sovereign default risk and climate change

by Adham Jaber & Ibrahima Diarra

Introduction

In the context of an accelerating increase in the global temperature (Figure 1) and the frequency of climate-related shocks such as storms (Figure 2), the interest in the economic impact of climate change is growing among investors and policymakers.

By 2040, the global average temperature is expected to reach 1.5 degrees Celsius higher than preindustrial levels, even under low greenhouse gas emissions scenarios1 .

1 / Scientific community considers that green gas emissions is the main driver to the anthropogenic climate change (IPCC 2022)

Beyond this threshold, climate-related shocks will intensify, and the socioeconomic impacts of climate change and adaptation-mitigation costs will grow drastically. These climate change-related consequences will negatively impact public finances in two ways: i. Economic growth will be affected negatively, reducing opportunities for fiscal revenues. ii. Public spending will increase along with government intervention to address climate change’s expected damages.

This is happening while advanced and developing countries are facing an unprecedented increase in their debt-to-GDP ratios. In such a context, climate change will likely worsen governments’ fiscal stance, limiting their ability to borrow to cover their financing needs, especially when it comes to financing adaptation and mitigation efforts.

Methodology

Climate change is the change in the distribution of climate variables such as temperature (Figure 3)2. In the paper, we consider changes in the distribution of temperature deviation from the 30-year moving average as a proxy for climate change. Alternative measures are also considered when assessing the robustness of our results such as temperature deviations from the country-specific and region-specific 1900-1950 mean.

As for sovereign default risk, we use sovereign Credit Default Swaps (CDS) on foreign sovereign debt as a proxy for default risk. We consider sovereign CDS spread at one, three, five, and ten-year maturities. We estimate the effect of temperature deviation on CDS spread using a panel of 76 countries from 1999-2017. The model is estimated using a two-way fixed effect estimator.