sovereign debt, reducing their fiscal capacity for
investments in climate adaptation and resilience.34 In this chapter, we present new research that
investigates the relationship between climate vulnerability, resilience and the sovereign cost of capital
further, using improved data.

5.1 Overview and main findings

Using a sample of 40 developed and emerging economies—many of which are particularly vulnerable
to climate risks due to their geographical location and exposure to climate hazards—econometric
evidence is provided to show that climate risks and resilience to these risks have significant effects on
the cost of sovereign borrowing. In particular, higher climate risk vulnerability leads to significant rises
in the cost of sovereign borrowing. Premia on sovereign bond yields amount to around 275 basis
points for economies highly exposed to climate risk, compared to 155 basis points for ASEAN, and
113 basis points for EMEs overall. In contrast, exposure to climate risk is not statistically significant for
advanced economies overall. As regards resilience to climate risk, this is statistically significant in
reducing bond yields across all country groups, although with magnitudes of less than 10 basis points.
Our analysis confirms that climate vulnerability has significant implications for sovereign borrowing
costs, and that the direct effects of climate change matter substantially more than climate risk
resilience. Furthermore, our results confirm and quantify the magnitude of the much larger effect on
bond yields for countries deemed highly vulnerable to climate change. Finally, impulse response
analysis suggests that the reaction of bond yields to shocks imposed on climate vulnerability and
resilience become permanent after around 12 quarters, and that high-risk economies experience
larger permanent effects on yields than other country groups.

5.2 Climate risk vulnerability, resilience to climate risk,

and the cost of sovereign borrowing
Across the sample of 40 developed and emerging economies used in our econometric work,35
Figure 35 and Figure 36 demonstrate the relationship between sovereign bond yields and two
measure climate risk: climate risk vulnerability and climate risk resilience. To measure climate
vulnerability, we use a refined measure of the Notre Dame Global Adaptation Initiative (ND-GAIN)
vulnerability index developed by Kling et al. (2020). The refined vulnerability measure comprises all of
the components from the ND-GAIN vulnerability index that are not highly related to economic
variables in order to mitigate against endogeneity concerns.36 Data for climate resilience were kindly

34 See also Buhr et al. (2018). In a related study, Kling et al. (2020) use firm-level data and find that climate vulnerability also
affects the cost of corporate financing and access to finance, controlling for various firm-specific and macroeconomic
factors.
35 Please refer to Table A.1 in the Appendix for the list of countries.
36 The original ND-GAIN vulnerability index (Chen et al. 2015) comprises three core measures: (i) the extent to which an
economy is exposed to significant climate change from a biophysical perspective; (ii) the degree to which an economy is

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Climate Change and Sovereign Risk

provided by FTSE Russell. This indicator refers to the extent to which an economy has measures in
place to address exposure to climate risks.

Figure 35: Cost of sovereign debt and climate risk vulnerability, 2002–2017

RoW = rest of the world.

Note: High risk countries denote those countries that are in the highest quartile for exposure to climate risk.
Source: Compiled by authors with data from Bloomberg, FTSE Russell, ND-GAIN (2020), and Kling et al. (2020).

Figure 36: Cost of sovereign debt and climate risk resilience, 2002–2018

RoW = rest of the world.

Note: High-risk countries denote those countries that are in the highest quartile for exposure to climate risk.
Source: Compiled by authors with data from Bloomberg, FTSE Russell, ND-GAIN (2020), and Kling et al. (2020).

dependent upon sectors that are particularly sensitive to climate change; and (iii) the extent of an economy’s adaptive
capacity to climate change. This measure can therefore be interpreted as an overall measure reflecting both physical and
transition climate-related risks. We use the refined measure by Kling et al. (2020) which strips out measures that are
highly correlated with macroeconomic variables, so that the new vulnerability index is less correlated with countries’
financial or economic conditions, which might cause endogeneity.

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 Climate Risk and Sovereign Bond Yields

Figure 37 shows that vulnerability to climate risk is positively related to sovereign bond yields. This
appears to be particularly the case for emerging economies (EMEs) in the high-risk category, i.e.
countries in the top quartile for climate risk exposure. In Figure 37 also displays a negative
relationship between yields and resilience. Economies that have in place measures that enable them
to combat the negative effects of climate change tend to have lower sovereign bond yields. The
positive relationship between bond yields and climate risk vulnerability, and the negative relationship
between bond yields and climate risk resilience, also holds across our sample of countries grouped
according to region and high risk.

Figure 37: Sovereign bond yields, climate risk, and resilience by country grouping

Note: Red line refers to the government bond yield in percent. Blue dashed line refers to the vulnerability. Dark Green dashed line
refers to the resilience.
Source: Compiled by authors with data from Bloomberg, FTSE Russell, ND-GAIN (2020), and Kling et al (2020).

Having established the directional priors for the relationship between sovereign bond yields and
climate risk vulnerability, and climate risk resilience, we then conduct a formal econometric analysis,
based on the methodology described in Box 3.

5.3 Empirical results

The results from our empirical analysis provide evidence that the cost of sovereign borrowing is
particularly exposed to climate risk vulnerability, while resilience to climate risk has only a very small
(but statistically significant) effect on sovereign bond yields. Figure 38 plots, for the full sample of
40 countries as well as sub-groups, the coefficients of the two climate risk measures from the panel
model estimation described in the methodology.37

37 For purposes of exposition, we present only the coefficients of the climate risk measures. Please refer to Table A.2 in the
Appendix for the full set of coefficients across all regressors.

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Climate Change and Sovereign Risk

Box 3: Methodology and data

In order to empirically test the relationship between the cost of sovereign borrowing and climate risk, we
employ two econometric approaches. First, using a quarterly data frequency, we use a fixed effects panel
model over the period from 2002Q1 to 2018Q4 across 40 developed and emerging economies. As well as a
subpanel for the member countries of ASEAN, we also examine a subpanel based on economies
characterized as having high climate-related risks, defined as being in the top quartile for risk exposure. The
panel model estimated enables us to assess the effect of climate risk vulnerability and resilience to climate
risk on sovereign bond yields, controlling for a large set of domestic macroeconomic factors and two global
factors. Second, a structural panel vector autoregression (VAR)_ is used to examine the response of
sovereign bond yields to shocks to climate vulnerability and resilience. Crucially, these shocks also control
for a range of macroeconomic fundamentals and global factors. The panel SVAR is implemented across the
same 40 countries as in stage one, but over the period from 2007Q1 to 2017Q4 in a balanced setup.
Drawing on the literature that examines the drivers of sovereign bond yields and the price of sovereign risk,
the domestic macroeconomic controls include the current account balance/GDP, public debt/GDP, the fiscal
balance/GDP, GDP per capita, GDP growth, and a domestic crisis dummy. The global factors comprise the
Chicago Board Options Exchange’s Volatility Index (VIX) as a measure of global financial market uncertainty
and US sovereign bond yields. These variables have been attained from Bloomberg, the IMF International
Financial Statistics, the OECD, and China Economic Database (CEIC). Regarding the climate vulnerability
indicator, data for vulnerability to climate risk are taken from a refined version of the ND-GAIN vulnerability
index developed by Kling et al. (2020). The refined vulnerability measure comprises all of the components
from the ND-GAIN vulnerability index that are not highly related to economic variables in order to mitigate
against endogeneity concerns. Data for climate resilience are from FTSE Russell. This indicator refers to the
extent to which an economy has measures in place to address exposure to climate risks.
For further details on the methodology employed and data used, please refer to the Appendix. In addition, a
technical background paper upon which the analysis is based is available (Beirne, Renzhi, and Volz 2020a).
For country-specific analysis for ASEAN countries see Beirne, Renzhi, and Volz (2020b).

Figure 38: The impact of climate risk vulnerability and climate risk resilience
on the cost of sovereign borrowing

EME = emerging economies.

Note: The y-axis refers to the climate risk coefficients from the estimation of the panel model on sovereign
bond yields, expressed in basis points.
Source: Authors’ estimations.

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 Climate Risk and Sovereign Bond Yields

Across all countries as a whole, controlling for domestic and global factors, it is clear that vulnerability
and resilience to climate risks have significant effects on sovereign bond yields. Increases in
vulnerability and lower resilience to climate risks lead to rises in bond yields. As shown in Figure 38,
the premium on sovereign bond yields from rising climate risk vulnerability is highest for the high-risk
group at 275 basis points, compared to 155 basis points for ASEAN and 113 basis points for other
EMEs. The effect of vulnerability on bond yields for developed economies is not statistically
significant. As regards climate risk resilience, the magnitude of the effect on bond yields is
substantially lower than that of climate risk vulnerability, with higher resilience associated with
declines in bond yields by fewer than 10 basis points across all country groups.
The results are striking in two main ways. First, it is apparent that vulnerability to climate risk matters
substantially more for the cost of sovereign borrowing than resilience to climate risk. In other words,
exposure to the direct effects of climate change remains key, with a sizable and significant impact on
the cost of sovereign debt for developing and emerging economies. Improving resilience efforts
further may help to combat exposure to these direct effects and hence bring down the cost of
sovereign financing. Second, it is clear that the magnitude of the effect on bond yields is notably
higher for economies that are more exposed to climate risks. In particular, the effect on bond yields
for the high risk group is higher than for EMEs as a whole by a factor of about three, and higher than
for ASEAN by a factor of around two. Our findings therefore suggest that those economies that are
particularly exposed to climate change and have the greatest need for resilience investment face the
highest climate risk premium on their sovereign borrowing costs. Given that a significant share of the
financing of adaptation and vulnerability reduction measures would have to be borne by the public
sector, a higher cost of borrowing could severely hamper these crucial investments. The results from
our empirical analysis are also robust to alternative measures of climate risk vulnerability, namely the
FTSE Russell measures for physical and transition climate risks.
As regard to the results from the impulse response analysis, we find that across the sample of
40 countries, sovereign bond yields respond positively to a positive shock imposed on climate risk
vulnerability, and negatively to a positive shock on resilience, in line with economic intuition. The
shock becomes permanent after around 12 quarters. The direction of the effect of the shocks on
bond yields is consistent across each of our sub-panels. Moreover, and in line with our stage one
analysis, the magnitude of the effect on bond yields is notably larger for economies in the high
risk category.38
For the high-risk economies, the upward effect on yields of the vulnerability shock peaks at around
six quarters, while for ASEAN and other EMEs, the peak is reached at a longer duration of around
15–18 quarters, albeit with lower magnitudes. The upward reaction of developed economy bond
yields also peaks after around six quarters. For shocks to climate risk resilience, the downward
response of yields is most pronounced after around six quarters for EMEs, ASEAN, and the high risk
group, with developed economy bond yields peaking downward much more quickly after around two
quarters. Given that the effect of climate risk vulnerability and resilience to climate risk on sovereign
bond yields is not transitory and does not subside over time, this underscores the importance for
policy makers to ramp up efforts aimed at mitigating the effects of physical climate risks. Without
such action, the negative ramifications for fiscal sustainability and, as a result, economic growth could
be substantial.

38 Please refer to Figure A.1 in the Appendix for further details on the SVAR impulse response results.

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6. What Are the Implications for
Macrofinancial Governance?
From the preceding analysis it should be clear that climate change can have a material impact on
sovereign risk. However, both the analysis of the various transmission channels in Chapter 3 and the
illustration of these risk channels for the countries of Southeast Asia in Chapter 4 have shown the
complexity of the nexus between climate change and sovereign risk. Just as it is impossible to capture
these medium- to long-term risks adequately in a handful of indicators or develop a comprehensive
model that will reliably forecast sovereign risk, there are no easy policy fixes. Appropriate public
policy responses will have to comprise a broad range of measures to minimize macrofinancial risk,
while at the same time building capacities to better manage risk and developing contingency plans.
Efforts have to involve all parts of government, including monetary and financial authorities.
The five areas in which climate-related financial risks should be addressed in a coordinated
manner are:
1. conduct a comprehensive vulnerability assessment and develop a national adaptation plan;
2. mainstream climate risk analysis in public financial management;
3. adjust monetary and prudential frameworks to account for climate risks;
4. implement financial sector policies to scale-up investment in climate adaptation and
resilience and develop insurance solutions; and
5. provide international support to mitigate and manage climate-related sovereign risk.

6.1 Conduct a comprehensive vulnerability assessment and develop

a national adaptation plan
The starting point ought to be a comprehensive vulnerability assessment, where all sources of
vulnerability for the macroeconomy, the financial system, and public finances are systematically
assessed and possible actions are considered. A vulnerability assessment should comprise a scenario
analysis of climate and socioeconomic change and address both physical and transition risks.
Importantly, it needs to consider short-term and long-term risks, including those usually beyond the
horizon of policy makers. Such an assessment could be conducted by a dedicated national climate risk
board that should include the central bank and supervisor along with key government departments
responsible for finance, economy, planning, agriculture, among others. It should also seek input from
science and civil society. The vulnerability assessment should form the basis for a number of
subsequent, coordinated actions aimed at mitigating and managing climate-related sovereign risks.
Vulnerability to climate change is defined by the IPCC as “[t]he degree to which a system is
susceptible to, or unable to cope with, adverse effects of climate change, including climate variability
and extremes. Vulnerability is a function of the character, magnitude, and rate of climate variation to
which a system is exposed, its sensitivity, and its adaptive capacity.” (McCarthy et al. 2001, 995).
Vulnerability is dynamic and depends on adaptation strategies taken in response to the exposure. A
vulnerability assessment shall help to recognize the degree to which a system is subject to potential
risks, the likely impacts, and how capably it can cope with these. A vulnerability assessment needs to
identify the major macrofinancial risks discussed in Chapter 3, their likelihood under different
scenarios, and the priority with which they should be dealt. Vulnerability assessments ought to be a
continuous process that will get refined over time as methodologies and data availability improve.
Indeed, trying to improve the availability and accuracy of various climate vulnerability indicators
needs to be a key component of the vulnerability assessment process. Based on an assessment of the

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 What Are the Implications for Macrofinancial Governance?

level of exposure to the various risks, it needs to consider possible responses that will help to
minimize or avoid risk. These will form an adaptation strategy.
Many countries have already established a national climate change commission or committee on
climate change policy that has developed or is working toward a national adaptation plan (NAP). The
NAP process was established by the United Nations Framework Convention on Climate Change
(UNFCCC) under the Cancun Adaptation Framework to feed into nationally determined contribution
(NDC) adaptation goals. NAPs are meant “as a means of identifying medium- and long-term
adaptation needs and developing and implementing strategies and programmes to address those
needs” (UNFCCC 2020b). Adaptation processes are continuous, progressive, and iterative (Figure 39).
The bodies developing NAPs usually include finance ministries, given the fiscal implications, but in
most cases central banks and supervisors are not involved as climate change was until recently
considered to be outside their remit. However, it is crucial that monetary and financial authorities
contribute to the development of NAPs to make sure that macrofinancial risks are properly accounted
for in vulnerability assessments and also that appropriate strategies to reduce and manage
macrofinancial risks are adequately included in the NAPs.

Figure 39: Adaptation cycle under the United Nations climate change regime

Source: Compiled by authors based on UNFCCC (2020a).

6.2 Mainstream climate risk analysis in public financial management

Climate change requires extending time horizons in public administration. To this end, it is of
crucial importance that financial planning extends beyond the annual budgeting cycle, and that
administrations consider the potential impacts of climate change on the medium- to long-term quality
and sustainability of public finances. To mitigate climate-related sovereign risks, climate risks need to
be considered at all levels of public financial management.

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Climate Change and Sovereign Risk

Vulnerability assessments should feed into macroeconomic impact analysis and forecasting, which are
an integral part of the annual budget process. However, it is important that the analysis and the
budget planning goes beyond the short term and includes also medium- and long-term risks to the
budget, so that potential risks on both the expenditure and revenue side are identified. As in the
vulnerability assessment, both physical and transition risks should be considered. Moreover, finance
ministries need to enhance transparency, develop their budgetary instruments, enhance public sector
funding and debt management strategies, and diversify government revenue streams away from
high-risk sectors.
Disclose and analyze climate risks
As part of its recommendations for fiscal risk analysis and management, the IMF’s (2019b, 3) Fiscal
Transparency Code recommends that “governments should disclose, analyze, and manage risks to the
public finances and ensure effective coordination of fiscal decision-making across the public sector”.
Among the specific risks to public finances that “should be regularly monitored, disclosed, and
managed”, the IMF lists “the volume and value of major natural resource assets under different price
and extraction scenarios”, as well as “the main fiscal risks from natural disasters” (IMF 2019b, 14–15).
Regarding the former, it will be important to include stranded asset risk facing resource rich
countries. More broadly, all of the risk channels discussed earlier need to be considered.
The IMF recommends the systematic incorporation of natural disaster risks into the budget process
with a medium-term perspective (Cevik and Huang 2018). It also recommends the analysis of disaster
risks in the context of a fiscal risk statement as part of the Medium-Term Fiscal Framework (Cevik and
Huang 2018).39 The IMF’s Fiscal Transparency Code also recommends that governments regularly
publish “multiple scenarios for the sustainability of the main fiscal aggregates and any health and
social security funds over at least the next 30 years using a range of macroeconomic, demographic,
natural resource, or other assumptions” as part of a Long-term Fiscal Sustainability Analysis (IMF
2019b, 13). Going forward, all major climate risks should become a central part of such a long-term
fiscal sustainability analysis, which should become standard procedure for all countries. For the time
being, only a few countries conduct meaningful long-term fiscal sustainability analysis, and many
countries lack the capacity and expertise to do so. Hence, it will be important that the IMF and other
international financial institutions contribute to the development of such capacities.
Develop budgetary instruments to account for climate risk
Building on fiscal risk analysis, budget planning should build in fiscal buffers for climate-related risks.
The most commonly used budgetary instruments for ex ante disaster financing are contingency lines
and disaster, reserve or contingency savings funds (Cevik and Huang 2018, Schuler et al. 2019).
Contingent credit lines are offered by international financial institutions to support relief, recovery,
and reconstruction efforts after natural disasters. Contingency savings funds have been created in
countries facing high risk of natural disasters. Countries may also seek insurance and risk transfer
solutions, for example through parametric insurance for weather-related risks or catastrophe
insurance schemes that spread risks across countries.40

39 The World Bank also recommends incorporating forward-looking assessments of future climate shocks into the scenario
analysis that provides the basis of fiscal risks statements (Schuler et al. 2019).
40 Parametric insurance pays a fixed amount when a qualifying event occurs. A prominent example of a multi-country
catastrophe insurance scheme is the Caribbean Catastrophe Risk Insurance Facility. However, a weakness of such regional
schemes is that countries tend to face the same risks, which make it important to broaden risk pools (Schuler et al. 2019).

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 What Are the Implications for Macrofinancial Governance?

Mainstream and integrate climate framework, policies, and laws into national
and sectoral budgets
Going further, long-term budget planning needs to account for the estimated costs of NAPs and
climate policies more broadly, including for mitigation, as laid out in country NDCs. Public financial
management should mainstream and integrate national climate policies and legislation in the
budgetary process (EFI, CPI, and UNDP 2019). In particular, it needs to ensure that spending is
redirected from activities that are not aligned with the national climate finance strategy to activities
that are consistent. Two tools that can support the mainstreaming of climate policies in budgets are
climate budget tagging, where all climate-relevant budget expenditures are marked, and climate
public expenditure and institutional reviews, which are a systematic qualitative and quantitative
assessments of a government’s public expenditures, policies, and institutional frameworks regarding
climate change (EFI, CPI, and UNDP 2019).
Develop public sector funding and debt management strategies
Climate risks should also be integrated in public sector funding and debt management strategies. For
developing countries, international climate finance is an important source of funding for adaptation
and mitigation investment. In countries that are vulnerable to climate hazards or other natural
shocks, governments can issue debt instruments with risk-sharing features that would help them to
better manage risks. For instance, governments can include natural disaster or “hurricane” clauses in
new public debt instruments. These stipulate that capital and/or interest payments are deferred in
the event of a pre-defined disaster. During a debt restructuring in 2015, Grenada was the first country
to pioneer a hurricane clause in its bonds. Barbados has also included a natural disaster clause in
most of its new public debt to increase financial resilience (Anthony, Impavido, and van Selm 2020;
Shutter 2020). Together with the IMF and the World Bank, the International Capital Market
Association, a trade association for participants in the capital markets, has developed indicative terms
and conditions for sovereign hurricane-linked bonds and loans (IMF 2020, ICMA 2020). Disaster
clauses could be promoted as the new standard in sovereign debt. Governments could also issue
GDP-linked bonds (Benford, Ostry, and Shiller 2018), a risk-sharing debt instrument that extends
beyond disaster risks.
Diversify government revenue streams away from high-risk sectors
Last but not least, public finance needs to fund, support, and incentivize investment in adaptation and
resilience that will help to reduce a country’s exposure and vulnerability to climate risks (Forni,
Catalano, and Pezzolla 2019). An important area are public investments in climate-resilient
infrastructure (OECD, World Bank, and UN Environment 2018). Moreover, fiscal policy should help to
advance structural change to diversify the economy out of climate-sensitive activities (Schuler et al.
2019). This is particularly relevant for economies whose prosperity depends to a large extent on fossil
fuels that are likely to be stranded (Cust, Manley, and Cecchinato 2017). Governments also need to
develop effective social safety nets to cushion adverse physical and transition impacts on the
population, especially more vulnerable groups. Governments should also seek to climate-proof public
assets to reduce the direct exposure to possible future losses (Bonen et al. 2016) and lessen the
dependency of their own revenue streams on climate-sensitive activities.

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For the time being, most governments are in early stages of climate-proofing public finances. But
awareness is rising, as shown by the formation of the Coalition of Finance Ministers for Climate
Action, which was launched in April 2019 and which now comprises 52 countries that represent 30%
of global GDP and that are responsible for 16% of global CO2 emissions. In the Helsinki Principles, the
Coalition of Finance Ministers for Climate Action (2019) has committed to “[t]ake climate change into
account in macroeconomic policy, fiscal planning, budgeting, public investment management, and
procurement practices”.41 Likewise, the finance ministries of the Climate Vulnerable Forum—a group
of 48 countries vulnerable to climate change—work together to address climate-related challenges
and mobilize support from the international community.

6.3 Adjust monetary and prudential frameworks to account for climate risks
Central banks and financial supervisors need to play an important role in supporting governments in
analyzing macrofinancial risks arising from climate change. But they also need to address climate-
related risks in their monetary and prudential frameworks and operations. Mainstreaming climate-
financial risk assessment in financial contracts is crucial for aligning finance flows with a pathway
toward low greenhouse gas emissions and climate-resilient development, as stipulated in Article 2.1c
of the Paris Agreement. Financing the global energy transition and low-carbon, sustainable
development requires the mainstreaming of climate-financial risk assessment in financial contracts
and substantial changes in financial governance (UNEP Inquiry 2016; Volz 2017; Battiston, Mandel,
and Monasterolo 2019; Dikau and Volz 2020). Importantly, monetary and financial authorities need to
fully integrate climate risks into their prudential and monetary frameworks.
Central banks and supervisors need to implement a comprehensive agenda for addressing climate-
related risks (Monasterolo and Volz 2020). Such an agenda should include the mandatory disclosure
of climate and other sustainability risks across the financial sector to help with better risk analysis,
require financial institutions to conduct regular climate stress-testing that considers multiple
transition scenarios, and the integration of climate-related financial risks into prudential supervision.
The implementation of prudential instruments that account for climate risks is imperative to minimize
the potential build-up of additional risks in portfolios.
Table 22 shows a toolbox with three broad categories of measures—monetary, prudential, and
other—covering nine types of tools that central banks and supervisors could employ to minimize
climate-related risks for individual financial institutions and the financial system at large and to
support the scaling-up of investment in climate adaptation and mitigation (Dikau, Robins, and Volz
2020). Not all instruments will be adequate for all countries, but a discussion is needed among central
banks and supervisors on how their operational frameworks and policy tools can be adapted to
mitigate climate risks and support a low-carbon transition of the economies they serve.

41 The shared Principles of the Coalition of Finance Ministers for Climate Action were drafted in Helsinki in February 2019.
The six Helsinki Principles are: 1. Align our policies and practices with the Paris Agreement commitments; 2. Share our
experience and expertise with each other in order to provide mutual encouragement and promote collective
understanding of policies and practices for climate action; 3. Work towards measures that result in effective carbon
pricing; 4. Take climate change into account in macroeconomic policy, fiscal planning, budgeting, public investment
management, and procurement practices; 5. Mobilize private sources of climate finance by facilitating investments and
the development of a financial sector which supports climate mitigation and adaptation; and 6. Engage actively in the
domestic preparation and implementation of Nationally Determined Contributions (NDCs) submitted under the Paris
Agreement (Coalition of Finance Ministers for Climate Action 2019).

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Table 22: Toolbox of sustainable monetary policy, prudential, and other measures
for central banks and supervisors
Conventional (sustainability-blind)
calibration Sustainability-enhanced calibration
1. Monetary policy
(1) Collateral • Collateral credit quality is assessed based • Collateral frameworks become carbon-neutral, take
frameworks on conventional methods, perpetuating climate- and other sustainability-related financial risks
exposure to and market mispricing of into account and apply haircuts to account for these
climate risks and carbon bias and risks.
maintaining financing conditions for • Collateral frameworks exclude asset classes that are
industries not aligned with the Paris not aligned with sustainability goals such as the Paris
Agreement. Agreement.
(2) Implement • Standard instruments such as refinancing • Align refinancing operations with sustainability goals
monetary policy: operations and programs are calibrated such as the Paris Agreement.
indirect instruments without sustainability considerations, • Differentiated reserve requirements, risk weights,
(open market leading to a potential carbon bias. accounting for carbon footprint, climate-related
operations, standing financial risk (particularly transition risks), or other
facilities, reserve sustainability factors.
requirements) • Interest rates based on sustainability criteria.
(3) Nonstandard • Asset purchase programs ignore climate- • Asset purchase programs exclude carbon-intensive
instruments and other sustainability-related financial assets.
risks, perpetuating financial markets’ • Direct (short-term) credit to the government to
exposure to climate risks and carbon support sustainable and/or Paris Agreement-aligned
bias. fiscal policies.
• Direct (short-term) credit to the • Purchase of green sovereign bonds.
government to support standard fiscal • Helicopter money conditioned on sustainable and/or
spending. Paris Agreement-aligned spending.
• Helicopter money without conditionality.
(4) Direct credit • Direct controls on interest rates (e.g. • Credit interest rate ceilings for sustainable priority
allocation minimum and maximum interest rates, sectors, asset classes, and firms.
instruments* preferential rates for certain loan • Minimum and/or maximum allocation of credit
categories). through credit ceilings or quotas to restrict and/or
• Credit ceilings (at aggregate level or on promote lending to carbon-intensive and/or
individual banks). sustainable sectors
• Directed lending policies (e.g. • Targeted refinancing lines to promote credit for
preferential central bank refinance sustainable sectors.
facilities to direct credit to priority • Window guidance and/or moral suasion to promote
sectors). lending to sustainable sectors.
• Window guidance and/or moral suasion
to promote priority sectors.
2. Financial stability: Regulation and supervision
(5) Microprudential • Conventional stress testing and/or • Stress testing frameworks that acknowledge climate
instruments excessive delay of climate-stress testing. and other sustainability risks and help firms take into
• No disclosure requirements for climate- account longer-term risks.
related financial risks. • Mandatory disclosure requirements for climate-related
• Standard supervisory review process. financial risks or other sustainability risks.
• Conventional calibration of other Basel III • Supervisory review process that highlights
instruments. management of climate-related financial risks or other
sustainability risks.
• Climate risk-sensitive calibration of other Basel III
instruments, distinguishing between low-carbon and
carbon-intensive and/or high-exposure assets to
create buffers against climate-related losses (e.g.
differential risk-based capital requirements, lower
required stable funding factor for green loans).

continued on next page

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Table 22 continued
Conventional (sustainability-blind)
calibration Sustainability-enhanced calibration
(6) Macroprudential • Conventional system-wide stress testing. • System-wide stress testing that acknowledges and
instruments • Calibration of instruments along the assesses systemic climate-related financial risks.
cyclical dimension without explicit • Cyclical instruments calibrated to account for and
acknowledgment of climate-related mitigate systemic risk implications of climate change
financial risks. and restrain the build-up of risk-taking during the
• Calibration of instruments along the recovery and/or expansion phase (e.g. countercyclical
cross-sectional dimension without and higher capital buffer in order to protect the
explicit acknowledgment of climate- financial sector from periods of excessive carbon-
related financial risks. intensive credit growth, loan-to-value ratios and loan-
to-income ratios to limit the extension of credit by
banks to carbon-intensive industries and investment in
non-sustainable asset classes).
• Cross-sectional instruments calibrated to account for
and mitigate systemic risk implications of climate
change and to mitigate individual institutions’
contribution to systemic risk (e.g. large exposure
restrictions to limit financial institutions’ exposure to
high carbon-intensive assets, capital surcharges for
systemically important financial institutions and
institutions with high exposure to carbon-intensive
assets).
3. Other policies
(7) Further financing • Corporate financing facilities or loan • Corporate financing facilities or loan guarantees
schemes and other guarantees without climate or subject to reduction of CO2 emissions or sustainability
initiatives sustainability conditionality. enhancing activities.
• Financial sector bailouts without climate • Incorporation of sustainability considerations into
or sustainability conditionality. bailout packages in case of partial or full
nationalization of financial institutions.
• Funding sustainable lending and/or investment
schemes by public banks and development finance
institutions (e.g. for renewable energy or retrofitting of
buildings) through refinancing credit lines or purchase
of bonds under asset purchase programs in secondary
market or direct refinancing operations.
• Tailoring of supervisory frameworks for development
banks to enhance their public policy capacity to bear
risk, promote economic transformation.
(8) Management of • Management of central bank portfolios • Disclosure of climate-related financial risks in own
central bank without consideration of climate change portfolios.
portfolios and other sustainability risks. • Adopting sustainable and responsible investment
principles for portfolio management.
(9) Supporting • Sustainable finance roadmaps and/or guidance for
sustainable finance financial institutions.
• Advice and dialogue with other parts of the
government.
• Research and publication of handbooks and resources
(e.g. reference scenarios, risk assessment
methodologies).
• Capacity building programs in sustainable finance for
the financial sector, convening role of central banks.

Note * Direct instruments, which are mostly relevant in the emerging market and developing economy context where
underdeveloped financial markets permit the effective employment of indirect instruments, operate by setting or limiting either
prices or quantities through regulations and may also be used to allocate credit. Furthermore, it is important to note that the
calibration of many central banking and supervisory instruments can have intended or unintended consequences for the allocation
of credit.
Source: Dikau, Robins, and Volz (2020).

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Reconsider the prudential treatment of sovereign exposures in financial regulation

With respect to the prudential treatment of climate-related sovereign risks, it is important to highlight
the relevance of sovereign assets for systemic financial stability. In many countries, a significant share
of banking assets is invested in domestic sovereign debt, and exposures are twice as large when
lending to subnational governments, loans and receivables, and sovereign guarantees are considered
(Jobst and Oura 2020). Sovereign exposures of banks tend to be higher in developing and emerging
economies (Jobst and Oura 2020)—where climate risks tend to be higher too. As previously discussed,
sovereign risk can directly affect financial stability, and a worsening of sovereign risk can lead to a
doom loop between worsening sovereign risk and banking risk, as seen during the euro crisis. It is
therefore important to integrate sovereign risk into macroprudential solvency stress testing (Jobst
and Oura 2020). For the reasons discussed throughout this report, such stress testing needs to
integrate various climate scenarios.
What is more, supervisors need to reconsider the treatment of sovereign exposures. As noted by the
Basel Committee on Banking Supervision, under the current Basel regulatory framework for banks
(Table 23), “[i]n most cases, the existing treatment of sovereign exposures is more favourable than
[of] other asset classes” (BCBS 2017, 18). In particular, the risk-weighted framework allows
supervisors to exert discretion “to apply a preferential risk weight for sovereign exposures
denominated and funded in domestic currency” (BCBS 2017, 18). Moreover, the large exposures
framework exempts banks’ exposures to sovereigns and central banks. Last but not least, no limits or
haircuts are applied to domestic sovereign exposures that are deemed high-quality liquid assets as
part of the liquidity standards. In other words, sovereign debt is in most cases treated as a safe asset,
which in many cases is not a reflection of actual risk.

Table 23: Summary of current regulatory treatment of sovereign exposures

under the Basel regulatory framework
Credit risk: standardized approach
Ratings-based look-up table.
National discretion to apply a preferential default risk weight for sovereign exposures denominated and funded in domestic
currency.
Credit risk: internal ratings-based approach
Exemption of 0.03% probability of default floor for sovereign exposures.
Credit risk: credit risk mitigation framework
National discretion to apply a zero haircut for repo-style sovereign transactions with core market participants.
Revised market risk framework
Standardized approach: national discretion to apply a preferential default risk charge for sovereign exposures denominated
and funded in domestic currency.
Internal models approach: sovereign exposures included in models, including default risk models.
Large exposures framework
Exemption of sovereign exposures.
Leverage ratio framework
Inclusion of sovereign exposures.
Liquidity standards
No limits on amount of domestic sovereign debt eligible as high-quality liquid assets, with no haircuts applied.

Source: BCBS (2017).

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Even in the absence of climate risk, the treatment of sovereign debt as risk free assets is highly
problematic. Climate change is making this even more perilous. The high-level Task Force on Climate-
related Financial Risks, which was established by the Basel Committee on Banking Supervision in
October 2019, should consider how climate-related risks could be adequately reflected in the Basel
framework. Likewise, regulation for the treatment of sovereign exposure for institutional investors
should adequately reflect climate risks.

6.4 Implement financial sector policies to scale-up investment in climate

adaptation and resilience and develop insurance solutions
As discussed, to minimize exposure to climate-related risks and to support the mobilization of private
capital for adaptation and mitigation finance, financial sector activities need to be aligned with
climate goals. Financial authorities need not only to play a role in incorporating climate risks in
prudential and monetary policy, they also need to support the scaling-up of sustainable finance and,
especially in developing economies, the mobilization of domestic resources for financing sustainable
infrastructure and adaptation.
While foreign aid and foreign private capital can be an important source of finance for development,
it is important to acknowledge the limits to the role of foreign capital in financing infrastructure and
the financial vulnerability risks associated with foreign private financial flows (Chen and Volz 2020). It
is also important to make better use of domestic savings in developing and emerging economies,
many of which invest significant amounts of their savings in low-yielding assets in the financial centers
of developed economies. Strengthening domestic resource mobilization is therefore crucial, and
concerted efforts to this effect are need.
Since the emerging market crises of the late 1990s and early 2000s, progress has been made in
developing local currency bond markets (Burger, Warnock, and Cacdac Warnock 2012; Berensmann,
Dafe, and Volz 2015; Dafe, Essers, and Volz 2018). Yet, these are in part still very dependent on
foreign investors. The large-scale withdrawal of international capital from emerging economies’ bond
markets in March 2020 has once again highlighted the vulnerabilities associated with a shallow
domestic investor base and a heavy reliance on international portfolio investors (Hofmann, Shim, and
Shin 2020; Beirne et al. 2020). There clearly is a need to further develop local currency capital
markets with a strong domestic investor base. Monetary and financial authorities can play an
important role in building these markets, and make sure that these can be used for long-term
financing of sustainable infrastructure. They can also support the development of fintech in mobilizing
domestic savings and channeling these into sustainable investments (Chen and Volz 2020; Task Force
on Digital Financing of the Sustainable Development Goals 2020).
Monetary and financial authorities can play a supportive role in developing insurance markets. The
need for governments to provide support for recovery and reconstruction will be greater if large parts
of the economy lack insurance. Greater insurance coverage will enhance the financial resilience of
households and businesses. As pointed out by Mechler (2014, 185), awareness has been growing that
“there is a need for more holistically tackling commercial insurance as part of disaster risk
management in order to address some of the primary barriers and gaps: inadequate insurance
infrastructure, limited risk awareness, lack of solid risk management techniques, lack of insurance
regulation and disaster laws, and a scarcity of solid information on losses as well as risks.” In the
absence of significant public intervention, market-based insurance mechanisms are unlikely to meet
the aspirations of loss reduction and equitable compensation as set out in the Warsaw International
Mechanism for Loss and Damage (Linnerooth-Bayer et al. 2019). Financial authorities can help build
the infrastructure for insurance services and make them affordable to poorer clients. This will help
recovery when disasters strike—and take a burden off public finances. Financial authorities can also
provide an enabling environment for fintech based insurance solutions. It should be emphasized,
however, that not all risks can be insured.

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6.5 Provide international support to mitigate and manage climate-related

sovereign risk
International financial institutions—including the IMF, multilateral development banks, and regional
financing arrangements—have a special role to play in supporting member countries to address
climate-related sovereign risks and strengthen adaptive capacity and macrofinancial resilience.
Support is needed in technical assistance and training, surveillance and risk monitoring, financing
adaptation and resilience, the development of insurance solutions, emergency lending and crisis
support, and the development of an international debt resolution mechanism.
Technical assistance and training
International financial institutions, along with other international bodies and development agencies,
can help develop approaches for the various policy responses discussed in this chapter, and support
their implementation through technical assistance and training. To this end, the IMF and others need
to strengthen their own capacity in analyzing the macrofinancial risks of climate change and lead
by example in developing best practices for integrating climate risks in all aspects of their own
operations. The IMF, in particular, could support its member countries’ financial and monetary
authorities, where needed, in developing capacity to better assess climate risks, e.g. via climate stress
testing to inform the design of prudential policies, and in mainstreaming climate risk analysis in public
financial management. The IMF and others could also provide support to member countries in
strengthening public debt management to enable them to better account for climate risks in public
budgets. Importantly, governments should be supported in developing contingency plans and
securing pre-arranged contingent financing facilities from different sources, as well as insurance-
based solutions.
Surveillance and risk monitoring
Conducting assessments of macrofinancial risk is at the core of the IMF’s work. In its surveillance and
monitoring operations, which are carried out at the global, regional, and country levels, the IMF seeks
to identify potential risks to macroeconomic and financial stability and puts forward policy
adjustments that should support economic growth, promote financial and economic stability, and
prevent the buildup of financial risks. At the country level, surveillance centers around the annual
Article IV consultations. The IMF has only recently started to address climate change in some of its
Article IV consultations with its member countries (Volz 2020a). Since the early 2010s, when climate
change was still virtually absent from Article IV consultations, a small number of Article IV reports
each year included substantial references to climate change. A large increase was recorded in 2019.
However, in the vast majority of Article IV consultations, climate change and climate-related
macroeconomic and fiscal risks still play no role. The IMF needs to make climate risk a core part of its
surveillance and monitoring operations, and a mandatory component of all Article IV consultations.
Moreover, the IMF could add a mandatory section on climate-related financial risks to the Financial
Sector Assessment Program assessments it conducts together with the World Bank. Likewise, the
joint World Bank–IMF Debt Sustainability Framework for Low-Income Countries could be enhanced by
an analysis of the impact of climate-related risks on debt sustainability. The IMF should also include
climate risk in its stress testing exercises (Adrian, Morsink, and Schumacher 2020).

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Financing adaptation and resilience and developing insurance solutions

International financial institutions need to ramp up support to climate-vulnerable countries. A rapid
scaling-up of investment in climate resilience is a matter of urgency for the most climate vulnerable
countries, which are also those struggling the most to finance adaptation and resilience. As shown in
Chapter 5, the governments of climate vulnerable countries are already facing a climate risk premium
on the cost of capital. To avoid a vicious circle in which greater climate vulnerability raises the cost of
debt and diminishes fiscal space for investment in climate resilience, climate-vulnerable developing
countries will need more external support for investment in climate resilience, mostly in the form of
grants instead of loans. Moreover, international financial institutions and other development agencies
should continue to support climate vulnerable developing countries through initiatives such as the
InsuResilience Global Partnership for Climate and Disaster Risk Finance and Insurance in developing
insurance and risk transfer solutions (Jarzabkowski et al. 2019).
Emergency lending and crisis support
The IMF and regional financing arrangements should consider how to develop their emergency
financing facilities for supporting member countries facing balance of payment difficulties or needing
temporary financing because of a climate-related, adverse shock to their economy. For the IMF, one
option is to raise access under the Rapid Credit Facility and a Rapid Financing Instrument, the two IMF
facilities meant for catastrophe situations including climate disasters. Moreover, options should be
explored to converting these facilities into grants, particularly for low-income countries eligible to
concessional financial support through the Poverty Reduction and Growth Trust. A further option
would be to establish an entirely new climate disaster emergency facility. The IMF could also explore
ways to link a climate disaster facility to an issuance of special drawing rights, which could then
benefit only countries hit by climate disasters. Multilateral development banks as well as national
development banks can also assume an important role by providing countercyclical emergency
support in times of distress.
Develop an international debt resolution mechanism
Last but not least, a discussion is needed around the treatment of climate debt, i.e. public debt that
has been incurred as a direct result of climate disasters or necessary adaptation measures (Volz
2020b). Such a discussion should consider options for adding natural disaster clauses to sovereign
debt contracts, developing instruments such as GDP-linked bonds, and developing a new framework
for dealing with climate debt, including a sovereign debt restructuring mechanism and debt-for-
climate swaps (Akhtar et al. 2020).

6.6 Summary
A multitude of actions is needed to climate proof the economies and public finances of countries
vulnerable to climate change. Importantly, these actions need to be coordinated. Monetary and
financial authorities will have to play a key role, working with other parts of the government and with
international organizations in safeguarding macrofinancial stability and the sustainability of public
finances. Table 24 provides an overview over the actions discussed in this chapter.

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Table 24: Overview of policies to mitigate and manage climate-related sovereign risk
1. Conduct a comprehensive vulnerability Systematic assessment of all sources of vulnerability for the
assessment and develop a national adaptation macroeconomy, the financial system, and public finances
plan Scenario analysis of climatic and socioeconomic change, addressing
both physical and transition risks
2. Mainstream climate risk analysis in public Disclose and analyze climate risks
financial management Develop budgetary instruments to account for climate risk
Mainstream and integrate climate framework, policies, and laws into
national and sectoral budgets
Develop public sector funding and debt management strategies,
including debt instruments with risk-sharing features
Diversify government revenue streams away from high-risk sectors
3. Adjust monetary and prudential frameworks to Mandatory disclosure of climate and other sustainability risks
account for climate risks Regular climate stress testing of financial institutions
Integrate climate-related financial risks into prudential supervision
Align monetary and prudential measures with climate goals
Reconsider the prudential treatment of sovereign exposures in
financial regulation
4. Implement financial sector policies to scale-up Support the development of local currency bond markets for long-
investment in climate adaptation and resilience term financing of climate-resilient infrastructure
and develop insurance solutions Support the development of insurance markets
5. Provide international support to mitigate and Technical assistance and training
manage climate-related sovereign risk Surveillance and risk monitoring
Financing adaptation and resilience and develop insurance solutions
Emergency lending and crisis support
Develop an international debt resolution mechanism
Source: Compiled by authors.

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7. Summary and Recommendations
Climate change can have a material impact on sovereign risk. Global environmental change is eroding
natural capital and natural services, undermining the foundation of economic prosperity and the
development prospects of countries. In particular, climate change can have direct and indirect effects
on public finances and threaten debt sustainability. This study has identified and scrutinized six
different transmission channels through which climate change can amplify sovereign risk and worsen
a sovereign’s standing: the fiscal impacts of climate-related disasters; the fiscal consequences of
adaptation and mitigation policies; the macroeconomic impacts of climate change; climate-related
risks and financial sector stability; the impacts of climate change on international trade and capital
flows; and the impacts of climate change on political stability.
The nexus between climate change and sovereign risk is complex. The various transmission channels
are not independent from each other. A worsening of climate impacts in one area can magnify the
transmission of risk through other channels. Just as the physical effects of global environmental
change are highly complex, with tipping points and feedback loops, the socioeconomic and fiscal
effects of climate change are multifaceted and depend on the policies taken or not taken to mitigate
and adapt to these risks.
This report has illustrated the relevance of the six transmission channels for sovereign risk in
Southeast Asia, one of the most climate-vulnerable regions of the world. Southeast Asian countries
will not only be exposed to an increase in the frequency and intensity of extreme weather events,
large parts of the region will also suffer from chronic physical impacts such as worsening heat and
water stress and sea level rise, which are expected to significantly impact economic activity. Some
countries, including Myanmar, the Philippines, Viet Nam, Thailand and Cambodia, are heavily exposed
to the physical impacts of climate change and the implications these have for international
commerce, output, employment, and public finances. Others face lower physical risk but are exposed
to high transition risk as their exports and economies will be affected by international climate policies,
technological change, and changing consumption patterns worldwide. Among Southeast Asian
countries, Brunei Darussalam faces the greatest transition risk, given its reliance on fossil fuels
exports. For sure, much more granular analysis of the macrofinancial risk resulting from climate
change is required, but even the high-level analysis for ASEAN countries conducted in this report
shows that the implications of climate change for macrofinancial stability and sovereign risk are likely
to be material for most if not all of them.
The report also presents new empirical evidence on the relationship between climate vulnerability,
resilience, and the sovereign cost of capital. Using a sample of 40 developed and emerging
economies, our econometric analysis shows that climate risks and resilience to these risks have
significant effects on the cost of sovereign borrowing. In particular, higher climate risk vulnerability
leads to significant rises in the cost of sovereign borrowing. Premia on sovereign bond yields amount
to around 275 basis points for economies highly exposed to climate risk, compared to 155 basis
points for ASEAN, and 113 basis points for EMEs overall. In contrast, exposure to climate risk is not
statistically significant for the group of advanced economies. Resilience to climate risk is statistically
significant in reducing bond yields across all country groups, but with smaller magnitudes. Overall, our
analysis confirms that climate vulnerability has significant implications for sovereign borrowing costs,
and that the magnitude of the effect is much larger for countries highly vulnerable to climate change.
Impulse response analysis suggests that shocks imposed on climate vulnerability and resilience have
permanent effects on bond yields, and that economies highly exposed to climate risks experience
larger permanent effects on yields than economies with lower exposure.

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 Summary and Recommendations

All branches of government will have to address climate-related risks. Monetary and financial
authorities will have to play crucial roles in analyzing and mitigating macrofinancial risks. We
recommend five broad policy actions to mitigate and manage climate-related sovereign risk in a
coordinated manner.
First, governments need to conduct a comprehensive vulnerability assessment and develop national
adaptation plans. To address and mitigate climate-related sovereign risk properly, it is important to
understand the ways in which climate change can amplify sovereign risk. To this end, a systematic
assessment of all sources of vulnerability for the macroeconomy, the financial system, and public
finances is needed. Along with vulnerability to climate risks, this assessment should include the
projected change in the country’s risk exposure. This should include scenario analysis of climatic and
socioeconomic change, addressing both physical and transition risks. Such an assessment could be
conducted by a dedicated national climate risk board that should include the central bank and
supervisor along with key the government departments responsible for finance, economy, planning,
agriculture, among others. Regional bodies such as ASEAN can play an important role in facilitating
the exchange of best practice among member countries, as they seek to understand the scale of their
relative climate risk exposure.
Second, and based on the vulnerability assessment, governments need to mainstream climate risk
analysis in public financial management. This should include appropriate analysis, disclosure, and
management of risks to public finances as well as coordination of fiscal decision-making across the
public sector. Furthermore, governments need to develop budgetary instruments to account for
climate risk, and mainstream and integrate climate framework, policies, and laws into national and
sectoral budgets. Finance ministries also need to develop public sector funding and debt
management strategies, including debt instruments with risk-sharing features, and diversify
government revenue streams away from high-risk sectors.
Third, central banks and financial supervisors need not only play an important role in supporting
governments in analyzing macrofinancial risks arising from climate change. They also need to address
climate-related risks in their monetary and prudential frameworks and operations. In particular,
they should make disclosure of climate and other sustainability risks mandatory and conduct
regular climate stress tests of financial institutions, fully integrate climate-related financial risks
into prudential supervision, and align monetary and prudential measures with climate goals.
Mainstreaming climate-financial risk assessment in financial contracts is crucial for aligning finance
flows with a pathway toward low greenhouse gas emissions and climate-resilient development.
Importantly, supervisors should reconsider the prudential treatment of sovereign exposures in
financial regulation.
Fourth, governments and financial authorities should implement financial sector policies to scale-up
investment in climate adaptation and resilience and develop insurance solutions. Especially in
developing economies, financial authorities should seek to facilitate the mobilization of domestic
resources for financing climate-resilient, sustainable infrastructure and other adaptation measures.
For instance, monetary and financial authorities can play an important role in supporting the
development of local currency bond markets for long-term financing of climate-resilient
infrastructure. They can also support the development of fintech in mobilizing domestic savings and
channeling these into sustainable investments. Financial authorities can also help build the
infrastructure for insurance services—including fintech based insurance solutions—and make them
affordable to poorer clients. Developing insurance markets and broadening insurance coverage
can help to enhance the financial resilience of households and businesses and take the burden off
public finances.

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Climate Change and Sovereign Risk

Fifth, international financial institutions—including the IMF, multilateral development banks, and
regional financing arrangements—have a special role to play in supporting vulnerable countries to
address climate-related sovereign risks and strengthen adaptive capacity and macrofinancial
resilience. Building on their respective strengths, they can provide technical assistance and training,
support surveillance and risk monitoring, provide finance for adaptation and resilience investment,
support the development of insurance solutions, and provide emergency lending and crisis support.
For the most climate vulnerable countries, a rapid scaling-up of investment in climate resilience is a
matter of survival. Sadly, those who have the greatest need for investment in adaptation and
resilience are also those who are struggling the most to finance it. As shown in this report, climate
vulnerable developing countries are already facing a climate risk premium on the cost of capital.
There is a risk that these countries enter a vicious circle, in which greater climate vulnerability raises
the cost of debt and diminishes fiscal space for investment in climate resilience. As financial markets
increasingly price climate risks, and global environmental change accelerates, the risk premia of
climate vulnerable countries, already high, are likely to increase further. International support for
increased investments in climate resilience and mechanisms to transfer financial risks is urgently
needed and could help these countries to enter a virtuous circle. Greater resilience investments could
reduce both vulnerability and the cost of debt, providing these countries with extra room to scale up
investments to tackle the climate challenge.
As the COVID-19 crisis is worsening public finances and as debt sustainability is threatened in
countries around the world, it will be even more important for governments to analyze and mitigate
climate-related sovereign risks. The pandemic has hit at a time when we have about a decade left to
achieve a low-carbon transition and bring the world economy onto a 1.5°C trajectory (IPCC 2018). The
next years are the last chance to avoid catastrophic global warming. Regardless, most countries also
face a great urgency in preparing for the effects of climate change that are already underway. The
COVID-19 crisis has revealed the vulnerability of our economies and societies—with dire
consequences for public finances. It is imperative that the various crisis responses aimed at protecting
jobs and boosting a recovery are coupled with longer-term, strategic goals of mitigating climate
change and shoring up climate change adaptation and resilience (Volz 2020b). As much as possible,
economic stimulus and recovery measures should be used to strengthen the resilience of economies
and support a just transition.
In many countries, climate change threatens to undermine the sustainability of public finances.
Governments need to take urgent action to climate-proof their economies and public finances. If they
don’t succeed in this, they will be left helpless in an ever-worsening spiral of climate vulnerability and
unsustainable debt burdens.

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129
Appendix to Chapter 5

Sample of countries
Our analysis comprises 40 developed and emerging economies, as outlined below.

Table A1: List of countries by grouping

Developed Emerging ASEAN High Risk
Australia Argentina Indonesia Indonesia
Belgium Brazil Malaysia India
Denmark Chile Philippines Japan
Finland Columbia Singapore Netherlands
France Czech Republic Thailand Philippines
Germany Hungary Viet Nam Republic of Korea
Greece India Singapore
Ireland Israel Sri Lanka
Italy Mexico Thailand
Japan Nigeria Viet Nam
Netherlands People’s Republic of China
New Zealand Peru
Portugal Poland
Spain Republic of Korea
Sweden Russian Federation
United Kingdom South Africa
United States Sri Lanka

Source: Compiled by authors.

130
 Appendix to Chapter 5

Econometric approach and data

Firstly, we estimate a fixed effects panel model with the following baseline specification:

yi,t = βxi,t-1 + γZi,t-1 + χVIXt-1 + τUSYt-1 + CRISISi,t-1 + δi + εi,t i=1,…,N, t=1,…,T

where yi,t represents the government bond yield; xi,t represents a set of domestic macroeconomic
fundamentals (current account/GDP, GDP per capita, public debt/GDP, fiscal balance/GDP, GDP
growth); Zj denotes our climate vulnerability and resilience indicators; VIX stands for the Chicago
Board Options Exchange (CBOE) Volatility Index, a measure of global risk aversion; USY are US long-
term government bond yields; CRISIS represents the Laeven and Valencia (2018) indicator for the
incidence of a crisis event for each country in the sample; δi are country fixed effects; and εi,t is the
error term. The variables are lagged by one period to mitigate against endogeneity concerns.
Secondly, a structural panel VAR is used to examine the response of sovereign bond yields to shocks
to climate vulnerability and resilience. Crucially, these shocks control for a range of macroeconomic
fundamentals and global factors. The panel SVAR is implemented across the same 40 countries as in
stage one, but over the period from 2007Q1 to 2017Q4 in a balanced set-up. The panel SVAR can be
denoted as follows in its general specification, with structural shocks identified by a recursive
restriction:

𝐴(𝐿)𝛥𝑌D,E = 𝜀D,E

where A(L) is the matrix of lag polynomial; Yi,t refers to the demeaned value of Xt of country i to
accommodate country-specific fixed effects; and εi,t is a vector of structural disturbances. Following
the setting of the previous SVAR model, we take a first-differencing form of Yi,t as ΔYi,t. The ordering of
the variables imposed in the recursive form is the same as the previous SVAR model. The panel VAR
includes two lags selected by the Akaike information criterion (AIC).
Our identification strategy is based on a block recursive restriction (Christiano, Eichenbaum, and
Evans 1999), which results in the following matrix A to fit a just-identified model:

𝑎K,K 0 … 0
⎡𝑎 ⋱ ⋱ ⋮ ⎤
M,K
𝐴=⎢ ⎥
⎢ ⋮ ⋱ ⋱ 0 ⎥
⎣𝑎KK,K … 𝑎KK,KP 𝑎KK,KK ⎦

The ordering of the variables imposed in the recursive form implies that the variables at the top (such
as a1,1) will not be affected by contemporaneous shocks to the lower variables (such as a2,1, a11,1, ...),
while the lower variables will be affected by contemporaneous shocks to the upper variables. Usually,
slower moving variables are better candidates to be ordered before fast-moving variables (Bruno and
Shin 2015). It follows therefore that we place the climate vulnerability variable at the top in the
ordering, which implies that it will only be affected by contemporaneous shock to itself. Following the
vulnerability variable, we place the climate resilience variable second in the ordering, which implies
that resilience will be affected by contemporaneous shocks to vulnerability and itself, but not by
contemporaneous shocks to macroeconomic fundamentals or sovereign bond yields. Importantly, we
put the sovereign yields in last place in the ordering, which is not only based on the assumption that
climate risk will affect bond yields, but also on the consideration of our first-stage empirical results
that imply the macroeconomic fundamentals that are driving bond yields. Last, we place our
macroeconomic fundamentals in the middle of the ordering. The lag selection of the SVAR model is
based on the AIC, which suggests that our model should be with two lags.

131
Appendix to Chapter 5

Baseline empirical results

Table A2: The determinants of sovereign bond yields

(1) (2) (3) (4) (5)
All ADV EME ASEAN HRSK
Climate risk vulnerability and resilience
Vulnerability 0.634*** –0.001 1.134*** 1.549*** 2.753***
(0.150) (0.164) (0.434) (0.328) (0.388)
Resilience –0.067*** –0.084*** –0.070*** –0.057*** –0.057***
(0.009) (0.013) (0.016) (0.015) (0.016)
Domestic factors
Current account/GDP –0.051*** –0.019 –0.127*** –0.0650*** –0.106***
(0.011) (0.015) (0.029) (0.013) (0.015)
GDP per capita -0.748* –9.181*** –0.265 –4.587*** 1.049
(0.385) (0.992) (0.571) (0.868) (0.666)
Public debt/GDP 0.016*** 0.013*** –0.0133* 0.0294*** 0.00991***
(0.001) (0.002) (0.008) (0.005) (0.003)
Fiscal balance/GDP 0.008 -0.014 0.172*** –0.015 –0.023
(0.008) (0.008) (0.035) (0.022) (0.020)
GDP growth –0.180*** –0.142*** –0.242*** –0.042 –0.042*
(0.014) (0.019) (0.027) (0.027) (0.023)
Crisis 0.673*** 1.325*** -0.129 n/a 0.605
(0.203) (0.226) (0.377) (0.743)
Global factors
US bond yield 0.803*** 0.832*** 0.587*** 0.282** 0.861***
(0.052) (0.072) (0.092) (0.129) (0.101)
VIX 0.049*** 0.035*** 0.059*** 0.006 0.038***
(0.005) (0.007) (0.009) (0.010) (0.009)
Constant –14.94** 102.3*** –36.96** –30.90* –142.3***
(7.242) (13.16) (17.67) (17.54) (20.95)
Observations 2,399 1,088 949 362 600
R-squared 0.296 0.430 0.236 0.573 0.411
Number of countries 40 17 17 6 10
Country fixed effects Yes Yes Yes Yes Yes
Time effects No No No No No
Note: Standard are errors in parentheses; *** p<0.01, ** p<0.05, * p<0.1.
Source: Authors’ estimations, for explanations see the technical background paper (Beirne, Rhenzi, and Volz 2020a).

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 Appendix to Chapter 5

Figure A1: Response of sovereign bond yields to climate risk vulnerability

and climate risk resilience shocks
All countries

Developed economies

Emerging economies

ASEAN

High-risk economies

Note: The pink line represents the 95% confidence interval. The blue line represents the impulse response of government bond
yields to shocks.
Source: Authors’ estimations, for explanations see the technical background paper (Beirne, Rhenzi, and Volz 2020a).

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