Sovereign Debt Default and Climate Risk

TL;DR

This paper analyzes how environmental factors, especially pollution and climate risk, influence sovereign debt default likelihood, bond spreads, and the incentives for climate adaptation in developing countries.

Contribution

It introduces a framework linking climate risk and sovereign default decisions, highlighting limited incentives for climate action and the modest impact of climate risk on bond spreads.

Findings

Climate risk has limited influence on default decisions.

Bond spreads are modestly sensitive to climate vulnerability.

Financial support for climate abatement can promote adaptation actions.

Abstract

We explore the interplay between sovereign debt default/renegotiation and environmental factors (e.g., pollution from land use, natural resource exploitation). Pollution contributes to the likelihood of natural disasters and influences economic growth rates. The country can default on its debt at any time while also deciding whether to invest in pollution abatement. The framework provides insights into the credit spreads of sovereign bonds and explains the observed relationship between bond spread and a country's climate vulnerability. Through calibration for developing and low-income countries, we demonstrate that there is limited incentive for these countries to address climate risk, and the sensitivity of bond spreads to climate vulnerability remains modest. Climate risk does not play a relevant role on the decision to default on sovereign debt. Financial support for climate abatement expenditures can effectively foster climate adaptation actions, instead renegotiation conditional upon pollution abatement does not produce any effect.