The European Central Bank warns that climate related disasters can increase the cost of public debt. In a blog authored by Sofia Anyfantaki, Marianna Blix Grimaldi, Carlos Madeira, Simona Malovana and Giorgos Papadopoulos, the authors stress that climate change has become a significant factor for fiscal policy, debt sustainability and sovereign risk.
Short to medium term effects of climate disasters
The analysis shows that, on average and over long periods, indicators of acute physical climate risk do not have a systematic impact on sovereign borrowing costs. However, the ECB also examines the short to medium term effects of shocks caused by climate related disasters such as floods, storms, droughts and wildfires. These are measured through the total economic damage and their impact on government bond yields.
The study looks at changes in yields from one to five years after a climate shock of average severity. The reaction is immediate and sharper for more severe events, such as droughts, and for more frequent ones, such as storms.
Developing countries experience the strongest and most immediate increases in yields, reflecting their geographical vulnerability and their dependence on agriculture and natural resources.
The authors also examine whether a country’s fiscal position at the time of the shock affects the impact on yields.
Countries with low debt levels tend to experience smaller effects, as their governments have the fiscal space to implement mitigation strategies and absorb economic disruptions.
In the case of floods, highly indebted countries may initially see lower yields due to expectations of external support and emergency financing. As fiscal pressures build, yields rise and remain elevated, signalling higher risk premia.
In low debt countries, short term borrowing needs push yields up, but this increase stabilises after a few years, suggesting that markets trust the government’s ability to absorb the shock without jeopardising debt sustainability.
Storms present a more complex picture. High debt countries face the largest and most persistent increases in yields, peaking at around 0.2 log points in the second year. This corresponds to an increase of roughly 22 per cent, or about 66 basis points for a typical advanced economy with a ten year yield of 3 per cent, and more than 140 basis points for a typical emerging economy with a ten year yield of 6.4 per cent.
Heatwave damage in Europe
The authors note that even advanced economies are not immune to climate shocks. Europe’s 2023 heatwaves, accompanied by widespread wildfires, caused major infrastructure damage, significant agricultural losses and higher emergency spending across several EU member states.
These events illustrate how both sudden and gradual climate shocks can affect sovereign borrowing conditions. Yet systematic cross country evidence on how such risks are priced in global bond markets remains limited.
Policies to mitigate the impact
Effective climate policies can help limit increases in debt servicing costs. The analysis finds that transition risk has a stronger impact on public debt costs in developing countries. Markets appear concerned about the fiscal implications of shifting to a low carbon economy and the potential effects on future tax revenues. Advanced economies show a more muted reaction, likely reflecting their progress in decarbonisation.
For countries facing higher transition risks, the link between carbon emissions and sovereign yields has strengthened since the Paris Agreement. This suggests that investors increasingly recognise transition risk as a key factor in sovereign bond valuations.
Regarding physical risk, the study finds that higher chronic climate risks are not associated with higher sovereign risk. Acute physical risk, however, is partly priced into yields, with the effect depending on the frequency and severity of disasters and on whether the country is advanced or developing.
How climate risk affects sovereign bond prices
The blog provides new evidence on how climate risk influences sovereign bond pricing. It focuses on two types of climate risk: transition risk, measured by carbon emission intensity, and physical risk, classified as chronic or acute. Chronic risk refers to long term climate changes, measured by annual temperature deviations from the 1951 to 1980 average. Acute risk is assessed through the frequency of climate related disasters and their economic and human impacts.