Why does climate change matter for government bond investing?

Climate risks impact government debt in two ways: first, investors are aware, and increasingly sensitive, to the effects of economic activity on the environment. They want to encourage climate-friendly activity, and discourage activity that is the opposite. This is a manifestation of the “Greta Thunberg” effect: investors who recognise climate challenges are likely to act and this affects bond prices. Second, climate change creates risks to the fiscal position of a sovereign. There are acute effects from extreme weather conditions that a government may need to finance and there may be chronic effects from the gradual increase in temperature, rising sea levels and the transition to a low carbon economy. At the same time, the green transition may also spur innovation and growth, and these are priced by markets. The interaction between the climate and the economy is two-directional and has many complex channels with increasing evidence that markets price this in.

 
How do you measure climate risk?

There are more questions than answers when it comes to measures of climate risk. One way is to look at the climate risk premia implied by market prices. There are studies that show that government bond yields are prone to respond to temperature change. I am arguing for an approach based on our understanding of climate science and the channels between the climate and economic activity. We can use integrated assessment models of the climate-economy nexus, as pioneered by Nordhaus, and link them to economic fundamentals to generate scenarios. Scenario analysis will not give us definitive answers but it can go a long way to getting rough bounds estimates of the risks.

 
What can be done to manage climate risks to public finance?

First, we need to mainstream climate risk analysis in monitoring fiscal stability, just like central banks have been integrating climate risks in their financial stability work. Fiscal authorities should plan for climate risks in their budgets, perhaps using risk sharing instruments. Second, we need to develop the analytical tools that measure climate risks. Since these risks are global, regional cooperation is needed and European and national institutions mandated with fiscal stability should engage in this cooperation. A network for climate-proofing public finance will bring together EU and member state institutions on this issue. Again, we need to mirror the work of the network on climate and the financial system. Finally, better disclosure is needed, not only on how a country is progressing in meeting its Paris Agreement targets, but also on the climate risks of its debt position.
Stavros’ policy contribution on climate risks for sovereign debt in Europe is forthcoming by Bruegel.

Stavros Zenios is a Non-resident fellow at Bruegel.