Sovereigns on thinning ice: debt sustainability, climate impacts and adaptation

Abstract

A fundamental problem for sovereigns enacting climate policies is whether they can manage increasing debts as their economies suffer from adverse climate impacts. We develop stochastic debt sustainability analysis integrating a coupled climate-economy model with debt financing scenario optimisation, and stress test sovereign debt for representative countries globally under the Intergovernmental Panel on Climate Change marker narrative scenarios of climate change. The stress test combines socioeconomic and climate pathways with calibrated aleatory scenario trees of economic, fiscal and financial variables to generate forward-looking debt projections over the century. These projections incorporate climate-induced damages to economic growth, spanning the broad spectrum of impact functions from the literature. Our findings reveal significant risks to sovereign debt sustainability, particularly under high climate damages, that are large from mid-century. Expected costs increase by up to 3 percent of GDP under high climate impact  in a world of regional rivalries, or 0.25 percent under low impact in a middle-of-the-road narrative, with considerable variation between countries. The long-run debts of highly impacted countries are unsustainable. We assess whether adaptation investments or fiscal consolidation can mitigate potential climate-debt crises. Public financing of reactive adaptation is a justified expenditure that breaks even but does not fully restore the debt sustainability of highly impacted high-debt countries. Maintaining public spending while ensuring debt sustainability appears infeasible under climate impacts.

^{The authors thank for their useful comments Ottmar Edenhofer, Niclas Poitiers and Jeromin Zettelmeyer, as well as participants in the Finance Seminars at RFF-CMCC EIEE and research seminars at Bruegel, the University of Rome-Sapienza and Durham University.This paper is part of a project that has received funding from the European Union’s Horizon 2020 research and innovation programme under the Marie Sklodowska-Curie grant agreement No 870245. This study was funded by the European Union – NextGenerationEU, Mission 4, Component 2, in the framework of the GRINS – Growing Resilient, INclusive and Sustainable project (GRINS PE00000018 – CUP CUP C93C22005270001). Partial funding also provided by the Cyprus Academy of Science, Letters and Arts, Nicosia. The views and opinions expressed are solely those of the authors and do not necessarily reflect those of the European Union, nor can the European Union be held responsible for them.}