Climate change and sovereign risk

Climate change and sovereign risk

Prepared by Stephan Fahr, Margherita Giuzio, Clementine Mc Sweeny Pourtalet, Martina Spaggiari and Josep Maria Vendrell Simón^[1]

Published as part of the Financial Stability Review, May 2023.

Climate change can have a negative effect on sovereign balance sheets directly (when contingent liabilities materialise) and indirectly (when it has an impact on the real economy and the financial system). Part of this risk is embedded in the analyses of the macroeconomic costs of climate change which show that transition and physical risks can significantly reduce GDP growth and fiscal buffers. This special feature highlights the contingent sovereign risks that stem from an untimely or disorderly transition to a net-zero economy and from more frequent and severe natural catastrophes. It also looks at the positive role that governments can play in reducing climate-related financial risks and incentivising adaptation. If the recent trend of ever-lower emissions across the EU is to be sustained, further public sector investment is essential. In this context, the progress made to strengthen green capital markets has fostered government issuance of green and sustainable bonds to finance the transition. While putting significant resources into adaptation projects can increase countries' resilience to climate change, the economic costs of extreme climate-related events are still set to rise materially in the EU. Only a quarter of disaster losses are currently insured and fiscal support has mitigated related macroeconomic and financial stability risks in the past. Looking ahead, vulnerabilities arising from contingent liabilities may increase in countries with high physical risk and a large insurance protection gap. If these risks rise alongside sovereign debt sustainability concerns, the impact on financial stability could be amplified by feedback loops that see sovereign credit conditions and ratings deteriorate.

Introduction

In advanced economies, climate-related fiscal risks have not been explored as extensively as other climate-related financial stability risks. Much progress has been made in assessing the financial stability impact of climate change in recent years, mainly as it relates to non-financial firms, financial markets and intermediaries.^[2] While fiscal risks have been widely explored for emerging markets and developing economies,^[3] they remain less well examined for sovereigns in advanced economies.

Although climate change could affect sovereign balance sheets directly, many effects are dependent on the materialisation of physical and transition risks. Physical and transition risks can affect sovereign debt sustainability by impacting the public finances directly, in the form of the substantial investments needed for the transition to net zero and for adaptation as well as the higher fiscal costs incurred following disasters (Figure C.1). In addition, while climate policies such as carbon pricing might increase public revenues, the public finances might be affected indirectly through lower tax revenues as and when risks materialise in the real economy.^[4] Higher disaster losses and reconstruction costs for companies imply lower fiscal revenues in areas affected by physical risk. At the same time, governments will face calls for subsidies, social adjustments and compensation packages. Sovereigns may also face contingent liabilities through the financial sector, especially on account of credit losses and explicit or implicit sovereign guarantees, or also through gaps in insurance coverage that governments might be asked to cover. Taken together, these factors can affect a sovereign's credit quality and debt financing rates.

Governments can help to reduce these risks by fostering the transition to a low-carbon economy and encouraging adaptation.^[5] In the past, fiscal support has mitigated some climate-related financial stability risks, especially following large natural disasters. As such risks are expected to intensify, the vulnerabilities arising from contingent liabilities may increase, particularly in countries that are exposed to high levels of transition and physical risk and that have a large insurance protection gap. The following sections analyse how the public sector could reduce climate risk and foster private investment in adaptation measures and in the transition to net zero.

Financing the transition to a net-zero economy

The EU has set targets and designed policies to reduce greenhouse gas emissions by 55% by 2030 and become climate-neutral by 2050. The Fit for 55 package contains a set of policy proposals for achieving this objective. At the same time, the REPowerEU programme complements this with a plan to rapidly reduce dependence on Russian fossil fuels following the Russian invasion of Ukraine. Progress has also been made in strengthening green capital markets, with the European green bond standard designed to foster government issuance of green and sustainable bonds and reduce greenwashing risk. Overall, the EU economy has already reduced emissions by more than 30% compared with 1990 levels, with sectors covered by the EU Emissions Trading System making important contributions, and the share of renewables in the EU energy mix has almost tripled since 1990.^[6] However, the road to net-zero emissions is still long. Energy transition scenarios calibrated by the ECB on the basis of pathways defined by the Network for Greening the Financial System (NGFS) point to the need to reduce the share of fossil fuels in the aggregate EU energy mix from 65% in 2022 to 50% by 2030 to achieve the emission reductions outlined above. The share will need to fall to 31% by 2030 to limit the increase in temperature to no more than 1.5°C by the end of the century (Box A).

Governments have proposed transition plans that imply large-scale public and private investment. The European Commission estimates that the additional green investment needed at EU level by 2030 amounts to €520 billion per year (around 3.7% of 2019 GDP).^[12] The share of total green investment expected to come from the public sector is between 25% and 45%, but there is a considerable uncertainty around this estimate.^[13] A bottom-up analysis, run at firm level and covering around 50% of euro area corporates' total assets, estimates that the overall amount of green investment required will total around 3% of cumulative GDP over the next eight years in the current macroeconomic environment, and will be mainly targeted at the electricity sector (Chart C.1, panel b). Further public investment in the transition across sectors such as transport, water, housing and telecommunications infrastructure may also have a positive impact on medium-term growth and energy security. At the same time, temporary measures to replace Russian natural gas supplies could jeopardise the green transition in the medium term. More than 100 energy contracts have been signed in the EU since January 2022, mainly for the provision of gas and only half of which involve clean energy.^[14] Most of these contracts have long maturities averaging eight years.

The issuance of sovereign green bonds has picked up in the euro area in recent years. Green sovereign bonds increasingly help to fund government investment in projects with environmental objectives (mostly climate change mitigation). So far, clean transport has been the main beneficiary (almost 50%) of investment from green bond issuance by euro area governments, followed by energy efficiency (including green construction) and renewable energy which together represent a third of allocations (Chart C.2, panel b). Public sector participation also fosters the development of private sector green markets by increasing liquidity and by setting frameworks with best practices that promote standards for green bond classifications and their verification. This also helps to minimise the risk of greenwashing.

The efforts made to strengthen green capital markets in the EU have encouraged euro area sovereigns to enter green bond markets.^[15] While the market is expanding rapidly, it still only accounts for less than 1.5% of all euro area government debt (Chart C.2, panel a). Performance-linked bonds with a less restrictive use of proceeds and whose payout depends on verifiable reductions in overall greenhouse gas emissions - such as sustainability-linked bonds^[16] - could attract more investors, while also being more conducive to long-term policy commitments.

The non-bank financial intermediation sector is the main holder of euro area sovereign green bonds. Financial institutions are by far the main investors (over 90%), with households and non-financial corporations at the other end of the scale. The share of institutional investors with a long-term perspective, such as insurance corporations and pension funds, is almost 50% (Chart C.3, panel a). Many of these investors have incorporated ESG considerations into their mandates and asset allocation strategies, but are probably also attracted by the normally longer maturity of sovereign green bonds (given the longer horizon of green projects) that matches their buy-and-hold strategies. At the same time, participation rates for investment funds are substantially lower than in the corporate green bond market.

Early issuances of euro area sovereign green bonds benefited from the existence of a greenium.^[17] Similar to the green corporate bond segment^[18], euro area sovereigns have until recently been able to finance green projects using green bonds at a cheaper rate (averaging -3.5 basis points lower) than if they had issued an equivalent regular bond (with similar maturity and the same credit risk) (Chart C.3, panel b).^[19] The imbalance between supply and demand in the green bond market is the most likely factor behind the existence of a greenium. In recent months, this greenium has shrunk, which might reflect a better supply-demand balance but could also point towards worsening liquidity conditions in euro area sovereign bond markets (Chapter 2 and Special Feature A). While the disappearance of the greenium implies higher returns for investors, it also means that it has become more expensive for sovereigns to finance green projects.

Contingent liabilities and risk-reduction and adaptation policies

Governments can themselves face the risk of having to step in to cover some of the costs of climate risk. Public investments aimed at fostering the green transition may be characterised by a fiscal multiplier which is able to enhance economic growth while having a positive effect on the public finances. At the same time, higher costs following disasters, as well as greater investment (or the lack thereof) in adaptation and risk mitigation, can have direct fiscal implications.^[20] In particular, climate risks could have a gradual, negative impact on the conditions surrounding public finance as a result of lower tax revenues, higher public debt and the reallocation of funds from other investments. They could also trigger explicit and implicit contingent liabilities - which are potential costs that materialise if catastrophes occur - that may exceed previously allocated funds and thus suddenly hit public finances. Although the exact fiscal implications are difficult to predict, they could clearly weigh on debt sustainability and borrowing costs.

Contingent liabilities may be a significant source of risk for sovereigns, should the net-zero transition be untimely or disorderly.^[21] Historical evidence shows that the largest fiscal costs relate to financial sector claims and public bailouts of state-owned enterprises stemming from implicit commitments. This is especially the case in sectors of the economy that are relevant for the transition, such as utilities, transport and manufacturing. In addition, sovereign contingent liabilities tend to materialise in waves and can be exacerbated by drops in GDP growth.

As climate change advances, the explicit and implicit contingent liabilities from physical risk could increase as well. Historically, the fiscal costs of natural disasters have been less severe than financial sector claims (Chart C.4, panel a), but the frequency and severity of extreme weather events is on the rise.^[22] Explicit costs, such as damage to infrastructure and property, and implicit liabilities, such as guarantees for private investments and the financial sector, can become increasingly significant. In addition, this fiscal pressure may come in periods of lower growth and tax revenues, as capital is typically absorbed by reconstruction activities. A recent analysis by the European Commission, which simulates the fiscal shocks of natural disasters in 13 EU countries, projects debt-to-GDP ratios to be on average 2.3 and 2.7 percentage points higher by 2032 in 1.5°C and 2°C global warming scenarios respectively.^[23] This highlights the need for fiscal authorities to reflect contingent liabilities related to physical risk in their debt sustainability analysis.^[24]

In this context, insurance can mitigate the fiscal costs associated with disasters, yet only 25% of disaster losses are insured (Chart C.4, panel b). Fiscal support measures have mitigated macroeconomic and financial stability risks related to natural disasters in the past, as governments have typically funded some of the recovery and reconstruction activities.^[25] But expectations of such unconditional government support can create moral hazard and lower the incentives for households and firms to adapt and reduce their vulnerability to climate-related catastrophe risks. A large insurance protection gap can therefore increase the vulnerabilities arising from contingent liabilities in countries with high physical risk, amplifying the direct impact of disasters on debt sustainability and potentially having a negative effect on sovereign creditworthiness.^[26] Climate-related events are also likely to have varying effects on the fiscal stability of European countries, as economies differ significantly in their climate risk exposures, vulnerabilities and resilience.

This emphasises the need for enhanced catastrophe risk management tools and risk-sharing mechanisms that can complement private insurance and increase resilience, at both national and EU level. As climate-related risks are unlikely to be sufficiently insured by the private sector, targeted fiscal buffers, natural disaster funds, catastrophe bonds and investments in risk reduction and adaptation can help tackle uninsured losses from disasters. In addition, fostering stronger cooperation with the private (re)insurance sector through public-private partnerships could direct a greater share of financial assets towards climate resilience. Finally, an EU-wide scheme for catastrophe insurance could help further reduce the losses from less frequent and large-scale disasters by exploiting the risk-pooling benefits across EU countries, while incentivising and promoting adaptation.^[27]

As climate risks can materially affect public finances, credit ratings globally seem to reflect some climate-related variables at country level, especially after the Paris Agreement.^[28] Higher temperature anomalies and more frequent natural disasters are associated with lower ratings for advanced, emerging and developing economies. Countries that are more resilient to extreme weather events consistently tend to have higher ratings. But transition risk factors, such as carbon emissions and energy consumption, do not appear to be reflected in ratings. And even when statistically significant, climate variables play a marginal role in influencing credit ratings.

For financial stability, it is important for rating agencies to incorporate all relevant climate-related variables into their credit risk assessments. This would reduce the risk of abrupt repricing and allow investors, financial institutions such as banks and insurers, and central banks to reflect sovereign climate-related risks adequately and consistently in the risk weights used for prudential and risk management purposes. In addition, following its strategy review, the ECB is exploring the extent to which climate considerations are included in credit ratings.^[29]

Conclusions and policy implications

Climate change can be a significant source of risk for sovereigns through contingent liabilities and through its impact on the real economy and the financial system. Beyond the sizeable investments associated with the transition to net zero and the costs of adaptation, higher disaster losses and reconstruction costs imply lower tax revenues from companies in areas affected by physical risk, while governments will face calls for subsidies, social adjustments and compensation. In addition, if climate-related financial risks rise together with sovereign debt sustainability concerns, the impact may be amplified by feedback loops that see credit conditions and ratings deteriorate.

The public sector can adopt policies and investments to increase countries' resilience to these risks and incentivise risk reduction and adaptation. The available evidence suggests that green investments should increase further if the EU emissions-reduction target is to be met by 2030. The ECB's recent economy-wide stress test shows that the corporate sector needs an overall amount of green investment totalling around 3% of cumulative GDP over the next eight years. The progress made to strengthen green capital markets, such as the European green bond standard, has fostered government issuance of green and sustainable bonds by reducing greenwashing risk to some extent and reinforcing flows of funding that support the transition. Governments also face the risk of having to step in to cover the costs of climate-related catastrophes materialising. In this context, a recent ECB-EIOPA Discussion Paper sets out possible actions to tackle the insurance protection gap and mitigate catastrophe risks from climate change in the EU. These include enhanced disaster risk management tools for the public sector and risk-sharing mechanisms that can enhance resilience at both national and EU level, such as public-private partnerships and an EU scheme for natural disaster insurance.^[30]

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