Do the SDGs Affect Sovereign Bond Spreads? First Evidence

11 January: We study the relation between a country’s performance on the United Nations’ Sustainable Development Goals (SDGs) and its sovereign bond spread. Using a novel country-level SDG measure for a global sample of countries, we find a significantly negative relation between SDG performance and credit default swap (CDS) spreads, while controlling for traditional macroeconomic factors. This effect is stronger for longer maturities, in line with the notion that the SDGs represent long-term objectives. The results are most consistent with perceived default risk driving this relation, rather than investor preferences. In sum, our initial evidence suggests that investing in the SDGs provides governments with financial benefits besides ecological and social welfare.

Climate Change and Fiscal Sustainability: Risks and Opportunities

Both the physical and transition-related impacts of climate change pose substantial macroeconomic risks. Yet, markets still lack credible estimates of how climate change will affect debt sustainability, sovereign creditworthiness, and the public finances of major economies. We present a taxonomy for tracing the physical and transition impacts of climate change through to impacts on sovereign risk. We then apply the taxonomy to the UK’s potential transition to net zero. Meeting internationally agreed climate targets will require an unprecedented structural transformation of the global economy over the next two or three decades. The changing landscape of risks warrants new risk management and hedging strategies to contain climate risk and minimise the impact of asset stranding and asset devaluation. Yet, conditional on action being taken early, the opportunities from managing a net zero transition would substantially outweigh the costs.

Climate Change and Sovereign Risk

Ulrich Volz (SOAS Centre of Sustainable Finance; German Development Institute; INSPIRE), John Beirne (Asian Development Bank Institute; INSPIRE) and Emilie Mazzacurati (Four Twenty Seven; INSPIRE) present their INSPIRE supported research with responses from Shamshad Akhtar (Karandaaz Pakistan), Ekhosuehi Iyahen (Insurance Development Forum), Nick Robins (Grantham Research Institute, LSE), Ahmed M. Saeed (Asian Development Bank), and Mark Thomas (World Bank).

Conference on Climate Risk and Sovereign Risk in Southeast Asia

Recent research on the relationship between climate vulnerability, sovereign credit profiles, and the cost of capital in climate-vulnerable developing countries shows that these countries incur a risk premium on their sovereign debt, reducing their fiscal capacity for investments into climate adaptation and resilience. This raises serious questions about the impacts of climate risk on the sustainability of public finances for climate-vulnerable countries whose fiscal health is also threatened by 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.

This workshop will examine the nexus between climate risk and sovereign risk in Southeast Asia, a dynamic that is an increasing focus of rating agencies but has been little studied compared to the macroeconomic impacts of climate change. It will also explore how the climate-sovereign risk nexus may be integrated into the operational frameworks of central banks and supervisors to help them maintain price and financial stability, thus contributing to broader macroeconomic stability.

The workshop will mark the start of a research project co-funded by ADBI, the Climate Works Foundation, and the International Network for Sustainable Financial Policy Insights, Research, and Exchange (INSPIRE). The project is co-organized by ADBI, the SOAS Centre for Sustainable Development, World Wildlife Fund’s Asia Sustainable Finance team, and Four Twenty Seven.

To identify the channels through which climate-related risks affect sovereign risk as well as the scale of the impacts in Southeast Asia.
To examine the monetary policy, regulatory and supervisory implications for financial supervisors and central banks in the region.

Adjusting sovereign credit ratings to reflect climate change

Financial markets face increasing pressure to factor climate risks into decision-making. Enthusiasm for ‘greening the financial system’ is welcome, but a fundamental challenge remains: Investors lack the necessary information. This creates a potential conflict of interest and information asymmetry: Sovereigns want cheap access to capital and have an incentive to downplay climate risk, while investors want to manage climate exposure but do not know how much risk they face. Without a standardised framework and regulatory requirement for disclosing climate risk, organisations face little incentive to provide such information accurately to investors.

Existing climate risk disclosures are rare, ad hoc, voluntary, unregulated, and generally based on internal assessments rather than climate science. Credit ratings agencies are key intermediaries between investors and investment opportunities, serving an important role by rating the creditworthiness of potential investments. They use established and published methods to combine publicly available information with an ‘inside look’ to measure the ability of the issuer to repay its debt obligations. Ultimately, their role is to help reduce information asymmetries, overcome conflicts of interest, and provide investors with standardised information about risk.

We examine how well ratings agencies capture climate risks in ratings. We investigate how well the financial system factors in climate-related risk and makes such information available to investors. First, using historical evidence, we determine whether past ratings have factored in observed climate-related losses. Next, we combine forward-looking climate models with the ratings methodology from a major credit ratings agencies to compare sovereign creditworthiness in a world with climate change, versus a counterfactual world without warming (in which temperatures are held constant at their 1980-2010 average). Finally, we mobilise our extensive network in finance, climate science, and economics to develop a provocative position piece on the state of green finance and future priorities.

Do the UN SDGs affect sovereign bond spreads? Initial evidence

The traditional relationship between sovereign bond spreads and macroeconomic fundamentals appears to be weak since the financial crisis. In search of additional determinants, scholars shifted their attention toward intangible factors related to ESG dimensions. Country ESG ratings are used to measure a country’s sustainability level, but often solely provide information about a country’s policy toward these intangible factors. We believe that the SDGs can provide a better measure for sustainability of a country. The strength of the U.N. SDGs is that all goals are interlinked; governments are unable to cherry-pick their favourite goal. Unlike ESG ratings, the SDGs can be seen as a measure of the transition of the country toward full sustainability and are therefore output- and future-oriented. In addition, the SDGs are a direct measure of a government’s pledge to achieve social inclusion and environmental protection by 2030.

We use the dataset of the latest Sustainable Development Report, which includes an overview of countries’ performance on the SDGs to investigate the impact of SDG performance on sovereign bond spreads. We will use a broad range of low- and high-income countries to capture government bonds issued in different currencies. We are interested in the governments that are unprepared will increase the risk of unforeseen future SDG-related government expenses. An increase in government expenditures will negatively impact a government’s budget and its likelihood to repay its debt. Investors may demand to be compensated for this higher perceived country risk, influencing borrowing costs for governments.

Sovereign risk and climate change

We investigate how climate risks impact sovereign credit risk and debt sustainability and assess the implications from a financial regulation and central banking perspective. We address the following two sub-questions:

  • Through which channels can climate-related risks affect sovereign risk and how important are their respective impacts?
  • What are the regulatory and supervisory implications for financial supervisors and central banks?

First, we develop a conceptual framework that characterises the transmission channels between climate risk and sovereign risk, stressing the importance for financial regulators and central banks to integrate these risks into their operational frameworks in achieving their mandated objectives. Second, building on this conceptual work, we assess the climate-sovereign risk nexus for the 10 member countries of the Association of Southeast Asian Nations (ASEAN), a group that includes four NGFS members (Indonesia, Malaysia, Singapore, Thailand).

We find climate change can have a material impact on sovereign risk through direct and indirect effects on public finances. Furthermore, it raises the cost of capital of climate-vulnerable countries and threatens debt sustainability. All branches of government will have to address climate-related risks and must climate-proof their economies and public finances or potentially face an ever-worsening spiral of climate vulnerability and unsustainable debt burdens. Monetary and financial authorities will have to play crucial roles in analysing and mitigating macrofinancial risks. Our research provides insights into policy coordination between the central bank and government in order to optimise public debt management.

Feeling the heat: Climate risks and the cost of sovereign borrowing

This paper empirically examines the link between the cost of sovereign borrowing and climate risk for 40 advanced and emerging economies. We find that vulnerability to the direct effects of climate change matters substantially more for sovereign borrowing costs than climate risk resilience. Moreover, the magnitude of the effect on bond yields is progressively higher for countries deemed highly vulnerable to climate change. Finally, a set of panel structural VAR models indicate that the reaction of bond yields to climate risk shocks become permanent after around 18 quarters, with high risk economies experiencing the largest permanent effects on yields.