A Climate Risk Assessment of Sovereign Bonds
44 Pages Posted: 7 May 2019 Last revised: 24 Mar 2020
Date Written: May 8, 2019
A disorderly low-carbon transition could bring new sources of risk for financial stability for countries that are lagging behind in decarbonizing their economy. In this paper, we quantitatively assess the impact of forward-looking climate transition scenarios aligned with the Paris Agreement’s climate targets, on government bond yields and spreads, after controlling for conventional country-specific and global determinants of sovereign risk. We use non-monetary policy data on OECD countries’ sovereign bonds that compose the Austrian National Bank’s portfolio. As a main innovation on traditional financial pricing models, our approach allows to embed the deep uncertainty, non-linearity and endogeneity of climate risk in the performance of financial contracts and investors’ portfolios. We find that countries where low-carbon sectors play a large role in the economy have lower bond yields and spreads relative to countries where fossil fuels still play a large (direct or indirect) role. In carbon intensive countries, the cost of climate misalignment could be reflected in a higher Climate Spread and affect sovereign risk and investors’ portfolio performance, with potential implications on financial stability. We conclude with a discussion of the implications for prudential regulation and financial supervision.
Keywords: Climate transition risk, financial pricing models, deep uncertainty, sovereign bonds, climate spread, prudential regulation
JEL Classification: G01, G11, G32, G33
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